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STUDENT NAME: Lili Dididze PROGRAMME: BA Business Management

STUDENT NUMBER: st20096781 YEAR: 2017

Module Number: Term: Module Title: Money bank and risk


Instructor: Sotiria Plastira

Assignment Due Date:21.05.2017 Hand in Date:21.05.2017

ASSIGNMENT TITLE: Financial crises and their effect to the economy



I certify that this assignment is a result of my own work and that all sources have been

Signed: l.dididze Date: 21.05.2017


(based on assignment criteria, key skills and where appropriate, reference to professional

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Financial crises and their effect to the economy
Money banking and risk

BA in Business and Management Studies

Cardiff Metropolitan University
Cardiff School of Management, City Unity College

Lili Dididze

Count of word: 3000

Table of Contents

Crisis Agency Theory and Asymmetric Information Analysis 1

The difference ways under which a financial crisis can began.2

Focusing on the 2007-2009 crisis4



This paper is examined firstly, crisis Agency Theory and Asymmetric Information
Analysis. Secondly, the different ways under which a financial crisis could began and
lastly, focusing on the 2007-2009 crisis, housing market, financial institution balance
sheets, the banking system, global financial markets and the failures of major firms in
the financial industry.

Crisis Agency Theory and Asymmetric Information Analysis

The Crisis Agency Theory explains the conflict of interest that may arise say,
between the CEO and other principals and shareholders who are the agents. This
theory deals with resolving problems between the agent and principals over different
goals or risk aversion. This involves a question of trust where one party determines
the work and the other does it. Hence the employer (agent) and employee (principal)
may have different interests and agendas. e. g. an agent may act in his own interests,
where a travel agent will sell expensive thickets to get commission which is not what
the company had in mind.
Whereas, Asymmetric Information Analysis is where, one party in a transaction has
superior information than the other. e. g the seller of an item will know more than
buyer. Asymmetric Information Analysis changes the idea of perfect information in
neo classical economics. Information asymmetry means there will be an in balance of
power in any transaction, from buying an electrical hoover to major market failure,
adverse selection, moral hazard and information monopoly. In our current political
climate the power of misinformation and fake news and media manipulation is all too
familiar. Asymmetric Information Analysis is also used as a diversionary tactic when
making deals where all moral correctiveness is forgotten and it is blatantly used for
the advantage of one party, as they say knowledge is power! One well-known
example is that of the tacklics used by second hand car salesman to sell cars of a
dubious quality .( Lewis, Gregory. 2011)

The difference ways under which a financial crisis can began.

First of all it must be pointed out that a financial crisis does not just happen on its
own but is the result of the economic cycle commonly called boom and bust. These
are alternating phases of economic growth and decline. There is nothing new about
this economic trend which was expected to appear every decade or so prior to World
War 1.
The boom cycle is characterized by period of positive growth where GDP is healthy,
within 2-3% range this is the accompanied by a bull market, rising house prices, wage
growth and low unemployment. This period of prosperity will not end unless it is
allowed overheat. The dangerous occurs when there is too much liquidity in supply
leading to inflation as prices rise an irrational exuberance takes over investors. ( many
of whom have no previous experience in stock market trading and expect immediate
returns). This pushes GDP growth above 4% for 2 or more in a row. Everyone
thinks this will last forever but it wont. This is known as an asset bubble.
But it will bust, resulting in another cycle that was expected to last only 18 months
however, the last financial crisis of 2007 was to result in the cycle of decline being
considerably long lived. This bust cycle is marked by negative GDP growth,
unemployment at 7% or more, the value of investments fall and if this continues for
3 months it is officially called recession. This situation can also be trigged by stock
market crash followed by bear market. The period of bust is known for low supply
and demand as the availability of capital is limited and failure expectations. Whereas
in a boom phase strong consumer demand drives it on. If confidence is high it is
reflected by high price of houses, job security increase supply of goods responding to
demand and creation of new jobs. This is what we traditionally associate with
prosperity. But if demand is more than supply inflation is created because there is too
much money about chasing too few goods. Now investors try to outperform the
market. As confidence declines and the bust cycle starts the stock market has to make
readjustments or even crashes. Investors sell off their stock or buy into safe markets
like bonds, gold or US dollars. No demand leads to arise unemployment and the lack
of spending power by consumers. This is our traditional recession.
In theory the bust cycle should stop on its own as when prices are low investors can
buy again however, as we have seen banks and governments step in to end this cycle
before it runs its natural course by initiating economic and fiscal policies to limit the
damage control or forestall any global melt down. ( Beltratti, A., and R. Stulz 2012)
Every boom and bust cycle is linked in some way, even though there may be
different factors involved. E.g. if we examine the post World War 1 period from 1918
to 1939 to 1945 and beyond to 1950 we can see three periods of boom and bust. In
1918 much of Europe was in ruins, millions of the potential male workforce was dead,
returning troops needed employment, then millions more were to die in flu epidemic
of 1919. European and American industry had to be changed peace time production
and in Germany reparations ended in chronic inflation. In America there was a short
crash 1920-1921 followed by the roaring twenties, this boom ended in 1929 when
the Dustbowl lead to depression, this in turn changed back to a boom period from
1933-1937 thanks to Roosevelts New deal policy. Again there was a short period of
bust between 1938-1939 but due to the armaments required by the Second World War
America enjoyed period of prosperity until 1948. And so it goes on, round and round.
To jump to the beginning of this century between 2000-2001 there was a short
recession in US caused by stock market crash and high interest rates. This was
followed by period of boom until 2007, when derivatives created a housing bubble in
2006. From 2007-9 the bust cycle was marked by a subprime mortgage crisis which
sparked a worldwide financial crisis and the subsequent Great Recession. Since 2009
America has made a recovery thanks to new government policy regarding
reinvestments, banking constraints and quantative easing. However, the situation in
many European countries is not so optimistic and many are still copying with
economic crisis and debts which have stalled the process of regeneration into a boom
Stage One
Initiation of Financial Crises

Deterioration in Asset Price Decline Increase in Interest Increase in

Financial Institutions rates Uncertainty
Balance Sheet

Adverse Selection and

Moral Hazard Problems

Stage Two
Banking Crisis

Economic Activity Banking Crisis Adverse Selection and Economic Activity

Decline Moral Hazard Problems Declines

Stage Tree
Debt Deflation

Economic Activity Decline Adverse Selection and Unanticipated Decline in

Moral Hazard Problems Price Level

Focusing on the 2007-2009 crisis

Most would accept that this began in 2007 as a crisis in the subprime mortgage
market in America and was to develop into a global financial crisis. American bankers
knowingly encouraged borrowing from all levels of society being fully aware that a
large percentage of these borrowers would not be able to sustain repayments and get
in to debt. The collapse of Lehman Brothers in September of 2008 was a result of
excessive speculation and risks taken. This had a global impact, resulting in many
banks across the world needing massive financial bailouts from their perspective
governments to shop a global financial collapse. This caused an economic down turn
resulting in recession and the EU debt crisis. In America, the Dodds Frank Act
allowed the government to regain control over the banks however, by restricting
credit, new business and regeneration is slowed down. In Greece, for example, it was
only in April 2017 that individuals could withdraw 840 Euros from 420 euro a week.
One way that the health of an economy can be measured is by looking at the
housing market and its effect on the economy. This is called Housing Wealth Effect.
This is seen when the impact of raising house values stimulates consumer spending
which indicates high economic growth. However, when house pricing drop (even if it
becomes a buyer market) it reduces customer confidence in spending which leads to
lower economic growth in the country. The wealth effect examines the impact of the
rising value of assets on consumers spending. When house prices rise householders
are confident about spending and borrowing and using credit cards because they have
their house as security, which they can sell if necessary. As an increase in equity is
withdrawn, home owners can take out a bigger mortgage so banks can lend more
money and make more interest from the increase in the price of houses. In turn house
prices rise along with housing equity. When house pricing rise, more bank loans are
made and money borrowed. They see an improvement in their values and feel more
confident to lend.( Becker, B., and T. Milbourn 2011)
On the other hand when house prices fall it follows that there will be decline in
banks lending money and they will see their values lowered.
Banks become depleted when too much money has been put to circulation or lent.
This can result in quantitative control which is a form of credit control to ensure
monetary stability within a country. In America, Janet Yellen who is in charge of the
reserve bank, in March 2017 increased the interest rate from 0.75% to1.0, which
indicates a strengthening economy with near full employment where prices are under
control. This triggers rise in the cost of mortgages (which are up by 16% again), card
loans, credit card debt also the value of savings has increased which is good for
pensioners, and in short it all helps to stimulate spending. However, there are parts of

America and some EU countries which have yet to catch up in terms of economic

External Factors and Market


Political Factors and

unwieldy, fragmented Housing Prices Leverage and
Regulatory structure Consumption
Growth of Securitization
and the originate-tor Housing price High bank and
distribute (OTD) model. Bubble in the consumer leverage and
Financial Innovation U.S. growth in consumption
U. S Monetary Policy
Global economic
Misaligned incentives and
managerial fraud
Success-driven skill
Diversification fallacy

Liquidity Bubble Bursts Risky Lending

Housing price Screening
Liquidity crisis Bubble bursts standards
Financial in shadow become lax and
banking mortgages get

The effect of the financial crisis under residential housing market in America was
catastrophic. From 2006 equity plummeted from 13.4 trillion dollars Q1 to 6.1 trillion
dollars Q1 2009, in all 54% decline. There was a severe slow down in building
projects and houses although there was still in demand for property. In America value
of homes had peaked in 2006 and reached a new law in 2012. The credit crisis
resulting from the bursting of the housing bubble is generally agreed to have lead to
the primary cause of the credit default swap bubble and consequent recession in
America. In short the crisis had enormous impact on home values, mortgage markets,
building contractors, real estate companies and the many spin off businesses around
the home supply retail market. On a personal level millions of people lost their homes
because they could not afford to pay their mortgages and together with arise in an
employment resulted in sharp increase in homelessness. This situation was portrayed
in Will Smiths film The Pursuit of Happiness in 2006. This showed the struggle
experienced by a single father and his son who were evicted and had no place to go.
Even when he does land good job in a brokerage farm affording a house is still out of
rich .( Becker, B., and T. Milbourn 2011)
The effect of the prices on institutional balance sheet has often been dramatically
referred to as causing tectonic damage. The term balance sheet comes from an
accounting equation that holds that assets must always be the equal some of liability
plus equity. So if asset prices fall below the value of debt incurred to buy them, then
the equity must be negative which means the customer or business is insolvent. So,
until they regain in solvency the entity focus on the repayment. ( Barro, Robert J. and
Jos F. Ursa 2009).
Poul Kugmen 2014 said the best working hypostases seems to be that the financial
crises was only one manifestation of a broader problem are excessive debt that was so
called balance sheet secession. This happens when high levels of private sector debt
causes individuals and companies to focus on saving rather than spending, this lack of
investment slows down economic development and can even contribute to its decline.
As a result of this there was swing from a deficit of 200 million dollars in the Q4 2007
to surplus 1.4 trillion in the Q3 2009 and this was still high at 720 billion dollars in
the Q1 in 2014, this all shows that there are huge amounts of cash been saved by the
banking industry. In 2012 Martin Wolf described the financial crisis as a balance
sheet recession because the economy was being driven not by government fiscal
policy but by the private sector. ( Aizenman, Joshua and Yothin Jinjarak 2008).
It would be fair to say that all banking systems were in same way effected by the
crisis. In America the burst of the housing bubble led to a high default rate in the
subprime home mortgages sector. Such risky policy had been encourage by the CRA
(Community Reinvestment Act) which aimed to help low and moderate income
Americans get loans to by houses. These subprime loans were sold onto quasi-
government agencies like Fannie May and Freddy Mac. In retrospect the federal
government deliberately created a moral hazard by stimulating a glut of risky lending.
These mortgage backed securities were sold on as low risk because they were backed
by credit default swap insurance however this system was nether underwritten nor
regulated. The high default rate did incredible damage to some of the words best
known institutions, to name a few Lehmen Brothers, Merrill Lynch, AIG, F. Mac, F.
Mae, HBSO, Royal Bank of Scotland, Bradford and Bingley etc. As the value of
assets drop there was no market or buyers, and securities disappeared so the banks
that were heavily invested here experienced a liquidity prices. The rest is history, the
stock markets dropped and government bailouts were made to stop a complete
collapse .( Laeven, Luc, and Fabian Valencia, 2008 )
In a wide perspective the effect of the crisis on the global financial markets can be
described as ripples running over the systems. As we have seen the large financial
institution did not collapse because of the bailouts by the national governments. But
worldwide stock markets dropped and housing markets suffered an employment rose
and 2008-2012 Great Recession trigged the European Sovereign by debt crisis. In
such uncertain times cross-border bank lending felt sharply. However, banks in
emerging or developing states took the opportunity to expand abroad, whereas banks
in advance nations reduce their presence abroad. In poorer or slowing growing nations
many foreign and local banks disappeared. It can be said that crisis prompted
structural transformation within the global financial market but there is no real pattern
as some globally acting banks withdraw from foreign activity whilst others took the
chance, expanded abroad and increase their market share. In The Economist in an
article called The Origins of the Financial Crisis, welcomed the new regulatory
reforms introduced in the Basel Accord 111, which would try to stop the collective
delusion that lasting prosperity can be built on ever bigger piles debt. This measure is
a global, voluntary regulatory network. It is supposed to check the banks capital
adequacy, encourage stress tensing and the chances of market liquidity risk. However
it is only a guideline and does not force the banks to behave properly. ( Borio C and
Drehmann M 2009).
As we have already seen, the effect of the credit crunch due to the American house
market bubble bursting was unprecedented. E. g. Big companies like Freddy Mak
refuse to buy high risk mortgages knowing that defaults would be high as a result
New Century Financial Corp who had lent the money when bankrupt. The ABX Index
which keeps track of the prices of credit default insurance on securities on residential
mortgages warned a high risk of default and this led to large scale withdraws. Many
companies amalgamated to avoid bankruptcy e.g. 2008 mortgage lender Country
Wide Financial was bought out by the bank of America. In March 2008 Bear Stearns
shares dropped drastically from 133.20 dollars per share because of loses in its hedged
fund and other businesses. J.P. Morgan Chase offered Bear Stearn just 2 dollars per
share but later settled for 10 dollars per share when the Federal Reserve steps in with
financial help. Another victim was Indy Mac the largest mortgages lender in America
when it collapsed it was taken over by the federal government, next Funny Mai and
Freddy Mack who owned about 5.1 trillion dollars in US mortgages were in such
financial trouble that the government took them over in September 2008. It is
generally accepted that final straw was when Leman Brothers filed for bankruptcy on
September 15th 2008 as they couldnt raise the capital to downgrade securities. On the
same day AIG, prominent insurer of credit defaults was given 85 billion dollars in
government assistance to sort out its liquidity crisis. Another casualty was
Washington Mutual whose assets were transferred to GP Morgan Chase. ( Bernanke
BS 2005),

To sum up by October 2008 the crisis had effected European financial institutions
and was spreading around the globe by med October the US treasury had put 250
billion dollars to save the major banks. Institutions which had seemed untouchable
proved to be as vulnerable as the corner shop to unregulated market forces. The
financial crisis of 2007-2009 still reverberates today and many European countries
and their citizens are struggling to readjust and recover.
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