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Prof. Hafiz Arslan

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Ansa Khalid W2F17MCOM0001

Mehvish Akram W2F17MCOM0007

Sana Mairaj W2F17MCOM0010

Kainat Toqeer W2F17MCOM0013

Khadija Ansar W2F17MCOM0015

M.com Semester-IV
A global financial crisis is a financial crisis that affects many countries at the same time. It is a
period of severe difficulties which financial institutions, markets, companies, and consumers
experience simultaneously. During a global financial crisis, financial institutions lose faith and
stop lending to each other and traders stop buying financial instruments. Eventually, most
lending stops and businesses suffer significantly.

In most global financial crises, parties to financial contracts in many countries fear that their
counterparties will not honor them.

They also conclude that the financial assets they own will be worth less than they had previously
thought.

Eventually, banks stop lending and demand early settlement of loans and other financial
instruments. Banks also start selling all the financial assets that they can.

According to ft./com/lexicon, the Financial Times’ glossary of terms:

“The result is what is often referred to as “frozen” financial markets, where trading volumes fall
considerably and parties often cannot be induced to trade financial instruments no matter what
prices are offered.”
Financial crisis – features
Financial crises come in many forms. However, they have common elements. The information
below comes from an IMF Working Paper, written by Stijn Claessens and M. Ayhan Kose.

The authors say that at least one the following phenomena are present during a global financial
crisis:

 Credit volumes change significantly.

 Asset prices decline considerably.
 There are serious disruptions in financial intermediation.
 There is a severe disruption in the supply of external financing to many players in the
economy.
 Households, companies, financial intermediaries, and sovereigns experience large scale-
balance sheet problems.
 There is large scale government support, i.e., bailouts.

The authors add:

“As such, financial crises are typically multidimensional events and can be hard to characterize
using a single indicator.”

If a financial crisis spreads, it becomes an economic crisis. An economic crisis occurs when the
whole economy is in trouble, not just the banking and finance sectors.

The 2007/8 global financial crisis

When talking about the financial crisis of 2007/8, people often say the ‘Global Financial Crisis’
or the ‘2008 Financial Crisis.’ It was the worst global crisis since the Wall Street Crash and
the subsequent Great Depression in the 1930s.

The 2007/8 financial crisis was followed by the Great Recession, which lasted until 2012. It was
a period of general economic decline in most countries’ economies and global markets. If there
are two successive quarters of economic contraction, there is a recession.

When a recession lasts a long time it becomes a depression. Depressions last more than three
years and reduce GDP by at least ten percent.

In September 2008, Lehman Brothers, a sprawling global bank, collapsed. This collapse
subsequently brought down the global financial system.

Taxpayers in North America, Europe, and elsewhere spent hundreds of billions of dollars on
bailouts.

Despite the massive financial help, the ensuing credit crunch exacerbated what was already a
severe downturn. In fact, what followed was the worst recession in eighty years.
Even after 2012, when the Global Financial Crisis was over, there was a very weak and fragile
recovery. Workers have had to suffer almost a decade of below-inflation wage increases.

Causes of the 2007/8 global financial crisis

The Economist magazine says that the crisis had multiple causes. The most obvious culprits were
the financiers. Especially those financiers who claimed to have found a way to banish risk. In
fact, what they had done was to lose track of risk.

Regulators and central bankers were also to blame because they were the ones ‘who tolerated
this folly.’

The Economist adds:

“The “Great Moderation”—years of low inflation and stable growth—fostered complacency

and risk-taking. A “savings glut” in Asia pushed down global interest rates.”

“Some research also implicates European banks, which borrowed greedily in American money
markets before the crisis and used the funds to buy dodgy securities. All these factors came
together to foster a surge of debt in what seemed to have become a less risky world.”

What Is a Derivative?

A derivative is a financial security with a value that is reliant upon or derived from, an
underlying asset or group of assets benchmark. The derivative itself is a contract between two or
more parties, and the derivative derives its price from fluctuations in the underlying asset.

Role of Derivatives in Causing the Global Financial Crisis

The previous articles in the module have discussed how the global financial crisis has been
caused due to a combination of factors starting with the collapse of the housing market in the US
and then due to the integration of the global economy rapidly spread to other parts of the world.

An aspect that was touched upon but not discussed in detail is the role of derivatives or the
complex financial instruments used to hedge and guard against risk. In other words, derivatives
are financial instruments that are built on top of other instruments like securities, commodities
and just about everything else.

Derivatives as the name implies are derived from the value of the underlying asset and hence are
used to hedge against a rise or fall in the value of the underlying asset. Indeed, the global market
for derivatives covers just about every asset in the world and there are even derivatives for
hedging against the weather.

Since derivatives essentially are traded on the basis of the value of the underlying asset, any
disproportionate fall in the value of the underlying asset would cause a crash in the derivatives
designed for that purpose. And this is what happened in the summer of 2007 when the housing
market in the US started to go bust. Of course, the clever bankers had devised derivatives for
such an eventuality as well and this was seen as an acceptable way of hedging risk. So, the
obvious question is that if both sides of the risk have been hedged, then there should not have
been a bust in the derivative market. The answer to this is that those investment banks and hedge
funds that had found the right balance between the different hedging instruments survived the
crash whereas the other banks like Lehmann that were highly leveraged because of their
exposure to the subprime securities market collapsed.

Of course, the above explanation is a bit simplistic since the basic problem was that the
securitization of the mortgages was built on top of the plain vanilla mortgages and this coupled
with excessive risk taking by derivative trading resulted in the crash of 2008. The point here is
that except for a few hedge fund traders and investment banks like JP Morgan, many banks
simply were excessively leveraged which meant that the value of their liabilities far exceeded the
value of the “real assets” on their books. So, when the assets went bad, the liabilities mounted
and they were left with toxic derivatives that needed bailouts from the government and write-
downs to solve the problem.
Finally, as we shall discuss in subsequent articles, the absence of regulation played a major part
in causing the crisis as the derivatives were traded in the OTC or the Over the Counter segment
meaning that they were not subject to regulation. This meant that banks could play hard and fast
with the rules and devise their own rules for derivative trading outside of the purview of the
regulators.