Introduction
The 2007-2008 financial crisis resulted from improper use of the available economic instruments. In the United States, the crisis began after implementing unfavorable lending requirements and the readjustment of house piecing. While the financial overseers had good intentions, the nation faced multiple organizational accounting misconducts followed by the September 11 terrorist attack. Following these critical issues, the Federal Reserve decreased the federal fund’s interest rate from 6.5% to 1% between May 2000 and June 2003 (Sigh, 2022). Their primary intention was to boost the economy by making cash available to many consumers at affordable rates. However, their measures triggered and significant rise in home prices since consumers took advantage of the economical mortgage charges (Salter, 2021). Thus, the resulting outcome would later impact the banking sector.
Notably, all borrowers across different financial capacities could purchase homes irrespective of their credit history. The Wall Street banks bought the loans from the banks, then structured them into what they marketed as low-risk financial products, such as collateralized debt obligations (CDOs) and mortgage-backed securities. Subprime loan origination and distribution soon saw the growth of a sizable secondary market. Fueling greater risk-taking among banks, the Securities and Exchange Commission (SEC) in mid-October 2004 relaxed the net capital requirements for five investment banks, namely, Merrill Lynch (NYSE: MER), Goldman Sachs (NYSE: GS), Bear Stearns, Morgan Stanley (NYSE: MS) and Lehman Brothers. That allowed these banks to leverage their startup investments by about 30 to 40 times (Sigh, 2022). The existing financial conditions would later affect the operations of giant banks.
Homeownership finally hit its critical threshold as interest rates began to increase. The Federal Funds Rate was 5.25% two years after the Fed started hiking in June 2004, and it stayed there until August 2007. Early indications of difficulty were present. Homeownership in the US reached a peak of 69.2% in 2004 (Salter, 2021). After that, property values began to decline in early 2006. For many Americans, this was challenging. The value of their properties was lower than their original purchasing price. They owed money to their creditors. Thus they were unable to sell their homes. If any consumer had an adjustable-rate mortgage, their expenses increased as the value of their properties decreased. The most disadvantaged subprime debtors were forced to stay in mortgages they could never afford. Major subprime creditors after another declared bankruptcy as 2007 kicked off. Over 25 lending institutions failed in February and March. Sub-prime loan specialist New Century Financial, went bankrupt and fired half its staff in April. Bear Stearns halted paying payouts in two of its hedge funds before the end of June, which prompted Merrill Lynch to recover $800 million in assets from the accounts. Even these were minor issues in light of what lay in store for the upcoming months (Sigh, 2021). Therefore, this paper investigates the effect of the 2007-2008 financial crisis on the banking sector globally before and after the crisis.
Before the 2007-2008 Crisis
Globally, banks underwent much change in the years before the Recession. In particular, value-increasing acquisitions and mergers (A&M) agreements made banks bigger, more influential, and riskier by growing their market shares. Structurally, banks improved their strong edge and charter value due to their size, operations complexity, and better profit expectations resulting from bold risk-taking practices. Generally, the charter value hypothesis (CVH) limits bank risk-taking and gives banks a reliable resource of monopolistic power (Bakkar et al., 2020). Therefore, increased charter value is anticipated to reduce risk-taking incentives and boost capital due to the higher bankruptcy costs that failing banks may incur.
The converse will occur if the charter value drops because banks might be enticed to increase their level of risk-taking to take advantage of the put option on deposit insurance. Additionally, before the global economic crisis, banks had profited from deposit protection and comprehensive guarantee, especially for ‘systematically important financial institutions (SIFIs), which gave them a competitive edge enabling them to shift their expansion strategy and operating model. As a result, they take on more risky business practices. Systemic risk has also increased due to imperfect markets and system contagion susceptibility. The rise in bank charter value is a second element that drew less attention before the Global Financial Crisis (GFC) (Sigh, 2022). As a result, the charter value’s disciplinary function during this era of risk accumulation (before the GFC) played a significant role in determining the profitability of risk-averse banks.
The GFC originating from the US created a ripple effect that could be felt globally. In Europe, particularly Denmark, before the worldwide financial crisis in 2007–2008, the country’s economy was expanding quickly, the real estate industry was thriving, and banks significantly increased their loans. Since lending grew much more rapidly than deposits, some banks relied more on the global credit markets to fund their growth through loans with short maturities (Bosworth & Flaaen, 2008). Therefore, consumers borrowed more from financial lenders, and the nation experienced growth n household spending.
After the Global Financial Crisis
As of August 2007, it was clear that the capital markets could not resolve the subprime problem and that its effects extended beyond the boundaries of the United States. Due to widespread anxiety about the future, the global interbank market that guarantees the flow of money shut down. A liquidity issue forced Northern Rock to turn to the Bank of England for financial help. The first big bank to report losses from sub-prime-related operations was the Swiss bank UBS in October 2007, which lost $3.4 billion. The international credit systems, collapsing due to falling asset values, would receive billions of dollars in credit from the Federal Reserve and other central banks in the upcoming months (Claessens & Horen, 2014). Therefore, banking institutions were having trouble determining the value of the hazardous mortgage-backed assets worth billions of dollars that were still listed on their records.
The US economy spiraled into Recession by the 2008 winter season, characterized by liquidity struggles from critical financial institutions. The unstable stock markets and the September terrorist attack fueled the current crisis. In response, the Federal Reserve reduced its rates by three-quarters in January 2008. In 2008 the summer financial trouble hit the global financial sector, especially banking businesses. IndyMac Bank was among the large financial institutions vastly affected in the US. Furthermore, the Federal government seized the nation’s prominent home lenders, Freddie Mac, and Fannie. The fall of Lehman Brothers, a Wall Street bank, became a significant bankruptcy caused by the international economic crisis. Congress, the White House, the Fed, and the Treasury department struggled to devise a comprehensive plan to restore the nation’s financial stability. However, their intervention measures did not resolve the challenge immediately (Khan, 2018); more banks and accredited lenders filed for bankruptcy.
A bank failure in America did not cause depositors to lose money: By revealing this, the research can disclose the approximate number of bank failures resulting from the financial crisis can be disclosed. According to Cleveland’s Federal Reserve, over 500 banks collapsed between 2008 and 2015, as opposed to a maximum of 25 in the prior seven years. Most were modest regional banks bought out by larger ones along with their depositors’ accounts (Sigh, 2022). Thus, the economic crisis impacted all players in the banking sector, irrespective of their market share.
Notably, in Europe, while most Danish banks had minimal access to the US mortgage-backed instruments that set off the financial crisis, some had critically low liquidity when the world’s wholesale financial markets declined. Hence, between May 2008 and September, the central bank made repeated interventions to help the banking industry with liquidity. In October 2008, after Lehman Brothers failed, the state was obligated to offer a two-year unrestricted guarantee to all bank obligations (Khan, 2018). The governing bodies shuttered 15 banks from 2008 to 2011, and several others agreed to mergers to lower failure risks, bringing the total number of licensed banks down from 148 in 2007 to 112 in 2011. This followed, irrespective of the enormous efforts to keep the financial sector afloat. The banking challenges were preceded and worsened by a catastrophic real-financial crisis. Real private consumer power fell by almost 4% from 2007 to 2009, actual GDP by about 5%, real investment by about 18%, accurate house prices by about 20%, and existing stock values by over 40% (Jensen et al., 2017). Therefore, the collapse of central banks could not keep the financial sector afloat despite the government’s interventions.
Until the economic meltdown in 2008, when the credit expansion abruptly ended and consumption fell drastically, it demonstrated a sudden growth in both outcomes. The timing indicates a causal connection: the credit growth ended in the first three months of 2008, and a few months later, consumption began to decline. All through the economic meltdown, among the most significant causes of the banking sector’s fragility was bank financing risk (Merle, 2018). The escalation of this threat was one of the powerful effects of the current debt crisis. Banks have attempted to make up for this by resorting to more solid finances, including retail deposits, specifically in those euro-area nations where accessibility to market finance has been particularly curtailed recently. Many banks have raised deposit rates to entice depositors, which has led to declining, and recently even harmful, deposit margins that have had detrimental effects on bank profitability (Khan, 2018). Therefore, the global financial crisis significantly increased bank financing risk globally.
Similarly, due to the significant easing of monetary policy in late 2008, the euro area’s bank deposit ratios have deteriorated sharply. Bank deposit margins unavoidably contracted as policy rates and, consequently, short-term financial asset market rates got closer to the zero lower bounds (since banks typically set deposit rates slightly below their benchmark market rates to maintain positive deposit margins). The consequent restricted access to market financing, which made many banks contend for the most reliable deposit finance, added to this margin contraction (Bakkar et al., 2020). Moreover, after the crisis, retail and corporate deposit margins have been declining globally since the beginning of 2009, which has hurt banks’ overall net interest earnings and profitability. In addition, these changes have been especially noticeable in the nations of the euro area that were hardest hit by the restrictions on access to market-based financing (such as Portugal, Greece, and Ireland). Until the economic crisis, these nations’ deposit returns were average, more significant than those of the remaining euro-area countries. However, at the end of 2010, they reduced to significantly negative values (Financial Stability Review, 2011); thus. They were contracting their bank deposit margins.
Nevertheless, despite the critical impacts of the 2007-2008 financial crisis, Most of the largest banks in the United States are now more significant than before the financial crisis. Compared to $1.5 trillion in 2007, JPMorgan Chase currently has $2.5 trillion after property valuation. Approximately $2.3 trillion of assets make up Bank of America, up from $1.7 trillion in 2007. Wells Fargo’s holdings are nearly $2 trillion, more than twice what they were before the financial crisis. The S&P 2017 Global Market Intelligence report stated, “If and when another crisis hits, the biggest players will be far larger than they were during the last crash” (Merle, 2018). Therefore, despite the adverse effects of the crisis, more financial institutions have risen and dominated then banking sector.
Moreover, policymakers, such as Minneapolis Federal Reserve President Neel Kashkari in 2018, continued to call for the big banks dismantling. However, his efforts were futile. While discussing laws to restructure the financial sector, lawmakers discussed trying to reduce the number of banks and eventually rejected the plan. Instead, the Dodd-Frank Act, a 2010 economic reform law, gave regulators extensive additional authority to oversee the sector, and the largest banks are subject to the most stringent oversight (Jensen et al., 2017). Therefore, such initiatives global economy from any unforeseen financial challenge.
Many nations’ banking institutions underwent significant ownership changes in several ways between 2007 and 2013. This is no surprise, given that a shock of this magnitude would inevitably impact the worldwide growth and investment choices made by internationally engaged institutions, many of whom are domiciled in crisis-affected nations. However, while some banks cut back on their international operations, either involuntarily or forcibly, others seized the chance to expand internationally or improve their market shares overseas. Numerous data accurately reflect these developments (McKibbin & Soeckel, 2009). At the same time, a few well upcoming and third-world country banks could take advantage of available investment opportunities as several European and American banks consolidated their overseas operations (either forcedly or voluntarily). Hence the increase in the significance of banks from these regions was primarily caused by crisis-affected advanced nation banks. Among them are the acquisitions of Eastern European subsidiaries and Volksbank’s Central by Sberbank of Russia, the disposal of HSBC’s operations in Honduras, El Salvador, and Costa Rica to Banco Davivienda of Colombia Santander’s Colombian subsidiaries by Corpbanca of Chile. Banks from developing markets showed a rise in their total assets from about $365 billion to approximately $728 billion (Financial Stability Review, 2011). Hence, while the crisis discouraged key players in the banking industry, it introduced more developing countries’ to the foreign markets banking sectors.
Conclusion
2007 to 2008 global economic crisis that started in the US crippled worldwide economy. The banking sector was among the most hit sectors during the period. Banks were forced to consider mergers and acquisitions to recover from the adverse effects. Other huge banks went bankrupt and existed the industry. While governments tried various intervention measures, the crisis effects could not be reverted immediately. As a result, today, most nations are putting up plans that will protect their countries against such risks in future. Nevertheless, the crisis also created opportunities for some large banking institutions which bought off small banks at lower prices. In addition, it allowed developed countries to explore oversea banking by setting up banks in some European and American countries. Therefore, the major economic crisis reshaped the banking sector.
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