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Root causes of the recent global financial crisis

The key causes for the recent global financial crisis:

  • Macro –economic policies which have not been thought over completely can be considered as the primary reason. The crisis originated in the United States due to the imbalanced monetary policies for more than a decade. After the stock market growth of 1999-2000, the Federal Reserve cut the interest rates leading to the real estate boom before the crisis. Subsequently the rise in the Federal Funds rate to 5% led to the real estate crash. Along with this the savings too dropped due to the economic imbalances. By the year 2007, the gap between the domestic savings and the investments in the US reached to 5% of GDP in the US in conjunction with the US trade deficit which was excess of USD 700 billion.
  • Another reason is the transformation of the financial system across the globe. In the United States the commercial banks accumulated the profits into their personal incomes. Extraction of the profits from the wages and the salaries, known as financial expropriation is another reason for the crisis. Due to the deregulation which started in 1960s the commercial banks lost the captive liabilities which sustained their operations. Big corporations financed their investments through retained earnings or borrowed from open markets. So the commercial banks had to look for new opportunities of business –real estate loans. Before the recession, the subprime mortgages reached USD 1.75 trillion and were mostly from the labor classes and lower income groups.
  • Commercial banks also adopted the business practices of investment banking and tried to obtain profits through proprietary trading. The real estate crash might not have spread into a global crisis if the commercial banks have not done so. Hence this led to securitization wherein the subprime mortgages were repackaged with large assets and sold as new securities. The subprime mortgage backed securities were part of the portfolios of most of the financial companies across the world. Hence the subprime mortgage holders’ default in US spread rapidly across the globe.
  • The increasing incidence of mergers and acquisitions in the 1980s created the opportunity for securities underwriting. The 401K private pension scheme too led to the investment of the savings of the working class in the open financial markets. The abolition of Glass-Steagall Act enabled the commercial banks to enter the investment banking area and take heavier risks.
  • Due to the heave mortgage backed assets burden the investment and commercial banks could not borrow money from the market due to loss of liquidity leading for many banks to become insolvent. This created a chain effect in turn making liquidity scarcer. This further led to slashing down of exports and rising of the unemployment figures.
  • The recent financial crisis has highlighted the weaknesses of the global regulatory system. The different entities of the financial markets which were supposed to identify and subsequently respond the market trend could not effectively do so thus leading to the crisis. The banking system was having capital insufficiency issues and there was not much accountability in the regulatory bodies. The network of the policy makers in the governments, the central banks and the market regulators has become weak. Hence the crisis has led to a rethinking of the regulatory system.

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