A financial institution is seen as any institution that provides financial services to its members by acting as an intermediary in most cases. There are a variety of financial institutions depending on the type of services each offers to its customers. Some offer general services while others specialize in certain services. Some of the commonly known financial institutions include the deposit-taking institutions which take and manage the clients’ deposits and also provide loan services. These are institutions like the banks, credit unions and mortgage loans among others (Reserve Bank of Australia para 2). The other category of financial institutions is the insurance and pension funds; they provide various types of insurance cover and other benefits. Brokers and investment funds are also another category of financial institutions which invests money received from the members in areas like the money market or mortgages.
The financial crisis in 2008 was a global crisis that started showing its effects in the middle of 2007 and worsened in 2008. The crisis was so severe that it affected the global financial systems. This was seen in the fall of global stock markets and even the collapse of renowned financial institutions (Shah para 4). The reason this became even more severe is that these institutions are the ones known to provide a solution in times of financial crisis but this time they were the major cause of the crisis.
Role of Financial Institutions in the Crisis
The real cause of the crisis originated from the real estate and subprime lending crisis. This is where deposit-taking institutions, mostly the banks, decided to use some of their financial instruments like securitization after observing an increase in real estate since the 1990s. This led to these institutions making a mistake by lowering their lending standards to market mortgages where they allowed even those who were not qualified to take mortgage loans. This was accompanied by the government deregulation which brought together investment banks and those who offered mortgage loans. To make the matter worse, financial institutions like the banks borrowed from other sources in order to benefit more securitization after investing more in it. In addition, some banks that did not run mortgage services previously got into it in order to benefit like the others with the hope that this was not going to be any risky as the prices of houses were increasing at a high rate.
As a result, loans that were taken to cater for real estate were spread in the form of CDOs with an aim of scattering the risks in the financial system. This did not turn out as expected since the moment the home values fell by more than 80 percent and as a result; the owners of these homes were unable to raise enough finances to undertake their mortgage loans. This caused a lot of harm to banks since most of them had stopped depending on savings from their clients since they could easily get money from other banks and invest it on securities. When these securities came down, they had no other option as they were forced to undertake write offs and write downs on most of these products. This is particularly because these banks had initially been very insensitive by participating in risky lending where they gave loans to anyone so long as they would securitize them (Smith and Skinner 87). The problem that this crisis brought was so intense that even banks that initially owned huge capital were now in it. As a result, most financial institutions were forced to raise their own capital after things went sour but since some could not make it, they went bankrupt. The government therefore, had to assist them through giving them new capital to prevent them from going out of business.
Those who would have prevented the mortgage loaners from deepening in this crisis are the credit ratings agencies. However, they misled them by rating their securities way off higher the mark. By ranking these securities at the rate of AAA, the investment financial institutions were guaranteed that the debts they offered to their clients would be paid without failure and at the appropriate time. These agencies made an erroneous assumption by using information from historical data and unproved methods of risk diversification. This therefore led to subprime and loans that were of high risks. The conflict of interest in the incentive systems of the credit ratings agencies was another factor that made them make poor quality ratings. Since they earn revenues from the amount of securities they rate, the quality of the rating was not a factor to them so long as they could rate as much as possible. This led investment institutions to engage in a risk that came to affect them in the long run.
The other effect of this crisis was on real estate. The real estate prices went down at consistent rate which led to reduction and even elimination of homeowner equity. As these individuals’ debt maturation drew near, many ended up becoming defaulters as they were unable to pay the huge payments they had incurred which had increased due to interests.
Role of Financial Institutions in the Crisis Recovery
The recovery process from the financial crisis required focusing again on the economic ideology of the time and the contribution of all institutions and individuals. The financial institutions were not left behind in this process of recovery. According to Kidwell and Peterson (70), the deposit-taking institutions like the banks put into use their new policies with an aim of increasing the recovery process. This was after most of them were bailed out by the government. The banks, for instance, increased their interest rates which had been reduced exceedingly previously with an aim of encouraging individuals to participate in the process of economic boom. They also reduced their borrowing tremendously with an aim of first concentrating on repaying the already incurred debts. The large financial institutions also underwent several reforms making the crisis easy to deal with. This included the decision to increase capital and liquidity. This is to ensure that there is a guarantee of long term growth and sustainability that was achieved after the institutions put some restraints on their liberalization within the financial market. With this strategy, these institutions are able to reconsider their incentive structures through prevention of inappropriate competition and lack of transparency.
In order to restore trust in the financial market system, various regulations were also implemented. This was through redesigning their regulations so that they would be efficient in protecting institutions from falling into short term crisis and encouraging long term innovation. This was through simplification of the accounting procedures that enabled financial institutions to understand their financial positions in order to adopt efficient innovations that worked for the betterment of the economy. This was important as individuals had completely lost faith in the financial market which would have been a big blow to the process of economic recovery.
The other policy that was beneficial to the recovery process was the introduction of a bankruptcy code in a country. This was very important as it made it possible to achieve an orderly restructuring of debts. In addition, the decision to make credit access a bit harder during times of recession was a good decision as it increased the trust in financial market besides increasing the institutions’ capital. The financial markets have also increased as result of imposition of regulations that are strict on financial institutions and equity funds. This is because it has increased openness in the financial market. The credit rating agencies which were a major cause of the crisis have also been highly regulated to improve the quality of their rating processes while others have been replaced by a body that is global. With this decision, the financial institutions are assured of perfect rating making them avoid risky loans.
Another solution that the financial institutions provided to counteract this crisis was the negotiation of mortgage terms with an aim of preventing further increase in the number of their foreclosures. This was done with the involvement of both the financial institutions that offered the loans and the individuals who took the loans while the negotiation process was undertaken by the legislative bodies.
The decision by the major financial institutions to give the government a major stake in their decision process was an effective process as it assisted them by increasing their contribution to the recovery process. This is because it motivated the financial institutions that offered lending services to gain grounds and safety in their lending. After the fear that institutions like the banks had experienced after losing their capital to counterparts that were unstable, they had become reluctant to the process of lending which was heavily affecting corporations and even individuals who possessed very dependable records of repayment. This was halting the recovery process, thus, the involvement of the government served to restore their confidence in this process which is essential to the economy.
The 2008 financial crisis was a big blow to the nations’ economies especially since the financial institutions that had caused it were the ones that needed help instead of coming up with a solution. This is because the government’s huge inputs in restoration of the financial institutions was viewed as bailing out individual institutions who had put the whole economy into the crisis. However, after they were bailed out, these financial institutions were able come up with policies that finally resolved the financial crisis. Though some of the policies have not yet been fully implemented, for those that have began, their impacts can already be felt as the economy was able to rise again and the progress is still visible.
Kidwell, David S. and Peterson Richard Lewis. Financial institutions, markets, and money, Tenth edition. UK: Dryden Press, 1990. Print.
Reserve Bank of Australia. Main types of financial institutions. 2010. Web.
Shah, Anup. “Global financial crisis.” Global Issues. 2010. Web.
Smith, Adam and Skinner Andrew S. The wealth of nations, Books 4-5. Penguins, 1999. Print.