The initial response of the United States Federal Reserve was with monetary policy. They started by lowering the federal funds target rate. They also lowered the target rate from 5.25% to 2% in September 2007. And after the bank panic, it was further dropped to approximately 0.25% (Robinson and El Nasser, 2010). The policies the Federal Reserve utilised to reduce the effect of the financial crisis was known as quantitative easing6. QEI was introduced in late 2008, while QEII in introduced late 2009 and a
subsequent operation twist7 was introduced in 2011. The operation twist policy
required obtaining significantly huge quantities of targeted securities such as MBS, agent debt securities (enabling financial agencies to be able to back the mortgage market), commercial paper, money market, mutual fund securities, and medium and longer term treasury bonds. The total Federal Reserve assets skyrocketed from $0.91
6 Quantitative easing refers to a situation whereby Central Banks buy or sell government securities to
banks in order to either expand or contract the money supply and lower short term interest rates.
trillion in of September 2008 to about $2.2trillion on November of 2008. Most of this additional funding was soaked by banks in form of excess reserves, which rose from approximately $2billion in August 2008 to $0.77trillion in December 2008 (Robinson and El Nasser, 2013).
The bank panic created distrust between banks and the public but also among other banks. In Europe, investors had reservations about the financial strength of their counterparts in the interbank market. This forced the money markets’ rate upwards and put pressure on the resolution about the suitable interest rate transmission by the European Central Bank (ECB). Since the interbank market tension began in August of 2007, the ECB provided lots of funds so as to meet the demands of member countries’ banks, while at the same time helping them to improve their liquidity, which would eventually reduce uncertainties about domestic banks’ liquidity situation. The ECB above all else provided overnight loans to banks, assigning about €95billion in August 2007.
The European Central Bank also organised additional refinancing actions with maturation date of about six (6) months, as against the maximum period of three (3) months prior to the crisis. In order to lessen uncertainties about banks’ liquidity position during the early periods, any offers above the preceding programme’s marginal rates were selected in last refinancing programme of that period. Also, provisional swap lines were created in collaboration with other Central Banks in order to moderate the growing pressure on the American funding markets. (Cour-Thimann and Winkler, 2013).
After the Lehman Brothers went bankrupt in September of 2008, a panic arose about the financial positions of major global banks, which led to a severe decline in activities of both the financial sector and economic activities. Prior to the crisis, banks had accumulated great liquidity cushions and to protect themselves from risks associated with balance sheets and lending situations. Given the essential significance of banks in providing finance in the euro region, and the ECB’s monetary policy application, the liquidity problems were disturbing with respect to credit crunch and the dangers of monetary authority’s incompetence in protecting the financial market. The ECB like other major Central Banks around the world decreases vital interest rates to really low levels, however, a key component of the ECB’s solution was to maintain its effectiveness in controlling monetary conditions comprised of non-standard policy recommendations. The objective was to main the preservation of price stability, continue to maintain stability in financial situations, and regulating the fall of the real economy (Cour-Thimann and Winkler, 2013).
3.5.4 Euro Area Sovereign Debt Crisis
The European crisis was an aftermath of the global financial crisis. The GFC of 2007- 08 served as the trigger that debt contagion across Europe eventually causing a sharp decline in growth. As interest rates fell, it gave rise to excess borrowing that left commercial banks in serious debts, and left governments with huge fiscal deficits and high public debts among countries in the region. With a view of meeting liquidity problems that arose from the global financial crisis, the European Union (EU) organised a meeting in Paris in October 2008, to come up with a collective action for the Eurozone and settled on a bank rescue package to increase their funding and secure interbank lending. The effort to manage the crisis was viewed as an essential step to
avoid a situation whereby actions of one-member nation hurts other member nations ability to provide credit and liquidity to their indigenous banks.
Towards the end of 2009, Greece acknowledged that their fiscal deficit was undervalued. They disclosed actual figure of 12.7% of GDP, compared to the 3.7% stated in a previous meeting. In the same vein, Greece’s public debt in 2009 was disclosed to be about 113%, which was above Eurozone threshold of 60%. In the same period, there was lack of confidence by investors resulting from high fiscal deficits and that the sovereign debt was composed of risky insurance and CDS. As at 2010, a sovereign debt crisis had ensued in the euro zone and Greece was the most affected at that point. Subsequently, similar issues had started in Ireland, Portugal and Spain. Despite the fact that the composition of fiscal deficit, public and private debts, as well as conditions for bank lending were substantially unalike across the member countries, their financial sectors operated in identical fashion mostly using CDS premiums (Anand et. al, 2012). In order to reassure investors’ confidence, on May 2 2010, the European Union and International Monetary Fund developed a bailout strategy worth about 110billion Euros for Greece which was dependent on their ability to cut government spending and raise taxes.
The bailout strategy was accompanied by another strategy that was agreed in May of 2010. This strategy was decided by the 27-member nations of the EU, and it was to start an initiative, referred to as European Financial Stability Facility (EFSF). The aim of this initiative was to assist with the preservation of financial stability in the Euro area by offering financial support to member countries in crisis.
The EFSF had authority to trade securities and use these funds acquired to provide loans up to 440billion euros for EU member countries. The securities traded were supported by guarantees provided by the European commission on behalf of the entire European Union, the eurozone member nations, and the IMF. The EFSF added a €60billion worth of loans from the European Financial Stabilisation Mechanism (EFSM) and a 250billion euros loan funded by the IMF in an attempt to have a financial buffer. The arrangement enabled the ECB to procure government debts in form of bonds. In connection with the agreement in May 2010, Greece was able to gather $70billion through the sale of government enterprises to the private sector. Furthermore, in November of 2010, the European Union and IMF agreed to bailout the Ireland with €85billion, while in April of 2011, Portugal declared that they can no longer deal with their financial obligations and sought assistance from the EU. Subsequently, in May of 2011, the finance ministers of member nations approved a 78billion Euros rescue loan to Portugal (Anand et al. 2012).
Another surprising meeting was organised once more in July of 2011 in Brussels. The heads of states agreed on actions to end the spread of the crisis. They concluded that another bailout of 109billion euros would be helpful to for Greece. Therefore, in conjunction with the IMF and contributions from private investors, they were able to raise that money as a way of bridging the financial gap. The EFSF was a key financial agent, while the IMF and ECB undertook regular assessments. The agreement also incorporated extension of the maturity dates of loan repayment and also decrease in interest rates. In a bit to avert the perceived contagion, the heads of states decided to raise the flexibility of the EFSF so as to enable them to give loans to member nations as a precautionary initiative.
The EFSF was given the ability to recapitalise financial institutions by issuing loans to governments even if those countries are not part of the initiative. Furthermore, the EFSF was given the permission to interfere in secondary market activities in order to create an excellent financial markets situation, in case of financial instability circumstances. In order to raise fiscal consolidation and economic growth level within the euro area, the representatives of those countries agreed to continually support implementation of EFSF agenda. The representative also decided to give Portugal and Ireland the kind of package that was provided to Greece such as debt maturation period of 15 years also to reduce interest rate to about 3.5%. They further decided that all the Euro member countries have to strictly observe stipulated fiscal objectives.
Along with dealing with possible macroeconomic fluctuations and crisis, the member states (apart from the ones under the EFSF plan) agreed to decrease their deficits under 3% by 2013. The representatives of the EU member nations also requested that the European Investment Bank (EIB) support the nations seeking financial assistance from the EU and IMF. This happened because the Euro area had a special institutional arrangement in the form of the European Union, and because they cannot dictate the exchange rates, there was tension on employment levels in some of the member countries. This resulted in some member countries attempting to improve those employment burdens with fiscal spillage. The ensuing debt levels had been aggravated by the global financial crisis, which later contributed to the financial instability in the region (Blundell-Wignall, 2012).
In late 2011, the euro banking system gradually became under pressure because of the numerous interactions between the ECB and national banks, which exposed those individual countries to sovereign risks. Therefore, as the price of sovereign bonds reduced, national banks’ balance sheets were also affected. Consequently, investors began to have concerns over the ability of several national banks within the region to meet their financial obligations, and at the same time, concerns arose over the capability of the European Union to support impending crisis. This caused the bond prices of the sovereign organisation to fall even more, affecting not only Greece, Portugal and Ireland but it also put a stress on other economies like France, Belgium and Austria. The national banks’ equity prices decreased by approximately 70% in 2011, and the credit default swaps was more than that of Lehman Brothers. In a lot EU member countries, the funding from the union ceased, and their national bank’s guarantee of bonds was seriously limited (Cour-Thimann and Winkler, 2013).
Therefore, the European Banking Authority came up with further capital boost and increase the Core Tier-1 capital ratio8 to 9%. It was supposed to be a stabilising
programme, but it ended up initiating a necessity for funds in the European banking system of over 100billion euros that had to be raised before 2012. Speculators projected a deleveraging risk of over 1trillion euros, because banks would lessen their weighted risk assets in order to better their equity ratio (Cour-Thimann and Winkler, 2013).
8 Tier 1 Capital ratio is a measure of a bank’s financial strength by regulators such as the Basel
Committee. It is the comparison between banks’ core equity capital and total risk-weighted assets. A core firm’s capital is the sum of their equity capital and disclosed reserves while risk-weighted assets
In an attempt to increase investors’ confidence and to provide an efficient monetary policy system, the European Central Banks started its Securities Markets Programme (SMP) for ensuring that liquidity is available in the sectors that were not functioning properly. With the SMP, economic interventions by the EU can be easily done in both public and private debt securities markets. According to the treaty, involvements in sovereign bonds markets would be solely to secondary markets (Cour-Thimann and Winkler, 2013). Sovereign bonds held by the ECB through the SMP reached 219.3 billion Euros in February 2012 (Kang, 2015aka).
Even though the initial problems that arose from the sub-prime lending were observed first in the USA, the impact on the financial sector mostly felt in Europe, particularly in the United Kingdom and the Euro area, as financial institutions that survived in those areas lost significant amount of money and assets. It was projected that 51% and 70% of the total market capitalisation of the 10 of the biggest banks in Europe as well as insurance companies respectively, were lost at the peak the crisis and led to a subsequent worsening in investor’s confidence. At institutional level, the decrease in market capitalisation ranged between 30 and 96% (SESRIC, 2011).
With regards to the debt levels, the gross government debts in the Euro area reached from 69percent of the total GDP in the starting three months of 2007 to 85.5percent in the last three months of 2010. Also, as at June of 2011, the average government debt of the Euro area was about 87.3percent of the total Euro area GDP. For the case of Greece, government debt as percentage of GDP rose to about 152% in 2011, while the quickest rise in the government debt took place in Ireland where it was 24.8percent of
GDP in March of 2007 but had risen to 102.4percent of GDP June of 2011 (SESRIC, 2011).
As the sovereign debt crisis continued to affect the real economy, several European nations experienced a large unemployment rates, some of which was caused by the austerity measures proscribed by the EU and IMF, which resulting in a large about of workers’ turnover. In 2001, the unemployment numbers for Greece, Ireland and Portugal were 17.1%, 14% and 12.5% respectively in June 2011 (SESRIC, 2011). Spain on the other hand faced the highest unemployment rate with 21.3% in same period. Furthermore. It was observed that countries that had their national currencies pegged to the euro suffered high rates of unemployment when contrasted countries who had floating exchange rate regimes (SESRIC, 2011).
3.5.4.1 Response to the Sovereign Debt Crisis
The European Union is not a federal union and therefore operates under a treaty. The treaty included several agreements and corrective measures for affected member countries. The provision included the prevention of bailouts by national Central Banks; the restriction of special access certain public institutions, governments and financial institutions; nonexistence of bail out clause; and the Stability and Growth Pact (SGP, which is considered to be distinct from the Treaty itself) (Cour-Thimann and Winkler, 2013). The EMU under the Maastricht regime was designed for stability mainly through price stability-oriented monetary policies of ensuring that inflation rate is kept under but around 2% along with comprehensive public finance, i.e., government debt of 60% and budget deficit lower than 3% (or as stated otherwise by the SGP).
According to Anand et al. (2012), the formation of the euro area had a fundamental paradox in that it is a monetary union and not a fiscal union. The establishment of the current currency (The Euro) specifically prevented the European Central Bank or member nations’ Central Banks from funding government deficits. However, one of the methods employed by the EU included raising the minimum amount of bank capitalisation in order to promote stability and their capability to handle shocks. They also created the European Financial Stability Facility (EFSF). This was arm was created in 2010 for the purpose of raising the required funds that the union might need to provide assistance to member countries in distress, and also to buy government debt as well as provide financial assistance to banks. The EFSF is unanimously backed by all the members of the Euro area. Another initiative was also introduced in 2011 called the European Financial Stabilisation Mechanism (EFSM). This initiative was formed to enable the European Commission to acquire needed funds while using the European Union Budget as a security. The EFSM can lend funds in association with the EFSF and the International Monetary Fund.
3.6 LESSONS LEARNT FROM THE DISCUSSED CRISES
There are several similarities between all the crises discussed above such as the dangers of pegging your currency to a particular exchange rate regime, loss of investor’s confidence, inability of banks to carry out their financial obligations, bail out of large corporation among others.
The patterns of the crises are similar to the findings of Lai (2003), who listed some common features that occur during a financial crisis. They include economic peak
before crisis, banking crisis and loss of investors’ confidence, all features which were prevalent in the various crises discussed in previous sections.
Prior to those crises, there were periods of boom or economic expansion. This was the case for the great depression, the Asian crisis and the Global Financial Crisis. Similarly, all the crisis discussed resulted in the failure of both the stock markets and real estate markets and were usually introduced or followed by a banking crisis. This occurred in the case of the Asian crises, Financial crisis and the Euro Area sovereign debt crisis where major banks needed a bail out. Those financial instabilities were also characterised by loss of investors’ confidence which manifested itself as a capital flight.
Despite these similarities between the crises, there were several and significant contrasts between the economic and financial systems of the United States in the 1930s, East Asia before 1997 and that of the USA and Europe prior to 2007. The dissimilarities could be the reason why some policymakers concluded that the kind of crisis that the East Asian countries experienced is not likely in happen in industrialised countries (Hale, 2011).
Firstly, the financial sectors of industrialised countries are a lot more advanced, and the regulations are tougher than that of those Asian countries. The changes in regulations suggested for the Asian countries were intended to make their economic and banking regulations in accordance to that of industrialised nations. For instance, financial analysts suggested that the banks in East Asia align their capital ratios in accordance with the Basel Accord adhered to by industrial countries. In other words,
industrialised countries’ financial sectors were in an improved state in 2007 than the state of the East Asian Financial sector in the boom period prior to the Asian crisis (Hale, 2011).
Another set of distinction can be seen from the perspective of an established financial sector. It can be observed that the United States learnt from the mistakes of the great depression and the fall in Gold standard and were a lot more resistant to shocks because of their strong regulations and complexity. As earlier mentioned, the impact of the Global Financial crisis was felt more in Europe than in the United States of America where the crisis originated. A well-structured and monitored financial systems should be able to perform efficiently with little supervision and more leverage. Then again, as