Banking Crisis the Global Financial

Banking Crisis

The global financial crisis began as a banking crisis in the United States and spread quickly throughout the world. A crisis of this proportion does not gestate quickly or easily -- a large number of factors and substantial time are required to create this type of economic mess. Among the lead factors were deregulation of banking sectors around the world, interest rate policy at the Federal Reserve, and the rampant securitization of mortgage debt.

The banking crisis is, at its heart, a credit crisis. Banks no longer have the capability to lend as freely as they once did. As a result, firms and individuals have a more difficult time getting the credit they need for capital investments, operating lines of credit or mortgages. This results in a negative reinforcing cycle of economic contraction. Deregulation of banking sectors in the U.S., Europe and elsewhere allowed banks to hold much more risk, lend out more of their money and lend to riskier borrowers. When the housing bubble burst and mortgage defaults began to accelerate rapidly, this excessive risk resulted in bank failures and near failures.

Interest rate policy at the Federal Reserve was another key antecedent. The dot-com collapse in 2000 led the U.S. Federal Reserve to lower interest rates as a means of increasing the money supply. As a result, U.S. banks were flush with cash to invest. This, combined with lack of oversight, led to increased lending to subprime borrowers, and even competition to attract such borrowers. This increased the risk that banks held. Without the increase in money supply, deregulation alone could not have brought about such catastrophic consequences (Knowledge @ Wharton, 2009).

Lastly, the crisis was spread throughout the world by the securitization of mortgage debt. High-grade mortgages have been securitized for decades by Fannie Mae and Freddie Mac, but during the 2000s mortgage-backed securities became in vogue. These complex instruments were an attempt to diversify away the debt. Financial institutions and national governments around the world latched onto these securities, misled by claims of AAA debt ratings. When the high rate of default caused the value of these mortgage-backed securities to collapse, it created substantial liabilities at financial institutions worldwide, leading to a global banking crisis.

Compounding the situation, when U.S. financial institutions began to fail, all of the assets that they backed became of questionable value (or valueless). This was the primary impact on Australia's banking system. It was estimated that the Big Four were exposed to $412 million at Lehman Brothers, the U.S.-based investment bank that collapsed (Johnston, 2008). Only Westpac, with around $10 million in exposure to Lehman, was spared a heavy hit. These banks had exposure, however, to other U.S. financial institutions, including AIG and Bear Stearns.

Despite these exposures, the Australian banking system fared well, compared with banks in many countries. In October 2008 the World Economic Forum ranked the soundest banking systems in the world, with Australia tied for second just behind Canada (Reuters, 2008). This indicates that the Australian system has sufficient regulatory oversight to keep high-risk obligations to a minimum.

Despite being well-positioned from the outset, Australian banks remain saddled with some toxic assets (worthless MBSs and securities backed by insolvent financial institutions). Moreover, they found themselves at a competitive disadvantage. When foreign banks received government backing, their credit rating improved to the level of government securities. This resulted in a disadvantage to Australian banks. Thus, they petitioned for government assistance in order to remain globally competitive (Grubel & Bathgate, 2008).

The financial crisis of the early 1990s instilled strong risk management principles in Australia's banks, which has led to their insulation. Nevertheless, faced with exposure to bad assets, the banks have been forced to cut costs in order to better weather the storm. It is estimated that the banking sector will shed around 10,000 jobs this year (Insead, 2008). Other cost-cutting measures are also being taken by the banks, as part of improving efficiency in the face of an expected decrease in revenues as the economy slows. Part of this cost-cutting has involved the use of acquisitions in order shore up market share and increase economies of scale (Ibid).

All told, the response of Australian banks to the global financial crisis has been relatively muted. They are not heavily exposed to toxic assets, and did not engage in risky lending of their own. They were forced to take steps to remain competitive on the international scale, and to reduce costs to offset a slowdown in business. However, Australian banks still have access to capital and remain sufficiently liquid to lend it. This means that while it is not business as usual for Australian banks, neither is the situation at the crisis stage. Indeed, Australia has expanded its presence in the international stage with regards to financial industry policy and regulation, joining the Basel Committee and playing a more active role in the Financial Stability Forum (Ellis, 2009).