ECONOMICS OF COMPETITION

Economics of Competition

Economics of Competition

Recent recession created a disastrous change in global economies. Nearly all sector of the economy affected by the economic crises. This paper examines the factors that lead to banking crisis in recession period.

Roots of Banking Crisis

There were many factors that resulted in escalating the banking crisis situation which emerged in 2007-08. These factors vary in their dimensions; however, had significant impact in worsening the banking crisis situation. This includes low real interest rates, high credit outflow, apparent excess liquidity, sub-prime mortgages, and unreliable assessment of future risks associated with lending in consumer markets (Krugman 2009, 30). Hype in the market made the banks to focus on short-term earnings and an abrupt high-scale change was observed in lending without properly assessing the risk on liquidity position (Stiglitz 2010, 57).

Risk-taking culture is observed in US and UK banks as considerable incline in sub-prime mortgages were observed. Unexpected turn in economy resulted in credit crunch situation as majority of people withdrew their deposit money banks characterized as “bank run” condition. Simultaneously, banking panic situation occur due to lack of trust by people in baking ability to handle liquidity crunch. It signifies the impact of banking strategies developed in early years without assessing the critical risks associated with consumer banking (Cable 2009, 32). A major turnout was observed in consumer financing especially real-estate and automobile. Banks placed more concern on their expected revenues instead of balancing the risks of lending; large sums loans were provided to people having weak credit history mainly for commercial property deals (Rasmus 2010, 51). As a result, increase in banking financial fragility occurred.

Causes of Banking Crisis Ignition

Banking crisis ignited the economic recession in mainly four ways. Banks emphasized on increasing the financial product portfolio with high leverage that was sustainable only if conditions of increasing asset prices and investor confidence were met. Banks indulge heavily in sub-prime mortgages for real-estate industry. This resulted in uncontrolled creation of liquidity that was based on collateralized lending such as securities lending, margin lending etc irrespective of analyzing the counterpart risk. Third cause that underpin the economic recession is the growth of shadow banking sector involving investment banks, hedge funds etc. Offering of complex financial resulted in increased risk due to interdependency of industries such as valuation of real-estate property was essential for liquidity management (McFall 2009, 69). Last factor is the deficiency of public information regarding the distribution of risk in banking system. Inability of banks to properly assess the risk position of the lending and counterparties induced the panic situation in financial markets, thereby banks faced 'bank run' conditions.

Major Investigation and Crisis-Management

IMF survey reported approximate loss of $945 billion in recession period of 2007-08. Changes in real interest rates by Federal Reserve Board created a speculation in real estate market as sub-prime mortgages totalled $600 billion in 2006 (Kawai 2011, 118). Investigation reveals that lack of financial knowledge resulted in variation of returns and risk for financial products offered by ...