The Global Financial Crisis

What Happened

In the early 2000s, US banks lent heavily to home buyers, and house prices rose fast. When prices began to fall in 2006-07, many borrowers stopped paying, and banks around the world that had bought those loans made huge losses.

In the UK, savers queued outside Northern Rock in September 2007. A year later, on 15 September 2008, the US investment bank Lehman Brothers went bust. Banks stopped trusting each other and stopped lending. In October 2008 the UK government put billions of pounds into RBS and Lloyds to stop them collapsing. The world economy went into recession in 2009.

Contributing Factors

Sub-Prime Mortgages

Sub-prime mortgage: a home loan to a borrower with a poor credit record or low income, who is more likely than most to default.

US lenders offered these loans with low starting rates, often with little check on income. They then sold them on: thousands of mortgages were bundled into securities and bought by banks worldwide. Once rates reset higher and borrowers defaulted, the losses turned up in banks far from the US, and no one knew exactly which banks held them.

Speculation and Market Bubbles

Speculation: buying an asset mainly because you expect its price to rise, so you can sell it at a profit.

Market bubble: a rise in an asset's price far above what its underlying value can justify, driven by buyers expecting further rises.

Rising house prices made risky lending look safe: if a borrower could not pay, the house could be sold for more than the loan. Banks and buyers kept betting that prices would keep rising. When they fell, the bubble burst: borrowers owed more than their homes were worth, and lenders could not get their money back.

Moral Hazard: Too Big to Fail

Moral hazard: taking more risk because someone else will bear the cost if it goes wrong.

The largest banks were so big, and so linked to the rest of the economy, that governments could not let them collapse. Banks knew this → they expected a rescue if bets went wrong → they took bigger risks for bigger profits, with thin capital to cover losses.

When they failed, much of the cost fell on taxpayers and workers who had no part in the decisions: a negative externality (unit 4.3.2).

Collapse of Lending to Businesses

Credit crunch: a sudden, sharp fall in the amount banks are willing to lend.

Once banks were losing money, they hoarded cash to protect themselves. This turned a banking crisis into a recession:

• Firms: banks cut overdrafts and refused new loans → firms could not fund stock, wages or investment → even profitable businesses cut output, laid off staff or failed.
• The wider economy: less investment and more job losses → lower spending → lower sales for other firms → more loans go bad, and banks cut lending again.

The Role of Organisational Culture

Organisational culture: the shared values and habits that shape how people in a business behave.

In many banks, staff were paid large bonuses for selling loans and making short-term profit, and lost nothing personally when those loans failed later. Warnings from risk managers were often ignored while profits were high. Lenders that sold mortgages on had little reason to check whether borrowers could repay.

The Role of Banking Regulation

Before the crisis, regulation was light. UK supervisors checked each bank on its own, and no one was responsible for spotting a risk building up across the whole system. Banks were allowed to run with little capital and to rely on short-term borrowing from each other, which vanished in 2007-08.

Since the crisis, the UK has changed the rules:

The Bank of England's role in this is in unit 4.5.3. How well regulation works depends on:

• The cost to lending: safer banks hold more capital → they lend less, or charge more → less investment and slower growth.
• Risk moving elsewhere: tighter rules on banks can push lending to less regulated firms, such as investment funds, where the risk is harder to see.
• Moral hazard remains: as long as a bank is too big to fail, it may still count on a rescue. Rules that make shareholders and lenders bear losses first try to change that.

The Impact on Economic Agents and Governments

The crisis reached everyone through the financial sector:

• Households: recession and job losses → lower incomes → some could not repay mortgages and lost their homes. Mortgages became harder to get, especially for first-time buyers.
• Firms: the credit crunch cut their finance while demand was falling → lower sales and profit → investment cut and many businesses failed.
• Workers: firms cut jobs → unemployment rose → those still in work had little bargaining power, so real wages fell for years.
• Savers: the Bank of England cut Bank Rate to 0.5% in March 2009 and began quantitative easing → savings earned almost nothing for a decade.
• Government: bank rescues, a temporary VAT cut to support spending, lower tax revenue and higher spending on benefits → a much bigger budget deficit → more borrowing → spending cuts and tax rises in the years that followed.

The impact was uneven, and depended on:

• Debt or savings: borrowers on variable-rate mortgages gained from low rates. People living on interest from savings lost.
• Assets: low rates and QE pushed up prices of shares and houses, which helped those who already owned them more than those trying to buy.
• The industry: construction, car sales and other industries reliant on credit were hit hardest. Discount retailers gained as shoppers traded down.