The Global Financial System

Table of Contents
Introduction .................................................................................................................................................. 3
Literature Review .......................................................................................................................................... 5
The Global Financial System ..................................................................................................................... 5
The Financial Crisis .................................................................................................................................... 5
The 2007-2008 Global Financial Crisis. ..................................................................................................... 6
How the 2008 Crisis Affected the Global Market ..................................................................................... 7
Aftermath of the 2008 Crisis ..................................................................................................................... 9
Recommendation on Regulation of the Global Financial System............................................................... 11
Conclusion ................................................................................................................................................... 13
References .................................................................................................................................................. 14
Introduction
James & Patomäki, (2007) defined the global financial system as the legalized consensus
of global structure, organizations, and the official and non-official economic elements that
clears the way for the smooth circulation of financial capital which is used for trading and
investing in the global market. Global financial system first came into the scene in the
19th century which also ushered in the creation of central reserve bank systems with
multiparty agreements as well as international bodies whose function was aimed at
achieving the objective of market clarity, market control, and market advantage (James
& Patomäki, 2007). A financial crisis is a situation whereby asset prices experience a
sharp reduction in their overall valuation, business and consumers alike are deep in loans,
and banks experience visible debts. A financial crisis although more likely to be a global
event can also be bound to a single country or an organization (Kindleberger & Aliber,
2005).

Usually, what triggers a financial crisis is when investors sense a drop in the price of their
assets and then withdraw from a financial institution. This often leads to a rapid chain of
selloffs from other investors in other regions developing into a financial crisis. Other
examples which can lead to a financial bubble are, exposing a potential financial crisis,
or stock market failure, or a crash in national currency. Sometimes, a financial crisis is
beyond prevention, because even if careful steps are taken to prevent its occurrence, it
will still happen (Kindleberger & Aliber, 2005). The global financial crisis does not choose
favorites, although when not prepared for it, it can hit more badly in some countries or
organizations than others. Almost all the countries in the world in one way or another
have experienced a financial crisis of some sort. For most European countries, the crisis
often occurs in two stages; the first stage involves a national economic recession
downturn which ultimately grows into a global economic downturn. The second stage is
the out blown global financial crisis (Yurtsever, 2011).

It is important to know that a financial crisis is different from a recession. A recession or

economic slump is “a macroeconomic term that refers to a significant decline in general
economic activity in a designated region” (Singh, 2020). A financial crisis can often take
several expressions such as the fear of a bank going bankrupt, or a crash in the stock
market. These expressions are different from the usual economic slumps which occur
because of a financial crisis. Understanding the different forms a financial crisis can occur
will aid in figuring out a systemic way in handling its effect both in an organizational setting
and on a global view. Therefore, this study aims to look into the occurrence of a global
financial crisis, how it happened, the effects of the crisis on a global scale, and the
solutions taken in countering the effects of the crisis.

This study will also ask the question, how financial crisis can affect the financial system
of an organization operating abroad which will then be used to answer proffer a solution
as to how a company operating abroad can mitigate against a financial crisis when
operating abroad. At the end of this study, it is presumed that the findings and
recommendations provided will help in understanding the key factors to watch out for to
determine if a global crisis is at hand as well as the steps to take in the event of a global
crisis to minimize the effects of the crisis.
Literature Review
The Global Financial System
Following the occurrence of the 2008 financial crisis which crippled the financial system
of most nations globally, the European Union (EU) and other national financial regulation
bodies have sought different ways of building back the financial system and protecting
against any future financial crisis. There have however been challenges to setting up a
global financial system that operates across different countries and across different time
zones. It is believed that the establishment of a global financial system will complicate the
simple duty of controlling organizations that operate in different countries across different
time zones (Schooner & Taylor, 2010). Nevertheless, advancements have been made in
solving the challenges facing a global financial system. According to Dr. Eszter Solt
(2015), tightening the grip on the EU Member States in obeying the financial regulations
that have been set up will go a long way in making the global financial system more stable
and more resistant to a future financial crisis (Solt, 2015).

According to the IMF, the future of the global financial system is firmly on tightening its
grip on global financial stability. However, due to the various national economic policies,
challenges will be faced in establishing a favorable stability for the financial system. One
of the ways central banks are tackling this challenge is by exiting the old policies to give
way to the new financial policies. New economies on the other hand might encounter
greater challenges from the high rate of external investors affecting the market. The new
economies will require to carefully consider their external investors when transitioning to
a new financial system to accommodate for their continuous benefit (International
Monitary Fund (IMF), 2013). The occurrence of the 2008 global financial crisis further
raised the alarm on the need for a stable financial system that can withstand further
financial crises. It is imperative that the financial system be stable in the following areas,
economic incorporation, deficiency in international authority, and the rising possibilities of
the dangers of financial globalization (Wyman, 2010).

The Financial Crisis

The financial crisis isn’t something new to the financial world. Ever since the currency has
been introduced as a means of commodity exchange, there have been several financial
crises recorded in history. A few of these are the Tulip Mania of 1637 which occurred in
the Netherlands during the bubonic plague outbreak (Hayes, 2021). The Credit Crisis of
1772 (Credit crisis or Panic of 1772) occurred in London. A large credit loan taken by an
investor in a large bank led to panic by other investors in the bank and other banks.
Gradually, over 20 other banks in London were affected by this financial crisis. Gradually,
this expanded to other European countries (Sheridan, 2011). Another example is the
Stock Crash of 1929 (Black Tuesday). This is the Great Depression which occurred on a
Tuesday now known as the ”Black Tuesday” where investors traded 16 million shares on
the US stock exchange. This financial crisis lasted for 12 years and it was a global effect.
The depression led to the introduction of several market management and controlling
devices to better handle the crash (Kindleberger & Aliber, 2005).

The next example is the 1973 OPEC Oil Crisis. This crisis started when OPEC members
placed an embargo on oil thereby increasing its price from $3 to $12. This increase in oil
prices affected a lot of oil-dependent countries eventually leading to stock price crashes
across several countries (Issawi, 1979). The Asian crisis of 1997–1998 started in Thailand
due to a lack of foreign currency equivalence. The Thai baht experienced a devaluation
which then spread to other Asian countries. The solution to the crisis created better
financial regulations and supervision throughout the Asian banks (Kenton, Financial
Crisis., 2020). Finally, we have the 2007-2008 Global Financial Crisis also called the
“Great Depression”. After a failed attempt to rescue the negative effects that arose due
to the lending crisis of Lehman Brothers investment bank, a global scale financial crisis
started leading to a global economic recession. After the Great Depression, this financial
crisis is regarded as the next worst crisis to have happened (M., 2021).

The 2007-2008 Global Financial Crisis.

The 2008 crisis occurred as a result of a series of happenings which then gradually grew
into a ripple effect leading to the banking system almost collapsing. Some proposed that
the Community Development Act also has a part to play in the occurrence of the 2008
crisis. In a bid to create a market for borrowers, the Community Development Act was
initiated to allow lower-income consumers access to loans by telling financial institutions
to lower their credit requirements (Kindleberger & Aliber, 2005). One of the key factors to
have been said to be a cause of the global financial crisis is audacious steps taken in a
profitable macroeconomic conditions. Before the out-blown crisis kicked in, the
macroeconomic environment in the USA for real estate grew favorably high. A lot of real
estate investors and individuals sought to go in by taking loans and mortgages on their
houses which were relatively at prices close to the actual price of the house. It was the
expectation of everyone that prices would continue to increase or at the very least
stabilize. So, even banks and financial institutions gradually increased borrowers’ limits
and loaned out money to even low credit borrowers (Reserve Bank of Australia (RBA),
2021).

This careless lending on the part of individuals then led to an even careless act on the
part of the banks and investors. In a bid to compete with their competitors, banks and
other investors began borrowing also to meet the demands of the people wanting to lend
from them. Using borrowed funds to buy an equity (known as an increase in leverage) will
potentially increase your profit margins but in the instance of a loss, the loss will also be
great. Therefore, as the prices in houses dwindled, rather than get the profits they had
hoped for, they experienced losses on their borrowings. Borrowers who had loaned
money in the hope to get into the real estate boom began to delay in making their loan
payments (Reserve Bank of Australia (RBA), 2021). The final major factor that caused
the global financial crisis according to the Reserve Bank of Australia (2021) is the
regulation and policy errors. According to the report, the regulations on the lending limits
for the subprime borrowers were too lenient. Too many individuals took out loans and
mortgages that were clearly too much for them to afford. In a bid to cover their tracks,
even banks lied about the safety of their assets to investors thereby inviting them to invest
more in the system. In addition, as the disaster developed, national authorities and
financial institutions failed to quickly grasp the full scale the debts had grown during the
inflation which had led to an increase in mortgage loses throughout the financial system
(Reserve Bank of Australia (RBA), 2021).

How the 2008 Crisis Affected the Global Market

Before the global financial crisis hit, certain events occurred which set the motion towards
impending crisis, although no one knew it would be as catastrophic as the global financial
crisis. The European Union (EU) was created on the basis of solving European economic
concerns (Buti, Eijffinger, & Franco, 2003). Year by year, the European Economic
Community (EEC) has been growing since its inception in 1957, and in the mid-1980’s,
the EEC experienced some important changes. In 1985, the SEC (Single European Acts)
was formed. The aim of the SEC was to establish an internal market in the European
economy which was actualized n 1992. Following the actualization of the internal market,
a stable monetary union (i.e. the Euro) was created in 1999 for all the member countries
of the European Union. But not long after its adoption, member countries began breaking
the solidity and development treaty which was supposed to control the coordination and
discipline of the member countries (Mulhearn & Vane, 2008).

Without coordination in the SEC, problems began to arise. For most European countries,
the crisis often hits in two stages; the first stage involves a national economic recession
downturn which ultimately grows into a global economic downturn. The second stage is
the out blown global financial crisis (Yurtsever, 2011). In the summer of 2007, shortly after
the increase in the credit limit of subprime borrowers, early signs of the crisis began to
show. Borrowers began failing on paying back their loans and the mortgaged properties
also began reducing in valuation. After the American International Group failed in helping
Lehman Brothers from going bankrupt, a host of other banks went bankrupt. This led to
a chain of global events causing the global financial crisis (European Commission, 2009).

The crisis of the 2008 ‘great depression” was felt in the world and not just the European
countries alone. In 2009 alone, world trade reduced by a margin of 11%. Also, the world
output dropped by 0.6% and GDP across some developed countries fell by 3.2%
(International Monetary Fund, 2010). Meanwhile, in the European Union member
countries, GDP dropped by 8% and 18% for central and eastern member countries
respectively, while it dropped by 4.2% in others. Also, the EU countries experienced a
high unemployment rate during the crisis seeing the number rise by approximately 2%
from 2008 to 2010 (Eurostat, 2010). Further studies showed that Budget deficits with
levels of 7% of GDP on average and public debts over 80% of GDP exceeds the limits
(3% and 60 % respectively) set by Treaties of EU (European Commission, 2010).

In a detailed report shared by Claessen et. al., the majority of the national economies that
got affected by the crisis were those in trade with the US economy. Apart from the group,
nations depending on financial support from the countries in the first group also were
affected. Then, countries depending on expert for the majority of their GDP especially
those exporting to the affected countries also got affected by the crisis (Claessen,
Dell’Aricca, Igan, & Laeven, 2010). The effects of the crisis on affecting the economy of
countries and the world in general also meant that the individual economy of private
organizations were affected as well. This was the reason why companies such as the
Lehman Brothers went bankrupt.

Aftermath of the 2008 Crisis

Beginning from the start of the financial setback, the crisis can be divided into three
sections. The first stage of the failure generally occurs due to organizational and
administrative collapse, governmental mishandling of funds, etc. Then, the financial
institutions break down as well as their customers when they begin having problems
performing their basic functions. In the final stage, equities purchased with loans at higher
prices drop in value leading to an increase in debt margins. Knowing the different stages
of the financial crisis will help in figuring out when a pending financial crisis is set to occur
and the steps to take to either avert it or reduce its effect on the economy of the country
(European Commission, 2008).

With the aim of countering the consequences of the crisis, the EU developed 3 strategies.
The first strategy focused on development and rehabilitation of the markets with the
introduction of stimulus plans. The second strategy focused on the proper monitoring and
management of the financial system in place to avoid another occurrence of a financial
crisis. The final and third strategy focused on the developing economy policy agreement
between the EU Members which will be governed and controlled by the economic body
set up (European Council, 2010).

The plan and strategy was set in motion around September 2008 when the crisis was
deemed to be receding in its most critical stage. The first strategy which was to develop
and rehabilitate the market with the introduction of stimulus plans was set in motion. The
strategy which was aided by an allocation of 200 billion euros was aimed at bringing back
competition into the economic market thereby creating a green economy and reducing
the social impact of the crisis (European Commission, 2008).

The second strategy kicked off around March 2009. The EU developed a more standard
and straightforward financial system which will be monitored by the European Financial
Supervision System. The European Financial Supervision System in a bid to better
monitor the newly regulated financial system developed a 2 dimension monitoring system.
The first dimension known as the European Systemic Risk Board (ESRB) will monitor the
macro risks in the financial system. The EU Members are not directly accountable to the
ESRB although, in the event of an investigation, Member States might be required to give
explanations to their actions if they go against the statutes of the ESRB (European
Commision, 2008). The second dimension of the second strategy involved the creation
of three authorities to govern and monitor the financial system. The strategy was
approved by the EU and the bodies created for the monitoring of the new financial system
began operation in January 2011 (Council of the European Union., 2010).

The final and third strategy was developed to create an economy policy agreement
between the EU Members which will be governed and controlled by the economic body
set up. The aim of this strategy is to provide steady financial structure for all the EU
members.

This summarizes the conjunction of public accounting systems, budgeting predicting

techniques, numerical fiscal rules and liquidity (Rehn, 2010).
Regulation of the Global Financial System
The banks are part of the financial system and regulating the financial system will require
regulating the banking system as a whole which means ensuring that banks are financially
sound and well managed. Also, regulating the financial system means that the market
economy is financially stable. Stabilizing the market economy sometimes require the
intervention of the government either through taxation or regulation. While taxation is
used to achieve market social objectives, regulations are used to correct market failure
and achieve market efficiency. The three different ways a market can fail are: through the
monopoly of power, through the existence of externalities or spillover costs, and through
the existence of information imbalances (“asymmetries”) (Keohane & Nye, 2000).

According to Schooner and Taylor (2010), regulation of the global financial system is
strictly based on the possibilities that the economic market will fail. In such instances, and
using the banking industry as an example, market failures may occur either via
information asymmetry and systemic risk (a negative externality) (Schooner & Taylor,
2010). Information asymmetry is a major factor in deciding the regulation of a banking
industry. The reason being, in the banking industry, the information available to the
depositors is less compared to the information the banks and their investors possess.
These information hold the key in determining if a bank is in good shape or may go
bankrupt. Although, the customer is given a contract by the bank which should uphold the
bank to provide the required services to the customer. In the light of an economic
breakdown, the bank may not be able to provide the said services to the customer
(Schooner & Taylor, 2010).

In response to the crisis, the IMF and World Bank also set up policies and
recommendations to curb the effects of the crisis. Both parties considerably enlightened
all member countries on the issue of financial crisis and how they planned to solve it which
involved providing financial support to the countries. In a publication by the IMF, data on
countries affected by the crisis was released showing how bad each country was affected.
Most of the badly affected countries were the countries generally regarded as poor. The
IMF used this report determine the countries that needed the financial support to boost
their economies in the face of the crisis. The solution the IMF came up with was the setting
up of a credit line for countries with good credit scores and efficient financial policies. The
IMF ensured that the solution provided wasn’t too strict so as to be able to also cater for
the generally considered poor nations (Gurtner, 2010).

The World Bank also came up with their own solution to help the countries affected by
the crisis. The solution the World Bank came up with was channeled through a specially
created “Crisis Response Facility”. The first response of the World Bank was to increase
its borrowing capacity by 54% as regards the capacity of the last fiscal year. The
increased borrowing capacity was loaned to the poor countries who needed the money
to help rebuild their crumbling economies. Part of the funds also went into helping some
averagely stable countries to further help boost their economies. A partner with the World
Bank, Multilateral Investment Guarantee Agency (MIGA) which is responsible for the
private organizations also helped private organizations improve their economies in the
global scene (Gurtner, 2010).
Conclusion
In conclusion, it can be clearly seen that the effects of the financial crisis led to
destabilization in the economic and political power among the nations. The countries that
were able to ride the waves of the crisis and stabilize faster became more successful that
the poorly managed countries. The evidence shows that without a proper financial policy,
any nation or organization can fall into the trap of being affected by a financial crisis. Also,
the IMF and World Bank has greatly helped nations across the world in stabilizing their
economies after the crisis. Majority of these countries now regard IMF and World Bank
as a strong backbone in the global financial and economic scene.
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