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The depth and breath of the current global financial crisis is unprecedented in post-war economic history. It has several features in common with similar financial-stress driven crisis episodes. It was preceded by relatively long period of rapid credit growth, low risk premiums, abundant availability of liquidity, strong leveraging, soaring asset prices and the development of bubbles in the real estate sector. Stretched leveraged positions and maturity mismatches rendered financial institutions very vulnerable to corrections in asset markets, deteriorating loan performance and disturbances in the wholesale funding markets. Such episodes have happened before and the examples are abundant (e.g. Japan and the Nordic countries in the early 1990s, the Asian crisis in the late-1990s).
Economic Crisis in Europe: Causes, Consequences and Responses.
ROOT CAUSES OF THE CRISIS
The depth and breath of the current global financial crisis is unprecedented in post-war
economic history. It has several features in common with similar financial-stress driven crisis
episodes. It was preceded by relatively long period of rapid credit growth, low risk premiums,
abundant availability of liquidity, strong leveraging, soaring asset prices and the
development of bubbles in the real estate sector. Stretched leveraged positions and maturity
mismatches rendered financial institutions very vulnerable to corrections in asset markets,
deteriorating loan performance and disturbances in the wholesale funding markets. Such
episodes have happened before and the examples are abundant (e.g. Japan and the Nordic
countries in the early 1990s, the Asian crisis in the late-1990s). But the key difference between
these earlier episodes and the current crisis is its global dimension. When the crisis broke in the
late summer of 2007, uncertainty among banks about the creditworthiness of their counterparts
evaporated as they had heavily invested in often very complex and opaque and overpriced
financial products. As a result, the interbank market virtually closed and risk premiums on
interbank loans soared. Banks faced a serious liquidity problem, as they experienced major
difficulties to rollover their short-term debt. At that stage, policymakers still perceived the crisis
primarily as a liquidity problem. Concerns over the solvency of individual financial institutions
also emerged, but systemic collapse was deemed unlikely. It was also widely believed that the
European economy, unlike the US economy, would be largely immune to the financial
turbulence. This belief was fed by perceptions that the real economy, though slowing, was
thriving on strong fundamentals such as rapid export growth and sound financial positions of
households and businesses. These perceptions dramatically changed in September 2008,
associated with the rescue of Fannie Mae and Freddy Mac, the bankruptcy of Lehman Brothers
and fears of the insurance giant AIG (which was eventually bailed out) taking down major US
and EU financial institutions in its wake. Panic broke in stock markets, market valuations of
financial institutions evaporated, investors rushed for the few safe havens that were seen to be
left (e.g. sovereign bonds), and complete meltdown of the financial system became a genuine
threat. The crisis thus began to feed onto itself, with banks forced to restrain credit, economic
activity plummeting, loan books deteriorating, banks cutting down credit further, and so on.
The downturn in asset markets snowballed rapidly across the world. As trade credit became
scarce and expensive, world trade plummeted and industrial firms saw their sales drop and
inventories pile up. Confidence of both consumers and businesses fell to unprecedented
This set chain of events set the scene for the deepest recession in Europe since the 1930s.
Projections for economic growth were revised downward at a record pace.
Although the contraction now seems to have bottomed, GDP is projected to fall in 2009 by the
order of 4% in the euro area and the European Union as whole – with a modest pick up in
activity expected in 2010.
The situation would undoubtedly have been much more serious, had central banks,
governments and supra-national authorities, in Europe and elsewhere, not responded forcefully.
Policy interest rates have been cut sharply, banks have almost unlimited access to lender-oflast-
resort facilities with their central banks, whose balance sheets expanded massively, and have
been granted new capital or guarantees from their governments. Guarantees for savings deposits
have been introduced or raised, and governments provided substantial fiscal stimulus. These
actions give, however, rise to new challenges, notably the need to orchestrate a coordinated exit
from the policy stimulus in the years ahead, along with the need to establish new EU and global
frameworks for the prevention and resolution of financial crises and the management of systemic
A CHRONOLOGY OF THE MAIN EVENTS
The heavy exposure of a number of EU countries to the US subprime problem was clearly
revealed in the summer of 2007 when BNP Paribas froze redemptions for three investment
funds, citing its inability to value structured products. As a result, counterparty risk between
banks increased dramatically, as reflected in soaring rates charged by banks to each other for
short-term loans. Credit default swaps, the insurance premium on banks' portfolios, soared in
concert. The bulk of this rise can be that point most observers were not yet alerted that systemic
crisis would be a threat, but this began to change in the spring of 2008 with the failures of
Bear Stearns in the United States and the European banks Northern Rock and Landesbank
Sachsen. About half a year later, the list of (almost) failed banks had grown long enough to
ring the alarm bells that systemic meltdown was around the corner: Lehman Brothers, Fannie
May and Freddie Mac, AIG, Washington Mutual, Wachovia, Fortis, the banks of Iceland,
Bradford & Bingley, Dexia, ABN-AMRO and Hypo Real Estate. The damage would have been
devastating had it not been for the numerous rescue operations of governments. When in
September 2008 Lehman Brothers had filed for bankruptcy the TED spreads jumped to an
unprecedented high. This made investors even more wary about the risk in bank portfolios, and
it became more difficult for banks to raise capital via deposits and shares. Institutions seen at risk
could no longer finance themselves and had to sell assets at 'fire sale prices' and restrict their
lending. The prices of similar assets fell and this reduced capital and lending further, and so on.
An adverse 'feedback loop' set in, whereby the economic downturn increased the credit risk,
thus eroding bank capital further. The main response of the major central banks – in the United
States as well as in Europe – has been to cut official attributed to a common systemic factor.
European Commission Economic Crisis in Europe: Causes, Consequences and Responses
interest rates to historical lows so as to contain funding cost of banks. They also provided
additional liquidity against collateral in order to ensure that financial institutions do not need to
resort to fire sales. These measures, which have resulted in a massive expansion of central
banks' balance sheets, have been largely successful as three-months interbank spreads came
down from their highs in the autumn of 2008. However, bank lending to the non-financial
corporate sector continued to taper off. Credit stocks have, so far, not contracted, but this may
merely reflect that corporate borrowers have been forced to maximise the use of existing bank
credit lines as their access to capital markets was virtually cut off.
Governments soon discovered that the provision of liquidity, while essential, was not
sufficient to restore a normal functioning of the banking system since there was also a deeper
problem of (potential) insolvency associated with undercapitalisation. The write-downs of banks
are estimated to be over 300 billion US dollars in the United Kingdom (over 10% of GDP) and
in the range of over EUR 500 to 800 billion (up to 10% of GDP) in the euro area.
In October 2008, in Washington and Paris, major countries agreed to put in place financial
programmes to ensure capital losses of banks would be counteracted. Governments initially
proceeded to provide new capital or guarantees on toxic assets. Subsequently the focus shifted to
asset relief, with toxic assets exchanged for cash or safe assets such as government bonds. The
price of the toxic assets was generally fixed between the fire sales price and the price at
maturity to give institutions incentives to sell to the government while giving taxpayers a
reasonable expectation that they will benefit in the long run. Financial institutions which at the
(new) market prices of toxic assets would be insolvent were recapitalised by the government.
All these measures were aiming at keeping financial institutions afloat and providing them with
the necessary breathing space to prevent a disorderly deleveraging. The verdict as to whether
these programmes are sufficient is mixed, but the order of asset relief provided seem to be
roughly in line with banks' needs.