The Global Financial Crisis | Explainer | Education (2024)

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The global financial crisis (GFC) refers to the periodof extreme stress in global financial marketsand banking systems between mid 2007 andearly 2009. During the GFC, a downturn in theUS housing market was a catalyst for a financialcrisis that spread from the United States to therest of the world through linkages in the globalfinancial system. Many banks around the worldincurred large losses and relied on governmentsupport to avoid bankruptcy. Millions of peoplelost their jobs as the major advanced economiesexperienced their deepest recessions since theGreat Depression in the 1930s. Recovery from thecrisis was also much slower than past recessionsthat were not associated with a financial crisis.

Main Causes of the GFC

As for all financial crises, a range of factors explainthe GFC and its severity, and people are stilldebating the relative importance of each factor.Some of the key aspects include:

1. Excessive risk-taking in a favourable macroeconomic environment

In the years leading up to the GFC, economicconditions in the United States and othercountries were favourable. Economic growthwas strong and stable, and rates of inflation,unemployment and interest were relativelylow. In this environment, house pricesgrew strongly.

Expectations that house prices would continueto rise led households, in the United Statesespecially, to borrow imprudently to purchaseand build houses. A similar expectation onhouse prices also led property developers andhouseholds in European countries (such asIceland, Ireland, Spain and some countries inEastern Europe) to borrow excessively. Many ofthe mortgage loans, especially in the UnitedStates, were for amounts close to (or evenabove) the purchase price of a house. A largeshare of such risky borrowing was done byinvestors seeking to make short-term profits by‘flipping’ houses and by ‘subprime’ borrowers(who have higher default risks, mainly becausetheir income and wealth are relatively lowand/or they have missed loan repayments inthe past).

Banks and other lenders were willing to makeincreasingly large volumes of risky loans for arange of reasons:

  • Competition increased between individuallenders to extend ever-larger amounts ofhousing loans that, because of the goodeconomic environment, seemed to be veryprofitable at the time.
  • Many lenders providing housing loans did notclosely assess borrowers’ abilities to make loanrepayments. This also reflected the widespreadpresumption that favourable conditionswould continue. Additionally, lenders had littleincentive to take care in their lending decisionsbecause they did not expect to bear any losses.Instead, they sold large amounts of loans toinvestors, usually in the form of loan packagescalled ‘mortgage-backed securities’ (MBS),which consisted of thousands of individualmortgage loans of varying quality. Over time,MBS products became increasingly complex and opaque,but continued to be rated by external agencies as if they were very safe.
  • Investors who purchased MBS products mistakenly thought that they were buying avery low risk asset: even if some mortgage loans in the package were not repaid,it was assumed that most loans would continue to be repaid. These investorsincluded large US banks, as well as foreign banks from Europe and othereconomies that sought higher returns than could be achieved in their localmarkets.

2. Increased borrowing by banks and investors

In the lead up to the GFC, banks and other investors in the United States and abroadborrowed increasing amounts to expand their lending and purchase MBS products.Borrowing money to purchase an asset (known as an increase in leverage) magnifiespotential profits but also magnifies potential losses.[1]As a result, when houseprices began to fall, banks and investors incurred large losses because they hadborrowed so much.

Additionally, banks and some investors increasingly borrowed money for very shortperiods, including overnight, to purchase assets that could not be sold quickly.Consequently, they became increasingly reliant on lenders – which included otherbanks – extending new loans as existing short-term loans were repaid.

3. Regulation and policy errors

Regulation of subprime lending and MBS products was too lax. In particular, there wasinsufficient regulation of the institutions that created and sold the complex andopaque MBS to investors. Not only were many individual borrowers provided with loansso large that they were unlikely to be able to repay them, but fraud wasincreasingly common – such as overstating a borrower's income and over-promisinginvestors on the safety of the MBS products they were being sold.

In addition, as the crisis unfolded, many central banks and governments did notfully recognise the extent to which bad loans had been extended during the boom andthe many ways in which mortgage losses were spreading through the financial system.

How the GFC Unfolded

US house prices fell, borrowers missed repayments

The catalysts for the GFC were falling US house prices and a rising number ofborrowers unable to repay their loans. House prices in the United States peakedaround mid 2006, coinciding with a rapidly rising supply of newly built houses insome areas. As house prices began to fall, the share of borrowers that failed tomake their loan repayments began to rise. Loan repayments were particularlysensitive to house prices in the United States because the proportion of UShouseholds (both owner-occupiers and investors) with large debts had risen a lotduring the boom and was higher than in other countries.

Stresses in the financial system

Stresses in the financial system first emerged clearly around mid 2007. Some lendersand investors began to incur large losses because many of the houses theyrepossessed after the borrowers missed repayments could only besold at prices below the loan balance. Relatedly,investors became less willing to purchase MBSproducts and were actively trying to sell theirholdings. As a result, MBS prices declined, whichreduced the value of MBS and thus the net worthof MBS investors. In turn, investors who hadpurchased MBS with short-term loans found itmuch more difficult to roll over these loans, whichfurther exacerbated MBS selling and declines inMBS prices.

Spillovers to other countries

As noted above, foreign banks were activeparticipants in the US housing market duringthe boom, including purchasing MBS (withshort-term US dollar funding). US banks also hadsubstantial operations in other countries. Theseinterconnections provided a channel for theproblems in the US housing market to spill over tofinancial systems and economies in other countries.

Failure of financial firms, panic in financial markets

Financial stresses peaked following the failureof the US financial firm Lehman Brothers inSeptember 2008. Together with the failure or nearfailure of a range of other financial firms aroundthat time, this triggered a panic in financial marketsglobally. Investors began pulling their money outof banks and investment funds around the worldas they did not know who might be next to failand how exposed each institution was to subprimeand other distressed loans. Consequently, financialmarkets became dysfunctional as everyone triedto sell at the same time and many institutionswanting new financing could not obtain it.Businesses also became much less willing to investand households less willing to spend as confidencecollapsed. As a result, the United States and someother economies fell into their deepest recessionssince the Great Depression.

Policy Responses

Until September 2008, the main policy responseto the crisis came from central banks that loweredinterest rates to stimulate economic activity,which began to slow in late 2007. However,the policy response ramped up following thecollapse of Lehman Brothers and the downturn inglobal growth.

Lower interest rates

Central banks lowered interest rates rapidly to verylow levels (often near zero); lent large amountsof money to banks and other institutions withgood assets that could not borrow in financialmarkets; and purchased a substantial amountof financial securities to support dysfunctionalmarkets and to stimulate economic activity oncepolicy interest rates were near zero (known as‘quantitative easing’).

Increased government spending

Governments increased their spending tostimulate demand and support employmentthroughout the economy; guaranteed depositsand bank bonds to shore up confidence infinancial firms; and purchased ownership stakes insome banks and other financial firms to preventbankruptcies that could have exacerbated thepanic in financial markets.

Although the global economy experienced itssharpest slowdown since the Great Depression,the policy response prevented a global depression.Nevertheless, millions of people lost their jobs,their homes and large amounts of their wealth.Many economies also recovered much moreslowly from the GFC than previous recessionsthat were not associated with financial crises.For example, the US unemployment rate onlyreturned to pre-crisis levels in 2016, about nineyears after the onset of the crisis.

Stronger oversight of financial firms

In response to the crisis, regulators strengthened their oversight of banks andother financial institutions. Among many new global regulations, banks must nowassess more closely the risk of the loans they are providing and use more resilientfunding sources. For example, banks must now operate with lower leverage and can’tuse as many short-term loans to fund the loans that they make to their customers.Regulators are also more vigilant about the ways in which risks can spreadthroughout the financial system, and require actions to prevent the spreading ofrisks.

Australia and the GFC

Relatively strong economic performance

Australia did not experience a large economic downturn or a financial crisis duringthe GFC. However, the pace of economic growth did slow significantly, theunemployment rate rose sharply and there was a period of heightened uncertainty. Therelatively strong performance of the Australian economy and financial system duringthe GFC, compared with other countries, reflected a range of factors, including:

  • Australian banks had very small exposures to the US housing market and US banks,partly because domestic lending was very profitable.
  • Subprime and other high-risk loans were only a small share of lending inAustralia, partly because of the historical focus on lending standards by theAustralian banking regulator (the Australian Prudential Regulation Authority(APRA)).
  • Australia's economy was buoyed by large resource exports to China, whose economyrebounded quickly after the initial GFC shock (mainly due to expansionary fiscalpolicy).

Also a large policy response

Despite the Australian financial system being in a much better position before theGFC, given the magnitude of the shock to the global economy and to confidence morebroadly, there was also a large policy response in Australia to ensure that theeconomy did not suffer a major downturn. In particular, the Reserve Bank lowered thecash rate target significantly, and the Australian Government undertook expansionary fiscalpolicy and provided guarantees on deposits at and bonds issued by Australian banks.

Following the crisis, APRA implemented the stronger global banking regulations inAustralia. Together, APRA and the financial market and corporate regulator, theAustralian Securities and Investments Commission, have also strengthened lendingstandards to make the financial and private sectors more resilient.


Imagine that Jane buys an asset for $100,000 using $10,000 of her own money and $90,000of borrowed money. If the asset price increases to $110,000,then Jane's own money after paying back the loan has doubled to $20,000 (ignoringinterest costs). However, if the asset price falls to $90,000, then Janewould have lost all of the money she initially had. And if the asset price were tofall to less than $90,000, then Jane would owe money to her lender.[1]

The Global Financial Crisis | Explainer | Education (2024)
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