The role of securitized lending and shadow banking in the 2008 financial crisis
The financial crisis of 2008 started and engulfed the banking system of the United States and spread to many large European countries (Coffee, 2009) because of the financial institution’s fault was the excessive of borrowing, risky investments, a decrease in collapsing of mortgage lending standards and transparency (The Financial Crisis Inquiry Commission, 2011), but China only has a small impact on its economy and they were able to recover rapidly. This essay will discuss a summary about the financial crisis in the USA but it will mainly focus on the financial crisis in China and how the government has helped deal with the problem quickly in order to have a rapid recovery in the recession 2007-2008 and it will focus on shadow banking sector in China.
The USA economy was in recession in 2001, and the USA Federal Reserve — the banking system — cut the interest costs as a counter-patterned measure (Wirick and Mcintosh, 2015). Lower interest rate made it simpler for families to convey bigger measures of home loan obligation, thus the interest for US lodging expanded. The subsequent increment in costs animated private development action and the subsequent increment in work and yield in the lodging segment was a vital issue in the recuperation in the USA economy (Gordon, 2017).
A causal component behind the flood in lodging speculation was a gigantic inflow of remote venture into the USA, strikingly from China: by 2006, the USA current record shortage achieved 6 percent of GDP (Eastman and Ambler, 2013). A lot of this outside capital was thusly diverted into the US lodging division, offering bigger pools of funds for family units looking for home loan funding
The housing market is notable for its cycle of blasts and busts, and it ended up clear in the mid-2000s that US housing costs gave a significant number of the suggestions normal for a “bubble.” Asset-value bubbles happen when financial specialists make buys dependent on the desire for having the capacity to offer the benefit later at a higher cost, and not on the innate characteristics of the advantage itself (Hull, 2014). The purposes behind the production of the “rise” is the low interest and the relaxation of lending standards in the USA housing market (MacGee, 2009).
US housing costs at long last topped in mid-2006. Movement in the housing segment hindered, and the US economy started to embrace a change of speculation and work to different segments. This progress was not consistent, be that as it may, and the USA fell into downturn in the end of 2007.
One contributor was the deterioration in the mortgage guaranteeing standard: an expanding offer of advances was made to high-risk borrowers. The subprime contracts were effective from 2001-2006 by $2.5 trillion (Gorton, 2010). When lodging costs in the long run fell, these “sub-prime” contracts will probably go into default. Which has tightened the market to collapse.
One of the main causes which started in August of 2007 was securitization. Securitisation can be defined as a process that transforms illiquid assets (untradeable) into a security (tradable) this is according to (Gabbi, Kalbaska and Vercelli, 2014). The crisis contagion was helped from securitisation and spread almost all over the world. The expanded securitization of mortgages assets, and most strikingly the improvement (CDOs), enhanced the hidden risk. A CDO gave its proprietor a case on the stream of home loan instalments made by family units. CDOs that offered higher-need claims were viewed as sheltered resources and exchanged at a premium. The advancement of CDO and related instruments gave a further motivator to offer sub-prime credits: buyers of CDOs had a little method for confirming the nature of the hidden home loans whereupon the advantages were based.
When US housing costs fell, numerous property holders got themselves submerged: their loan debts obligations surpassed the estimation of their households and went into credit default swap. It before long ended up obvious to money related foundations and different speculators that a large number of them as far as anyone knows “safe” mortgage-based assets were worth substantially less than their book esteems. Financial market liquidity became scarce as establishments turned out to be less eager to make advances, out of dread that the counterparties may go bankrupt in the close term. These apprehensions reached a crucial stage with the fall of Lehman Brothers, the fourth-biggest US investment bank, in September 2008.
After the Lehman Brother bankruptcy helped this financial crisis to spread globally, which has caused a global downturn in the economies. Therefore it hits China economy very badly. China’s commercial banks have owned an MBS and CDOs in the USA, the losses was about $20 Billion, however in August of 2008 China was on about to fail when Fannie Mae and Freddie Mac were about to collapse, which the losses have been estimated $400 Billion but the USA has to place Fannie Mae and Freddie Mac into conservatorship which has saved the two companies and China from a big tragedy (Yu, 2010) (Figure 1).
The global crisis has effected china’s GDP to decrease from 13% in 2007 to 6.8% in 2008 (Yu, 2010) (Figure 2). This impact has reflected on the Chinese economic indicator performance such as the export and import (Whalley et al., 2009). The Chinese government has put the blame on worldwide economic slowdown because the world is less demanding on Chinese exports. Which means the production sector has decreased the doubled, when it’s compared to the previous year, this caused many other product sectors to drop to a negative percentage (Wearden and Stanway, 2008).
Furthermore, the decrease in GDP in 2008 was because of the sharp decrease in the export sector (Figure 3). Since the main export markets are effected for instance Hong Kong and Korea have all slipped into recession because of the worldwide financial crisis. However, China is a very dependent country on net export for an economic boost. In 2007, China net export was about 20% of GDP growth (Zhang, 2009).while, because of the effect of the global financial crisis, the export of China has been reduced dramatically due to the weakening of external demand. China as a labour-intensive industry. Exports are a huge number of unskilled employees from rural areas to other countries. The unexpected collapse of export market has made a lot of private companies to close down, which has resulted in a job loss which was about 20 million of job losses of unskilled employees (Zhang, 2009), which has increased in unemployment in China. The number of unemployment employees has increased from 12.5 million in 2008 to 21.7 million in 2009 (Whalley et al., 2009). Since most of the unskilled employees came from rural areas has a lack of education, they have faced the problem of poverty when being laid-off.
In 2008 the Chinese government has introduced a stimulus program to stabilize economic growth. In 2008 the government has implemented a stimulus program with a total cost of investment plan $586 billion in 2009 and 2010. The stimulus program has invested in key areas, for example, finance, tax cuts, housing, transportation, rural infrastructure, health and education (Msandgren, 2008) (Figure 4). The sources of financing of the stimulus program were divided into 4 parts. The government will pay one-quarter of the $586 Billion. Secondly, government bonds have been issued to cover the budget deficit. Thirdly the central government has created a bond on behalf of the local ones. Lastly bank loans to source a fund for the local governments. Although the Chinese government can print more money to spend it inside the economy which called “easy money”, but they wanted to keep inflation controlled and not fluctuating the currency. The China investment corporation (CIC) has invested $20 billion to China Development Bank, and 47 Billion to Agricultural Bank of China. The accompanying held $100 billion of bad loans and was the nation’s fourth-biggest state-possessed loan specialist to must be subsidized by the government. The rest of the fund has been allocated from the budget of provincial and local governments (Morrison, 2009) (Figure 4). It was one of biggest rescue plans. This strategy concerned on increasing the output expenditure and reducing tax. The budget mainly concentrated on the infrastructure of China and tax repayment for exports (Yu, 2010). While the China Central Bank (PBoC) was also releasing the monetary policy is to encourage the banks to lend more by cutting down the reserve ratio from 17.5% to 13.5%. Which means the interest rate for a loan has been reduced to increase consumer’s spending and borrowing (Zhang, 2009).
Moreover, the Chinese government has implemented expansionary financial policy. The government had to implement new strategy by using its own enterprises (SOEs) as a fiscal instrument (Raza, 2014). This critical decision from china using this fiscal stimulus programs that no other country has dared to adopt. Specially, the China’s government intelligently used its state-owned enterprises (SOEs) as a financial instrument to be actualized in their stimulus programs in 2009. Most of the companies are owned and controlled by the government, such as China Mobile. One of the largest mobile companies. The role they perform in Chinese economy seems to expand because of the financial crisis. As China fighting the recession with the stimulus program, while the banks increasing lending at the behest of the government (Kamrany, 2011). Which means the private sector is getting squeezed out. The loans have reached 61.7 Billion for private firms. It’s is not just financing that is flowing to SOEs.
The sector that has been affected the most is the Manufacturing industry, which was dominant by the private organisations, in 2008 most of the small and medium sized has been collapsed and the survivor is having more pressure, which leads to exports to decrease by 19.7% (Raza, 2014). SOEs revenues depend on government spending more than internal and external demand, in other words, the government state can create neglectful to the market demand but the private sector cannot do that. Which made the private sector to collapse, since they left standing. According to Li Rongrong, the chairman of State-Owned assets, the SOEs profits flowed 86% in March 2009, which means that government can increase its stimulus program spending (Ramzy, 2009).
Furthermore, the government starts to get concerns that the economy is over-reliance on their spending, so their economic goal is to boost the customers by spending more to make the economy more balanced, and less dependent upon customer’s requests from Europe and USA (Ramzy, 2009). They have boosted the rural incomes and spending levels to tighten the gap in living standards between urban and rural citizens (Morrison, 2009). If SOEs in a heavy sector, for instance, the steelmaking increase production at a time when the market is falling, this could waste their products cheaply internationally when the government will stop spending (figure 5).
In the other hands, when the credit crisis in China was promptly growing. Loans in the first quarter of 2008 are nearly equalling the total lending for the whole year, which leads to bad loans to increase, with small and medium size collapsing. The SOEs gave China banks margin of safety, which has the guarantee that the government will make a good loan (Kamrany, 2011).
Lastly, the government idea of implying SEOs on their stimulus program has a positive effect on the market, which indeed China was again on the track by having 11.9% increase in the GDP for the first three months in 2010 (Kamrany, 2011).
The shadow banking sector is a vital factor for the cause of the financial crisis 2007-2008. Shadow banking is described as activities that have been made by financial firms outside the former banking system, therefore, lacking a formal safety net such activities in credit intermediation is according to Global Financial Stability Report (2014). Shadow banking is totally different from traditional banking, this is because shadow banking cannot borrow in any situation from the central banks and they do not have any depositors, usually insurance company’s fund’s shadow banking (Kodres, 2013).
The 2007 – 2008 financial crisis was a framework wide bank run which happened in the securitized-managing an account framework and was driven by the withdrawals of a repurchase agreement (Claessens et al, 2012). The genuine issue was that these toxic assets were utilized by the banks to anchor financing in the repo market. As the value of was declining, the banks were ending up less liquid. Full-esteem for securitized securities was given by financial firms that got stressed that those securities may contain toxic subprime loans; accordingly, they reduced the measure of cash they would loan on the bonds. This reduction likewise called a “haircuts”. At the point when investors in light of the fact that worried about the value of these long haul, assets, they chose to pull back their funds at a time. Shadow banks should repay to these investors and, in this manner, needed to offer resources. Around then shadow delegates were profoundly utilized or had the very leverage of illiquid assets and were helpless against runs when investors pulled back vast amounts of assets at short notice (GFSR, 2014). It brought about “Fire sale” which for the most part diminished the estimation of these benefits. It constrained other shadow keeping money foundations and a few banks that had comparable advantages for lessening these benefits an incentive to mirror the lower market cost, making further vulnerability of their wellbeing (Kodres, 2013).
China has the third largest shadow banking system in the world (Jiang, 2014). In the past the traditional banks in China are almost owned by the state, they were strongly regulated and accounted for all lending happening in China. Nevertheless, at the present time, credit is accessible from a wide range of financers consisting of leasing and trusts. Which jointly called as shadow banking, but still traditional banking lending is much bigger than the shadow banking and is still growing, but the rate of the growth is stabilized. In contrast, shadow banking is increasing (figure 6), which made shadow banking to account a third of the rise in lending by expanding more than 50% in the process (Jiang, 2014).
Almost 90% of the shadow lenders in China are (SOEs). These firms were cash rich and cleverer than the private enterprise ones, in term of their ability to snitch around the regulation (Shen, 2013). The large-enterprise for example, China mobile has an excess cash to make directs loans to other companies by making a huge profit throughout shadow banking.
Shadow banking in China is getting an increase in attention not only due to its fast-growing but also for its new products and activities that have made a development in the financial system but at the same time increasing risk. Some of these new products have a positive effect on financial development such as trusts and credit guarantees. Which has proven that they are extremely risky, because of the rapid growth for the shadow banking and became hard to regulate and monitor all the aspects of the system.
Shadow banking in China involves of credit creation products and non-bank financial products, and these non-bank financial products consists of bank-trust corporation financial products, these products are issued only by financial leasing companies and trust companies, credit risk assets and Q-REITS (Li, Hsu and Qin, 2014). Credit creation are often issued to investment banks, small loans companies and many more. The shadow banking system in China is dominated by insurance companies, commercial banks (Off balance sheets transaction) and trust. Furthermore, this essay will explain more about trust.
Trusts is the third largest financial subsector and is considered as the riskiest subsector (Li, Hsu and Qin, 2014). These trusts are not subjectable to the same regulation that banks have, and it’s the primary reason for the encountered problems. Trusts are often involved in very risky activities, for instance, being invested in extremely risky investments. More often trusts offer returns as high as 10% and this particular way to increase money for the business and individual are discouraged on bank deposits due to the low cap and interest rates (Jiang, 2014). Usually, trusts lend firms that were unable to borrow from banks because of the fourth industries (steel market), where the regulators instructed banks to stop lending to them due to the overinvestment.
The total outstanding trust products assets in China has increased by 8% at the end of 2010 (Anderlini, 2014). The trust product worth of $400 Billion because of the borrowers is taking more loans and reinvest in them. After that many observers worried that investors lose faith in trusts can seriously damage parts of the financial system. Trust is the heart of the Chinese shadow banking sector, which has delivered more than $4.8 billion worth of loans to the county’s riskier enterprise since 2007 and created the largest credit boom (Anderlini, 2014). The rapid build-up of risk in Chinese shadow banking may cause similar damage last shadow banking bubble in the USA.
In addition, mostly of trust loans is secured with property and reliant on shadow finance, however china’s powerful housing market is cooling, precisely in smaller towns, so the fear cutting of the housing market bubble leads to a stress in shadow finance, which will shrink the access to credit, pushing the housing prices and economic growth decrease further.
Shadow banking in China is totally different from Europe and USA, they are still in an infant from without being integrated into a long intermediation chain (Shen, 2013), due to the disconnection of a wide range of securitization.
According to Li, Hsu and Qin (2014) the regulations gives attention to Chinese commercial banks, and not enough attention to other non-loan assets and the housing securities. As regards of trusts, both trust financing companies and issuing commercial banks are regulated, even some trust involved in the extreme risky investment. Regardless of the new laws and regulation that trying to keep the financial products and the development healthy, but the trust companies are involving in risky investments. Thus, the severity of shadow banking forces the government to increase lending and investment and issuing bonds.
In conclusion, this essay has discussed the impact of the financial crisis on China, and the fast response from the Chinese government by implementing the “stimulus program” and using SOEs in their program. As it discussed the Chinese shadow banking sector that recently became a primary concern to many investors, observers and other markets contributors around the globe. Being an important component of the global economy, the financial sector in China allows a number of questionable and risky banking activities that sets the world economy in danger of future recessions. Only well regulated, the aligned system in China and the rest of the globe nations can prevent the world from another financial crisis.
- Anderlini, J. (2014). Into the shadows: risky business, global threat | Financial Times. [online] Ft.com. Available at: https://www.ft.com/content/a123375a-d774-11e3-a47c-00144feabdc0#axzz3JuL1EHX1 [Accessed 28 Oct. 2018].
- Claessens, S., Pozsar, Z., Ratnovski, L. and Singh, M. (2012). Shadow Banking: Economics and Policy. INTERNATIONAL MONETARY FUND.
- Coffee, J. (2009), “What Went Wrong? An initial Inquiry into the Causes of the 2008 Financial Crisis” Journal of Corporate Law Studies, Volume 9, Number 1, pp. 1-22(22).
- Eastman, H. and Ambler, S. (2013). Balance of Payments | The Canadian Encyclopedia. [online] Thecanadianencyclopedia.ca. Available at: https://www.thecanadianencyclopedia.ca/en/article/balance-of-payments [Accessed 26 Oct. 2018].
- Gabbi, G., Kalbaska, A. and Vercelli, A. (2014). Factors generating and transmitting the financial crisis: The role of incentives: securitization and contagion. [online] Fessud.eu. Available at: http://fessud.eu/wp-content/uploads/2013/04/Factors-generating-and-transmitting-the-financial-crisis-the-role-of-incentives-securitization-and-contagion-working-paper-56.pdf [Accessed 5 Oct. 2018].
- Global Financial Stability Report. (2014). Washington, D.C.: International Monetary Fund.
- Gordon, S. (2017). Recession of 2008–09 in Canada | The Canadian Encyclopedia. [online] Thecanadianencyclopedia.ca. Available at: canada%20">https://www.thecanadianencyclopedia.ca/en/article/recession-of-200809-in-canada [Accessed 26 Oct. 2018].
- Gorton, Gary (2010), Slapped by the Invisible Hand: The Panic of 2007. Oxford University Press
- Hull, J. (2014). Options, futures, and other derivatives. Boston: Pearson.
- Jiang, J. (2014). Battling the darkness. [online] The Economist. Available at: https://www.economist.com/finance-and-economics/2014/05/10/battling-the-darkness [Accessed 28 Oct. 2018].
- Kamrany, N. (2011). China’s Rapid Recovery in the Great Recession of 2007 – 2009. [online] HuffPost. Available at: https://www.huffingtonpost.com/nake-m-kamrany/chinas-rapid-recovery-in-_b_825194.html [Accessed 26 Oct. 2018].
- Kodres, L. (2013). “What is Shadow Banking?”. FINANCE AND DEVELOPMENT, Vol. 50, No. 2
- Li, J., Hsu, S. and Qin, Y. (2014). Shadow banking in China: Institutional risks. China Economic Review, 31, pp.119-129.
- MacGee, J. (2009). Why Didn’t Canada’s Housing Market Go Bust?. [online] Available at: canadas-housing-market-go-bust.aspx%20">https://www.clevelandfed.org/newsroom-and events/publications/economic-commentary/economic-commentary-archives/2009-economic-commentaries/ec-20090909-why-didnt-canadas-housing-market-go-bust.aspx [Accessed 26 Oct. 2018].
- Morrison, W. (2009). China and the Global Financial Crisis: Implications for the United States. [online] Fas.org. Available at: https://fas.org/sgp/crs/row/RS22984.pdf [Accessed 27 Oct. 2018].
- msandgren, M. (2008). China 2008: The Global Financial Crisis – China Digital Times (CDT). [online] Chinadigitaltimes.net. Available at: https://chinadigitaltimes.net/2008/12/2008-financial-crisis-and-china/ [Accessed 26 Oct. 2018].
- Ramzy, A. (2009). Why China’s State-owned Companies Are Making a Comeback. [online] TIME.com. Available at: http://content.time.com/time/world/article/0,8599,1894565,00.html [Accessed 26 Oct. 2018].
- Raza, S. (2014). Why The “Great Recession” Only Had A Small Impact On China. [online] ValueWalk. Available at: https://www.valuewalk.com/2014/03/great-recession-minimal-impact-china/ [Accessed 26 Oct. 2018].
- Shen, W., 2013. Shadow Banking System in China – Origin, Uniqueness and Governmental Responses. Journal of International Banking Law and Regulation, vol. 1, pp. 20-26.
- The Financial Crisis Inquiry Commission. (2011). Final Report of the National Commission on the causes of the Financial and Economic Crisis in The United States. [online] Available at: https://www.gpo.gov/fdsys/pkg/GPO-FCIC/pdf/GPO-FCIC.pdf [Accessed 26 Sep. 2018].
- Wearden, G. and Stanway, D. (2008). China warns financial crisis is damaging its economic growth. [online] the Guardian. Available at: https://www.theguardian.com/world/2008/oct/21/china-globalrecession [Accessed 26 Oct. 2018].
- Whalley, J., Agarwal, M., Cai, Y., Dong, Y., Tian, H. and Wang, L. (2009). China and the Financial Crisis. [online] Cigionline.org. Available at: https://www.cigionline.org/sites/default/files/task_force_2.pdf [Accessed 26 Oct. 2018].
- Wirick, R. and Mcintosh, G. (2015). Monetary Policy | The Canadian Encyclopedia. [online] Thecanadianencyclopedia.ca. Available at: https://www.thecanadianencyclopedia.ca/en/article/monetary-policy [Accessed 26 Oct. 2018].
- Yu, Y. (2010). The impact of the global financial crisis on the Chinese economy and China’s policy responses. Penang: Third World network.
- Zhang, M. (2009). China’s New International Financial Strategy amid the Global Financial Crisis. China & World Economy, 17(5), pp.22-35
Source: (Yu, 2010)
Source: (Morrison, 2009)
Source: (Morrison, 2009)
Source: (Yu, 2010)
Source: (Yu, 2010)
Source: (Jiang, 2014)