Question

The Monetary System

In 2008-2009, during the Great Recession, banks found themselves with too little capital and many became insolvent.

Part 1. Briefly explain why this occurred. Use proper terminology and make sure to support your answer mentioning the changes in banks' assets, liabilities, and capital that occurred during that time.

Answer 1

Before 2008 the Great Recession had begun well. The first signs came in 2006 when prices for housing started to fall. The Federal Reserve had responded to the subprime mortgage crisis by injecting $24 billion in liquidity to the financial system by August 2007. In September 2008 Congress approved a bank bailout of $700 billion, also known as the Troubled Asset Relief Programme. By February 2009, Obama introduced an economic stimulus package of $787 billion which helped to avert a global depression. Here is a rundown of the big moments of the 2008 Great Recession.

By the third quarter of 2008, the subprime crisis hit the entire economy as GDP dropped by 0.3 per cent. Yet, in October 2006, the first hint was for early observers. Sustainable products orders were lower than they had been in 2005, predicting a decrease in housing demand. Such orders also calculate the health of manufacturing orders, which is a crucial indicator against national GDP.

The American Recovery and Reinvestment Act was passed by Congress on 17 February 2009. The economic stimulus package, worth $787 billion, ended the recession. It provided tax cuts of $282 billion, and new programs of $505 billion, including health care, education, and infrastructure.

Obama launched a $75 billion plan on February 18, 2009 to help stem the foreclosures. The Homeowner Affordability Program was designed to support 9 million homeowners before falling behind in their payments (most banks do not approve a loan waiver unless three payments have been skipped by the borrower). It subsidized banks that had their mortgage restructured or refinanced. But it wasn't enough to convince banks to change their Policies

The primary improvement on the liability side of the balance sheets of central banks was a significant accumulation of reserves that the banking system could access. That occurred in two phases. Firstly, many central banks around the world were instrumental in providing liquidity to fragile financial markets during the crisis itself. Second, post-crisis, many central banks started implementing unprecedented quantitative easing (QE) policies by purchasing vast quantities of certain forms of private-sector assets to support their fighting economies.

This increase was necessary to some degree to meet an rise in demand, as banks had to keep more liquid assets to shield themselves from shocks. However, in many instances the steps to maintain financial stability have resulted in an rise in the amount of reserves so big that it far outstripped banks 'increased demand. Thus, reserves may not have been sufficiently insufficient to conduct monetary policy in the "corridor" environment without further central bank interventions

During the crisis, central banks usually extended loans to banks to maintain financial stability, and often less traditional counterparties. These loans provided the banks and other financial intermediaries with much needed liquidity, and increased the amount of reserves. In the United States, for example, reserves rose from $13 billion to approximately $850 billion during 2008.