Corporate Finance

This document provides an explanation of the subprime crisis of 2007-09 and discusses the contribution of micro and macroeconomic factors in the financial crisis. It also explores the reformation of financial regulation in the UK for the prevention of such financial crises.

Running head: CORPORATE FINANCE
Corporate finance
Name of the Student
Name of the University
Author Note

CORPORATE FINANCE
Table of Contents
Answer to question 1:.................................................................................................................2
Answer to question 2:.................................................................................................................5
Reformation of financial regulation in UK for prevention of such financial crisis:..................5
Reference list:.............................................................................................................................8

CORPORATE FINANCE
Answer to question 1:
Introduction:
This section will provide an explanation of the subprime crisis of 2007-09. The financial
crisis of 2007-09 is regarded as the worst financial crisis and came as a major shock,
presenting a global threat to the financial. This caused a sharp decline in the prices of stock
forcing corporate borrowers to borrow loans at expensive rates thus resulting in lower
investment and a decline in lending to consumers. In the early stage of the crisis, there was a
sharp increase in collateral requirement and risk premia against secured borrowings. It was
found that the financial crisis of 2007-09 was due to the credit crunch culmination that had its
root in the housing market of the US (Olbrys and Majewska 2016). The lessons learned from
the previous financial crisis have led to major changes aimed at avoiding a repeat of such
crisis.
Discussion:
The next section discusses the contribution of micro and macro economic factors in
the financial crisis. The micro economic factors leading to the subprime crisis can be divided
into several stages:
The concerns about subprime mortgages resulted from a pervasive decline in the
housing prices of the US that were responsible for the subprime crisis of 2007-09. In the
beginning of 2000, there had been a dramatic increase in the average house price in the US
that reached its peak in early 2007. Increased demand resulted in increasing prices and the
secured mortgage prices fell further due to falling housing prices (Ftp.iza.org 2019).
Another factor is the collateralization of debt obligations and securitization of
subprime loans through Special Purpose Vehicle. One of the major contributing factors in the

CORPORATE FINANCE
subprime crisis was the securitization of subprime loans and debt obligations. Investors were
attracted to such mortgage securities as it offered higher interest rates. Due to the increased
risk of default, higher interest rates were enjoyed by subprime borrowers that had less than
perfect credit all of which added fuel to the crisis (Matthews and Thompson 2005).
Nationalization of Northern Rock in the UK contributed to the financial crisis. There
were issues with the funding strategy of the bank as it involved selling off packaged
mortgages to other banks. The security market simply dried up due to sceptical behaviour of
buyers about the securities value. There was also failure on behalf of the Northern Rock to
refinance their operations.
The collapse of Lehman Brother also triggered the financial crisis. Investors started
losing confidence in the Lehman Brothers due to a weakening market of real estate as they
were doubtful about the assets due to a lack of market liquidity. The debt ratings of Lehman
threatened to downgrade the ratings and when Lehman finally collapsed, it became the largest
US bankrupt filing (Garriga and Hedlund 2018).
The Bank Discount Window Facility was another factor leading to the financial crisis.
Most of the damage in the wake of the financial crisis was caused by the shadow which did
not fall under the primary regulatory purview of the comptroller of currency. The real
economy faced a credit crunch resulting from the panic in various parts of the shadow
banking system that caused businesses to layoff by way of spending cuts and layoffs that
triggered a recession (Valdez and Molyneux 2015).
The Credit Guarantee Scheme allowed institutional investors and banks to ensure
against the default of loans. Consequently, an end to proclaim credit risk was led by many
people in the financial industry. There was replacement of the credit risk by the counter party
as far more liability was accumulated by companies such as American International Group.

CORPORATE FINANCE
The operation of long term financing had been designed for reducing the interest rate
and makes investors to borrow loans at lower rates, so that greater rates are yielded in the
long term. However, there is no assurance that an income stream will be produced by assets.
This resulted in a decline of the long term assets and a rise in the short term borrowing cost.
The overnight deposit facility by the European Central Bank (ECB) has also been
responsible for financial crisis. The real economy was dragged down by the turbulence in the
financial market and credit condition deterioration. There was an erosion of the tax base that
had a massive toll on public finances and during the downturn for regaining the control of
fiscal positions had forced the government to adopt measures of fiscal consolidation (Valdez
and Molyneux 2015).
There are also macro economic factors which contributed to the severity of the crisis
severity included failing market discipline and corporate governance, lower real interest rates
and global financial imbalances and the introduction of reform, which aimed to address such
issues (Hall et al. 2017). The cause of the housing bubble was due to a lower interest rate and
the policy of government intending to raise the rate of interest from 2004 -06 eventually
causing financial crisis.
Conclusion:
Global imbalances were the result of increased current account surplus and increased
savings in emerging and developing countries. Such imbalances poses a greater threat on the
tendency of investment made in the US for earning a higher rate of return compared to
foreign liabilities.

CORPORATE FINANCE
Answer to question 2:
Reformation of financial regulation in the UK for the prevention of such financial crisis:
A reformed banking system is designed for strengthening the future financial system
and a special resolution regime was introduced for banks. Such reforms included brokering of
takeover rescues of ailing institutions and reform for arranging the protection of deposits,
nationalization of the failed institute, recapitalizing of the state banks by receiving funding
from the state and protection of capital through the scheme of asset protection. The financial
crisis witnessed a failure of the institutions and regulations that contained liquidity risks and
in response to this; it was recommended that there should be recognition of the equal
importance of the regulation of capital aside from fundamentally reforming it (Zestos 2015).
The liquidity position of individual banks has been supervised in a more dedicated and
intense manner.
Other reforms that have been proposed are designed to supervise and strengthen
regulation by supporting its corporate governance so that the occurrence of financial crisis is
less likely and its impact would be less damaging. Regulation of reforms intended to deliver
effective regulation of prudential and firm supervision and placed great emphasis on the
management and monitoring of the risks. Reforms also intended to provide greater protection
to the tax payer in the event of resolving the institute and instilling greater confidence in the
capacity of authorities to deal with the problems as they arise. The UK’s government planned
to supervise and strengthen financial regulation at an international level (Garriga and
Hedlund 2018).
The financial crisis highlighted the need for strong regulatory systems that should be
complemented by enhanced market and supervision of international firms. This can be done
by way of close cooperation between authorities, robust international standards and a

CORPORATE FINANCE
coherent structure of international regulation. It is also believed by the government that there
is scope for further strengthening regulation and international cooperation. Furthermore, in
light of the crisis, there is a necessity to improve the ability of the authority to identify the
systematic risks and rules of the European Union so that the rules are properly enforced. The
rules governing the cross border should be strengthened and safeguarded for increasing the
effectiveness of regulation which helps in securing a level playing field. Some of the policies
that it has been suggested the UK’s government to adopt are to ensure that there is consistent
application to the cross border group and minimum standards are strong. Moreover, the
exchange of information between host and home authorities should be strengthened. In
relation to the overall financial position of the group, the host supervisors should have access
to micro prudential information and should ensuring that there is supervisory audit and a peer
review of the audit of cross border supervision (Andrewbenjaminhall.com 2019).
There has been a proposal to introduce new macro-prudential tools and change the
existing micro prudential policy with respect to changes in the regulatory policy. The
recommendation of Lord Turner has been endorsed by the conservative party that requires
imposition of higher requirement of capital on activities that are of high risk and imposing
higher additional liquidity and capital on banks for reflecting the complexities and size of
institution. The structure of risky bonus is intended to exercise stricter control of capital
requirement (Singh and Kaur 2015). Furthermore, the lending by banks has been restricted by
the introduction of a backdrop leverage ratio that is internationally agreed. Additional
safeguards against the risk have been introduced by creating an interconnected and complex
institute by greater usage of central counterparty. This helps in creating greater financial
transparency and appropriate balance between over the counter and exchange traded
securities. To prevent the reoccurrence of such a catastrophic global financial crisis there
needs to be that supervision and financial regulation. In addition to this, the pro cyclicality

CORPORATE FINANCE
that is inherent in the financial regulation and systematic risk can be reduced by focusing on
supervision and macro prudential regulation.

CORPORATE FINANCE
Reference List:
Andrewbenjaminhall.com. (2019). [online] Available at:
http://www.andrewbenjaminhall.com/HKY_foreclosures.pdf [Accessed 26 Feb. 2019].
Ftp.iza.org. (2019). [online] Available at: http://ftp.iza.org/dp4934.pdf [Accessed 26 Feb.
2019].
Garriga, C. and Hedlund, A., 2018. Housing Crises. Center for Growth and Opportunity.
Hall, A.B., Yoder, J. and Karandikar, N., 2017, July. Economic distress and voting: Evidence
from the subprime mortgage crisis. In Annual Meeting of the Midwest Political Science
Association, Chicago, IL.
Matthews, K. and Thompson, J.L., 2005. The economics of banking. J. Wiley,.
Olbrys, J. and Majewska, E., 2016. Crisis periods and contagion effects in the CEE stock
markets: the influence of the 2007 US subprime crisis. International Journal of
Computational Economics and Econometrics, 6(2), pp.124-137.
Singh, A. and Kaur, P., 2015. Stock market linkages: Evidence from the US, China and India
during the subprime crisis. Timisoara Journal of Economics and Business, 8(1), pp.137-162.
Valdez, S. and Molyneux, P., 2015. An introduction to global financial markets. Macmillan
International Higher Education.
Zestos, G.K., 2015. The global financial crisis: from US subprime mortgages to European
sovereign debt. Routledge.

CORPORATE FINANCE

CORPORATE FINANCE