TERM PAPER

NAME – NANDINI KANODIA

ROLL NO. – 537

SEMESTER – V

COURSE – B.A (H) POLITICAL SCIENCE: DISCIPLINE

SPECIFIC ELECTIVE (DSE)

PAPER – INTERNATIONAL POLITICAL ECONOMY

TITLE - Systemic Risk and Market Failure: A Deep Dive

into the 2008 Financial Crisis

SUBMITTED TO – DR. KASTURI DATTA

Systemic Risk and Market Failure: A Deep Dive into the 2008 Financial Crisis

ABSTRACT - The 2008 Global Financial Crisis (GFC) was a catastrophic economic downturn
triggered by the U.S. housing market collapse, excessive risk-taking by financial institutions, and
regulatory failures. This paper analyses the causes, progression, and global impact of the crisis,
highlighting events like the liquidity crunch, banking collapse, and worldwide economic slowdown. It
explores recovery measures such as U.S. Federal Reserve interventions, bailouts, and international
cooperation, while also evaluating regional and economic impacts. A case study on India examines how
the crisis affected its financial sector and trade. The paper concludes by assessing the current market
and potential for future crises.

KEYWORDS – subprime crisis, monetary policy, Basel III, U.S. housing bubble, Lehman Brothers
bankruptcy, Credit default swaps (CDS), bank liquidity crises, TARP, Federal Reserve monetary policy

INTRODUCTION – The 2008 global financial crisis stands as one of the most significant economic
disruptions in modern history, reshaping the financial landscape and prompting responses that continue
to resonate today. Triggered by the collapse of the housing market in the United States, the crisis rapidly
unfolded into a worldwide economic downturn, exposing vulnerabilities within financial systems,
regulatory frameworks, and the interconnectedness of global markets. This research paper seeks to
provide a comprehensive analysis of the 2008 financial crisis, examining its underlying causes,
immediate impacts, and long-term consequences.

In the years leading up to the crisis, a confluence of factors—including lax regulatory oversight, reckless
lending practices, and the proliferation of complex financial instruments—created an environment ripe
for financial instability. As credit markets froze and consumer confidence plummeted, the repercussions
extended beyond national borders, leading to widespread unemployment, loss of savings, and a
reevaluation of economic paradigms. Governments and central banks around the world were compelled
to intervene with unprecedented fiscal and monetary measures in an attempt to stabilize economies and
restore public trust in financial institutions.

Despite extensive studies that have sought to dissect the elements contributing to the crisis, including
the role of major financial entities and the implications of globalization, critical lessons remain to be
learned. This paper will explore the intricate web of factors that led to the 2008 crisis, analyse the
effectiveness of the responses implemented by policymakers, and reflect on the enduring implications
for financial regulation and economic resilience. By delving into these areas, it aims to provide valuable
insights that not only enhance our understanding of past failures but also inform future policy decisions
in an increasingly complex global financial system.

THE BEGINNING OF THE CRISIS

The 2008 financial crisis was one of the largest economic disasters since the Great Depression, triggered
primarily by the U.S. housing market collapse. After the 9/11 attacks, the Federal Reserve lowered
interest rates to 1%, causing Treasury Bills to offer minimal returns. This made investors to seek higher
returns in the booming housing market. Mortgages, particularly subprime loans, were packaged into
mortgage-backed securities (MBS) and sold to investment banks, who then created Collateralized Debt
Obligations (CDOs). These securities, rated highly by credit rating agencies, were appealing due to
rising house prices, which were thought to provide a safety net in case of defaults.

As demand for these securities grew, lending standards were relaxed, resulting in predatory lending
practices. Borrowers with poor credit were offered adjustable-rate mortgages with no income
verification or down payments. This led to a housing bubble, where house prices soared as unqualified
borrowers flooded the market. Investors kept buying these securities, unaware of the mounting risk.

Eventually, the housing bubble burst in 2006 when house prices reached unsustainable levels. Defaults
surged as homeowners could no longer afford their payments, and many stopped paying when the value
of their homes fell below their mortgage debt. This caused a sharp decline in house prices and
widespread losses in the financial sector.

Institutions that held MBS and CDOs were severely affected. Credit Default Swaps (CDS), which were
insurance contracts sold to protect investors from mortgage defaults, added to the problem. Companies
like AIG had sold vast amounts of CDS without the capital to cover potential losses. When defaults
spiked, institutions faced immense financial strain, leading to the collapse of giants like Lehman
Brothers and forcing government bailouts for others.

The crisis, fueled by poor lending practices, over-leveraging, and complex financial products, created a
global economic shock, with ripple effects felt worldwide.

THE CRISIS

The Great Recession began with the U.S. housing market collapse in 2006. By November of that year,
the Commerce Department reported a significant 28% drop in new home permits, signaling the start of
a broader housing crisis. However, early warnings were largely ignored by the Bush administration and
the Federal Reserve, which believed the strong money supply and low-interest rates would limit the
crisis to the real estate sector. They failed to recognize how dependent banks had become on derivatives,
particularly mortgage-backed securities (MBS), which were supported by risky subprime loans.
Subprime borrowers, typically high-risk individuals, were offered interest-only loans with low initial
rates that reset to much higher ones later. When home prices began to fall and interest rates reset, these
borrowers defaulted, triggering the subprime mortgage crisis. Banks had sold excessive amounts of
MBS, which were backed by questionable mortgages. When home prices plummeted in 2007, the real
estate crisis deepened, and the wider financial sector became entangled.

To mitigate risk, banks had purchased credit default swaps (CDS) to insure against mortgage defaults.
However, insurers, including American International Group (AIG), did not have sufficient capital to
cover the CDS holders when defaults surged. This left AIG on the brink of collapse, necessitating a
federal government bailout. The excessive reliance on derivatives and bad mortgages underpinned the
growing financial disaster, which soon spread beyond housing and into the banking industry. Major
institutions like Lehman Brothers and Merrill Lynch were heavily impacted, leading to Lehman's
bankruptcy and Merrill Lynch’s forced sale. The crisis quickly became global.

The Federal Reserve, aware of the deteriorating situation, intervened in April 2007, encouraging lenders
to work with borrowers on alternatives to foreclosure, such as loan modifications and fixed-rate
mortgages. The Fed also began cutting interest rates in September 2007, eventually lowering the federal
funds rate to 4.25%. However, these actions were insufficient to calm the markets.

By the third quarter of 2008, the subprime crisis had spread throughout the economy, which shrank by
0.3%. Early signs of trouble, like declining durable goods orders in 2006, had been overlooked. As the
crisis deepened, government-backed mortgage giants Fannie Mae and Freddie Mac also fell victim.
Congress provided them with $100 billion in guarantees, but this move further destabilized the
companies, which were already struggling to remain competitive in a high-risk environment.

On September 29, 2008, the stock market crashed, with the Dow Jones Industrial Average plummeting
777.68 points, the largest drop at the time. This crash, exacerbated by Congress’s initial rejection of a
bank bailout bill, worsened an already dire situation. On October 3, Congress passed the Troubled Asset
Relief Program (TARP), authorizing $700 billion to stabilize the financial system. The U.S. Treasury
used $115 billion to buy preferred stock in troubled banks and increased the Federal Deposit Insurance
Corporation’s (FDIC) coverage limit to $250,000 per account.

In February 2009, President Obama signed the $787 billion American Recovery and Reinvestment Act,
aimed at ending the recession. The plan included $288 billion in tax cuts, $224 billion in unemployment
benefits, and $275 billion for public works. It also offered $54 billion in tax relief for small businesses.
Alongside this, Obama launched the Homeowner Stability Initiative, a $75 billion effort to prevent
foreclosures by assisting struggling homeowners. Together, these measures helped to end the recession
and stabilize the economy.
Main Causes of the GFC –

As for all financial crises, a range of factors explain the GFC and its severity, and people are still
debating 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, economic conditions in the United States and other countries were favourable.
Economic growth was strong and stable, and rates of inflation, unemployment and interest were
relatively low. In this environment, house prices grew strongly. Expectations that house prices
would continue to rise led households, in the United States especially, to borrow imprudently
to purchase and build houses. A similar expectation on house prices also led property developers
and households in European countries (such as Iceland, Ireland, Spain and some countries in
Eastern Europe) to borrow excessively. Many of the mortgage loans, especially in the United
States, were for amounts close to (or even above) the purchase price of a house. A large share
of such risky borrowing was done by investors seeking to make short-term profits by ‘flipping’
houses and by ‘subprime’ borrowers (who have higher default risks, mainly because their
income and wealth are relatively low and/or they have missed loan repayments in the past).

2. Increased borrowing by banks and investors: In the lead up to the GFC, banks and other
investors in the United States and abroad borrowed increasing amounts to expand their lending
and purchase MBS products. Borrowing money to purchase an asset (known as an increase in
leverage) magnifies potential profits but also magnifies potential losses.1 As a result, when
house prices began to fall, banks and investors incurred large losses because they had borrowed
so much. Additionally, banks and some investors increasingly borrowed money for very short
periods, including overnight, to purchase assets that could not be sold quickly. Consequently,
they became increasingly reliant on lenders – which included other banks – 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 was insufficient regulation of the institutions that created and sold the
complex and opaque MBS to investors. Not only were many individual borrowers provided
with loans so large that they were unlikely to be able to repay them, but fraud was increasingly
common – such as overstating a borrower’s income and over-promising investors on the safety
of the MBS products they were being sold. In addition, as the crisis unfolded, many central
banks and governments did not fully recognize the extent to which bad loans had been extended
during the boom and the many ways in which mortgage losses were spreading through the
financial system.
How the GFC Unfolded –

1. US house prices fell, borrowers missed repayments: The catalysts for the GFC were
falling US house prices and a rising number of borrowers unable to repay their loans. House
prices in the United States peaked around mid-2006, coinciding with a rapidly rising supply
of newly built houses in some areas. As house prices began to fall, the share of borrowers
that failed to make their loan repayments began to rise. Loan repayments were particularly
sensitive to house prices in the United States because the proportion of US households (both
owner-occupiers and investors) with large debts had risen a lot during the boom and was
higher than in other countries.

2. Stresses in the financial system: Stresses in the financial system first emerged clearly
around mid-2007. Some lenders and investors began to incur large losses because many of
the houses they repossessed after the borrowers missed repayments could only be sold at
prices below the loan balance. Relatedly, investors became less willing to purchase MBS
products and were actively trying to sell their holdings. As a result, MBS prices declined,
which reduced the value of MBS and thus the net worth of MBS investors. In turn, investors
who had purchased MBS with short-term loans found it much more difficult to roll over
these loans, which further exacerbated MBS selling and declines in MBS prices.
3. Spillovers to other countries: As noted above, foreign banks were active participants in
the US housing market during the boom, including purchasing MBS (with short-term US
dollar funding). US banks also had substantial operations in other countries. These
interconnections provided a channel for the problems in the US housing market to spill over
to financial systems and economies in other countries.
4. Failure of financial firms, panic in financial markets: Financial stresses peaked
following the failure of the US financial firm Lehman Brothers in September 2008.
Together with the failure or near failure of a range of other financial firms around that time,
this triggered a panic in financial markets globally. Investors began pulling their money out
of banks and investment funds around the world as they did not know who might be next
to fail and how exposed each institution was to subprime and other distressed loans.
Consequently, financial markets became dysfunctional as everyone tried to sell at the same
time and many institutions wanting new financing could not obtain it. Businesses also
became much less willing to invest and households less willing to spend as confidence
collapsed. As a result, the United States and some other economies fell into their deepest
recessions since the Great Depression.
RECOVERING FROM THE CRISIS

The global financial crisis created in the market a severe recession. However, because of the several
government interventions and recovery measures helped the economy to come round.

There were several measures those helped the economy recover this crisis. Among them government
bailouts, monetary and fiscal policy adjustment played the major part. Federal Reserve took massive
steps for recovery involving both monetary policies to stimulate the recovery and liquidity provisions
in order to support orderly functions of financial market.

5.1 MONETARY STIMULUS (BAILOUTS)

Troubled asset relief fund (TARF), the bush government most important provision, and AIG, for
recovery of the economic crisis was bailed out by the US government, with over $150 billion. The
economy recovery act in order to limit withdrawals from banks, raised the federal deposit insurance
limit temporarily from $10000 to $25000. Similarly European government conducted massive bailout
of around $10 trillion to prop up the economy in the banking system. Even the bank failure in Europe
had massive impact. Almost all the European countries such as Germany, Netherlands, and Luxemburg,
Belgium came forward to bailout their major European banks (Mishkin, 2013).

5.2 FISCAL STIMULUS

Fiscal stimulus was another key process in the way of recovery. Congress passed the economic stimulus
act of 2008, in February of 2008. The act gave the government one-time tax rebate of $78 billion and
sent $600 checks to taxpayers individually. Also, the Obama government passed the American recovery
and investment act of 2009, contributing $787 billion fiscal stimulus package (Mishkin, 2013).

With the help of all these recovery actions, the bull market in stocks took place and the spread began to
fall. Even the provisions helped the recovery of the economy through financial market, the pace of the
recovery was slow.

5.3 AFTERMATH

Aftermaths are usually consequences of any disaster or failure of any major event. It basically is
something unpleasant, but the recovery process comes along with it.

1. Among the main causes of the great depression, unregulated derivatives market played the major
role. After the crisis, the over the counter market has become more regulated that it has to clear
requirements through central counterparties (CCP). Banks now can be member of one or more CCPs.
Banks have to maintain initial and variable margin and contribute to the default fund (Hull, 2009).
2. The bonuses paid by banks are now under more strict scrutiny. Before the crisis, the trader’s bonus
of a year was paid at the end of the year in full amount, with no possibility of the bonus having to be
returned. Now the bonuses can be spread over several years and can be forfeited if the subsequent results
are poor (Hull, 2009).

3. The “Volcker Rule” proposed to make the retail operations of banking difficult. The rule made the
proprietary trading and deposit taking activities more difficult. This rule is encouraging and clearing the
path worldwide to separate trading and other banking related trading, which is a way of reducing the
risk of defaults in financial institutions (Foerster, 2014).

4. Another most important invention after this crisis is “Basel II.5”. Prior the crisis Basel committee on
banking supervision was formed with only Basel I and Basel II. After the crisis Basel II.5 was introduced
in the market, which increased the capital requirement over market risk. Basel III was also published,
but is going to be implemented after 2019. It increases the capital amount and the quality of the capital
requirement to satisfy certain liquidity requirements (Hull, 2009).

GLOBAL IMPACT

The IMF statistics on the real GDP of U.S.A clearly indicates that the output recession in U.S.A did not
begin until the fourth quarter of 2008. Japan got hit harder by the recession than U.S.A but Japan's
decline in real GDP started before the U.S.A economy entered the recession. The United Kingdom
experienced a decline in growth in 2008III and finally a decline in real production in 2008IV, but
generally the pattern is very much the same as for U.S.A.

Figure: The Percentage Change of Real GDP of U.S.A, Japan and U.K
Germany, France, Italy and Spain are all part of the European Monetary Union. It can be seen that Italy
has been the hardest hit of the four by the recession. Germany was initially not affected and then was
hit nearly as hard as Italy. Spain was the least affected of the four but ultimately was hit nearly as hard
as France.

Figure: The Percentage Change in Real GDP of Spain, France, Germany and Italy

Due to the recession, U.S. demand took a fall resulting in lower exports by European companies, as
well as lower sales and profits for European firms such as BMW, Unilever, and others that produce
everything from cars to consumer products in U.S.A. A weaker dollar caused the value in euros of
European investments in the U.S.A to suffer a major capital loss. Furthermore, high oil prices were also
a problem.

The graph shows what happened to a small economy such as Portugal in comparison to the much larger
economy of Spain. It can be seen that the smaller economy was initially not affected but then it was
affected very severely and much worse than Spain by the end of first quarter of 2009.

Figure: The Percentage Change in Real GDP of Spain and Portugal

Canada and Mexico heavily depend upon trade with U.S.A. Export to U.S.A represent about a quarter
of each country’s GDP. Therefore, the recession strongly affected their economies as expected. This is
justified and supported by the graph above as well. Moreover, the effect on Mexico was delayed but
when it hit it was severe by the first quarter of 2009. Canada, on the other hand, experienced the
recession in almost the same pattern as being followed by U.S.A.

Figure: The Percentage Change in Real GDP of U.S.A, Canada and Mexico

Hong Kong’s economy went through a boom in the beginning quarters but this was followed by a sharp
downturn that probably was due to the current global recession. On the other hand, China-the world’s
fastest-growing economy was highly affected when the world’s largest economy slowed down as China
relies on exports to U.S.A as one of its main sources of growth. The recession caused the double-digit
growth rate to fall to six or seven percent.

Figure: The Percentage Change in Real GDP of Hong Kong

Singapore is one of the Asian Tiger Economies. Singapore was unaffected in the early quarters of the
recession but when it was affected it was severely affected. Its economy went through a major recession.

. Figure: The Percentage Change in Real GDP of Singapore

 CASE STUDY

Economic Downturn: A Detailed Analysis of the 2008 Indian Market Crash

Introduction

The 2008 Global Financial Crisis (GFC) is often considered one of the most severe economic downturns
since the Great Depression. Triggered by the collapse of Lehman Brothers and a widespread meltdown
in the housing and financial markets in the U.S., the crisis quickly spread across the globe. While India
did not experience a full-blown financial meltdown, the ripple effects of the global downturn severely
impacted its economy, particularly in areas such as trade, capital flows, and investor confidence.

Channels of Impact

1. Stock Market Volatility: The first noticeable impact of the GFC on India was the significant
decline in the stock markets. In 2008, the Bombay Stock Exchange (BSE) Sensex fell by nearly
52%. Foreign Institutional Investors (FIIs) pulled out significant investments due to global risk
aversion, causing a sharp drop in market capitalization and liquidity.
2. Decline in Exports: India's export sector took a major hit, particularly in textiles, gems,
jewellery, and IT services. As demand from the U.S. and European Union, India’s major export
markets, plummeted, the Indian export sector saw a year-on-year decline. The export growth
rate, which was 28% in 2007, plunged to nearly 3% by 2008–2009. IT services, a major export
for India, experienced slowed growth as companies in the U.S. cut down on outsourcing.
3. Reduced Capital Inflows: The global liquidity crunch severely affected India’s capital inflows.
Foreign direct investment (FDI) and portfolio investment declined sharply. FIIs pulled out
nearly $15 billion from Indian markets, exacerbating stock market losses and causing pressure
on the Indian rupee. The rupee depreciated by about 20% against the U.S. dollar, adding to
inflationary pressures in the domestic economy.
4. Impact on Employment: Sectors such as export-oriented manufacturing and IT services saw
job losses as a result of declining global demand. By mid-2009, thousands of workers in export-
driven industries such as textiles and automotive were laid off. While India did not experience
a large-scale unemployment crisis like in Western economies, the job market was affected,
especially for urban and semi-skilled workers.

Policy Response by India

1. Monetary Policy Easing: The Reserve Bank of India (RBI) responded swiftly by cutting the
benchmark interest rates and injecting liquidity into the banking system. The repo rate was cut
 from 9% in mid-2008 to 4.75% by early 2009. The Cash Reserve Ratio (CRR) was also lowered
to free up more funds for lending.
2. Fiscal Stimulus: The Indian government implemented a series of fiscal stimulus packages
aimed at boosting domestic demand and stabilizing the economy. The government increased
public expenditure on infrastructure projects, provided tax cuts, and offered subsidies to key
industries like textiles, automobiles, and small-scale enterprises. The combined fiscal stimulus
accounted for about 3% of GDP between 2008 and 2010.
3. Rupee Management: To stabilize the falling rupee, the RBI intervened in the foreign exchange
markets. Measures were taken to curb excessive speculation, and the government allowed oil
companies to hedge their currency exposure. These efforts helped reduce the volatility in the
currency markets.
4. Banking Sector Stability: Indian banks, particularly state-owned banks, remained relatively
insulated due to conservative lending practices and limited exposure to toxic assets. The RBI’s
regulation also played a crucial role in ensuring that the banking system remained stable. The
central bank’s stress tests on Indian banks showed they were well-capitalized, and no major
institution was at risk of collapse.

Recovery and Long-Term Impact

India's economy began to show signs of recovery by mid-2009. By 2010, GDP growth had rebounded
to 8%, largely driven by domestic consumption, a revival in exports, and a continued government
spending spree on infrastructure. The resilience of India's banking sector and the timely policy
responses helped limit the severity of the downturn.

However, the crisis exposed certain vulnerabilities in the Indian economy, particularly its reliance on
foreign capital flows and exports. The slowdown also led to a rethinking of India's economic strategy,
with greater emphasis on boosting domestic demand and diversifying export markets.

Conclusion

While India was not as severely impacted as the U.S. or Europe during the 2008 Global Financial Crisis,
the effects were significant enough to cause a slowdown in growth, job losses, and a decline in exports.
However, the country’s relatively insulated financial system, along with timely fiscal and monetary
interventions, helped in mitigating the worst effects of the crisis. Going forward, the lessons from the
GFC have influenced India’s approach to financial regulation, capital market reforms, and economic
resilience-building.
 DISCUSSION

Before the 2008 financial crisis, global debt was high, volatility was low, and there was a mismatch
between risk and return. By 2018, global debt had surged 60% to a record $182 trillion, raising concerns
about unregulated parts of the financial system, including shadow banking in China, and large global
banks like JP Morgan and the Industrial and Commercial Bank of China, which may still be “too big to
fail.” The International Monetary Fund (IMF), under Christine Lagarde, warned that rising U.S. interest
rates could destabilize developing economies, vulnerable due to their debt build-up.

Several experts weighed in on the likelihood of another financial crisis. Bill Emmons from the Federal
Reserve Bank of St. Louis argued that while a crisis like 2008 is unlikely soon, key reforms have not
been fully implemented. He emphasized the need for stronger mortgage underwriting standards, better
disclosure for securitized debt, independent credit rating agencies, and stronger regulation of derivatives
markets like credit default swaps (CDS). While some reforms were made, the absence of guardrails
means a crisis in housing and financial markets could recur, though the severity of the last collapse may
delay another one.

Financial historian Richard Sylla agreed, noting that excessive credit and debt creation, the hallmark of
financial crises, has not been adequately addressed. While he acknowledged a future crisis is possible,
he doesn’t expect it in the near term.

Mark Zandi, Chief Economist at Moody’s Analytics, offered a more optimistic view, highlighting the
improvements in the financial system since 2008, including more stringent capital and liquidity
requirements for banks under the Dodd-Frank Act. Stress-testing and better risk management practices
now ensure banks are better prepared for financial shocks. Additionally, there is a clearer process for
resolving failing institutions, which was absent during the 2008 crisis. The Consumer Financial
Protection Bureau (CFPB) is also monitoring mortgage and lending practices, making reckless lending
less likely.

However, Zandi also pointed to risks in leveraged lending to non-financial businesses, which could
cause stress in the financial system during the next recession. Moreover, with banks holding more
capital and liquidity, risk-taking is shifting to the less regulated “shadow banking” system, which could
be the source of the next financial crisis. While Zandi believes the financial system is in better shape,
he emphasized the need for regulators to remain vigilant as memories of the last crisis fade and risk-
taking increases.
 CONCLUSION

The route of the 2008 Great Depression started from very early, however the depression is considered
to take place from December 2007 to June 2009. Basically, the years of deregulation, uncontrolled credit
policies in mortgages leading to increase in house prices, issuance of certain derivatives and unregulated
securitization process resulted the scarcity of valuable assets in the global economy. All of these led the
financial players to involve in gambling and created moral hazard problems. Hence leading to a collapse
in global financial sectors, banks. The crisis caused a huge cut in employment, many households lost
their home, the financial crisis spread across the border of US.

Widespread banking bailout and stimulus measures were taken in order to recover the financial
contraction, but the pace of the recovery was slow. The head of the IMF, Dominique Strauss-Kahn
mentioned that the free-fall in the economy may start to abate after the taken initiatives, but keeping it
in a stable situation depends on the appropriate measures and polices taken by the governments. IMF
also argues that income inequality among western countries and demand deflation is another key reason
for the upcoming financial crisis. After the 2008 crisis, the long-term unemployment rate in US is
alarmingly high, creating a new concern for the job market to collapse.

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verma

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