Introduction

Financial Crisis: A situation in which the economy of a country experiences a

sudden downturn brought on by a financial crisis. An economy facing an economic crisis will most likely experience a falling GDP, a drying up of liquidity and

rising/falling prices due to inflation/deflation. An economic crisis can take the form of a recession or a depression. Also called real economic crisis. The term financial crisis is applied broadly to a variety of situations in which some financial institutions or assets suddenly lose a large part of their value. In the 19th and early 20th centuries, many financial crises were associated with banking panics, and many recessions coincided with these panics. Other situations that are often called financial crises include stock market crashes and the bursting of other financial bubbles, currency crises, and sovereign defaults

Impact of global financial crisis on the economy of Bangladesh: Since the

collapse of the United States subprime mortgage market and the subsequent international global crisis, many developed and developing countries have been plunged into deep recession. Bangladesh though has found itself in a slightly different position. Its economy is not so dependent on international capital and foreign investment, which has helped to lower the immediate impact of the crisis. Despite this the Bangladesh government has formed a high-level technical committee and taskforce to monitor and advise on the crisis, and ministries and financial institutions have taken several precautionary measures. Importantly in October 2008 Bangladesh Bank withdrew 90 % of its total investment from foreign banks which has helped to further shield the economy, so that it is only now that the effects of the crisis are being felt. Additionally the Bank has taken measures to stabilize the exchange rate, provide extra liquidity to the financial sector and raised the limit on private foreign borrowing. It has also relaxed the conditions for opening fresh letters of credit (L/Cs). In February 2009, the Finance Minister AMA Muhith admitted that the global financial crisis was having an impact on trade in Bangladesh. In April the Government announced their stimulus package with 65 million dollars directed to assist exports. This though falls short of the 877 million dollars needed according to industry experts (Yahoo news, 2009).

During 2008, 57% of Bangladeshs economy was involved in the global economy and this is increasing. This indicates that the country might be progressively more affected should the crisis continue for an extended period. Trade, migration and remittance are the most likely sectors to be impacted as 43.3% of Bangladeshs openness is related to trade and 10 % to remittance. Overseas Development Assistance (ODA) and Foreign Direct Investment (FDI) may also be vulnerable in the longer term but to a lesser extent due to only 3.2% integration with the global economy (CPD and ILO, 2009). Whilst the longer term nature of FDI commitments has kept the net inflow of investment relatively stable, the sluggish growth of rich countries may eventually slow it down. Aid receipts (excluding dollars) are providing less in local currency due to unfavorable exchange rates and future aid commitments from donors may be in jeopardy if the downturn continues.

Chapter-1
The Origins of financial crisis: The financial crisis that has been wreaking havoc in
markets in the U.S. and across the world since August 2007 had its origins in an asset price bubble that interacted with new kinds of financial innovations that masked risk; with companies that failed to follow their own risk management procedures; and with regulators and supervisors that failed to restrain excessive risk taking. A bubble formed in the housing markets as home prices across the country increased each year from the mid-1990s to 2006, moving out of line with fundamentals like household income. Like traditional asset price bubbles, expectations of future price increases developed and were a significant factor in inflating house prices. As individuals witnessed rising prices in their neighborhood and across the country, they began to expect those prices to continue to rise, even in the late years of the bubble when it had nearly peaked. The rapid rise of lending to subprime borrowers helped inflate the housing price bubble. Before 2000, subprime lending was virtually non-existent, but thereafter it took off exponentially. The sustained rise in house prices, along with new financial innovations, suddenly made subprime borrowers previously shut out of the mortgage markets attractive customers for mortgage lenders. Lenders devised innovative Adjustable Rate Mortgages (ARMs) with low "teaser rates,"

no down-payments, and some even allowing the borrower to postpone some of the interest due each month and add it to the principal of the loan which were predicated on the expectation that home prices would continue to rise. But innovation in mortgage design alone would not have enabled so many subprime borrowers to access credit without other innovations in the so-called process of "securitizing" mortgages or the pooling of mortgages into packages and then selling securities backed by those packages to investors who receive pro rata payments of principal and interest by the borrowers. The two main government-sponsored enterprises devoted to mortgage lending, Fannie Mae and Freddie Mac, developed this financing technique in the 1970s, adding their guarantees to these "mortgage-backed securities" (MBS) to ensure their marketability. For roughly three decades, Fannie and Freddie confined their guarantees to "prime" borrowers who took out "conforming" loans, or loans with a principal below a certain dollar threshold and to borrowers with a credit score above a certain limit. Along the way, the private sector developed MBS backed by non-conforming loans that had other means of "credit enhancement," but this market stayed relatively small until the late 1990s. In this fashion, Wall Street investors effectively financed homebuyers on Main Street. Banks, thrifts, and a new industry of mortgage brokers originated the loans but did not keep them, which was the "old" way of financing home ownership. Over the past decade, private sector commercial and investment banks developed new ways of securitizing subprime mortgages: by packaging them into "Collateralized Debt Obligations" (sometimes with other asset-backed securities), and then dividing the cash flows into different "tranches" to appeal to different classes of investors with different tolerances for risk. By ordering the rights to the cash flows, the developers of CDOs (and subsequently other securities built on this model), were able to convince the credit rating agencies to assign their highest ratings to the securities in the highest tranche, or risk class. In some cases, socalled "monocline" bond insurers (which had previously concentrated on insuring municipal bonds) sold protection insurance to CDO investors that would pay off in the event that loans went into default. In other cases, especially more recently, insurance companies, investment banks and other parties did the near equivalent by selling "credit default swaps" (CDS), which were similar to monocline insurance in principle but different in risk, as CDS sellers put up very little capital to back their transactions.

These new innovations enabled Wall Street to do for subprime mortgages what it had already done for conforming mortgages, and they facilitated the boom in subprime lending that occurred after 2000. By channeling funds of institutional investors to support the origination of subprime mortgages, many households previously unable to qualify for mortgage credit became eligible for loans. This new group of eligible borrowers increased housing demand and helped inflate home prices. These new financial innovations thrived in an environment of easy monetary policy by the Federal Reserve and poor regulatory oversight. With interest rates so low and with regulators turning a blind eye, financial institutions borrowed more and more money (i.e. increased their leverage) to finance their purchases of mortgage-related securities. Banks created off-balance sheet affiliated entities such as Structured Investment Vehicles (SIVs) to purchase mortgagerelated assets that were not subject to regulatory capital requirements Financial institutions also turned to short-term "collateralized borrowing" like repurchase agreements, so much so that by 2006 investment banks were on average rolling over a quarter of their balance sheet every night. During the years of rising asset prices, this short-term debt could be rolled over like clockwork. This tenuous situation shut down once panic hit in 2007, however, as sudden uncertainty over asset prices caused lenders to abruptly refuse to rollover their debts, and over-leveraged banks found themselves exposed to falling asset prices with very little capital. While ex post we can certainly say that the system-wide increase in borrowed money was irresponsible and bound for catastrophe, it is not shocking that consumers, would-be homeowners, and profit-maximizing banks will borrow more money when asset prices are rising; indeed, it is quite intuitive. What is especially shocking, though, is how institutions along each link of the securitization chain failed so grossly to perform adequate risk assessment on the mortgage-related assets they held and traded. From the mortgage originator, to the loan servicer, to the mortgage-backed security issuer, to the CDO issuer, to the CDS protection seller, to the credit rating agencies, and to the holders of all those securities, at no point did any institution stop the party or question the little-understood computer risk models, or the blatantly unsustainable deterioration of the loan terms of the underlying mortgages.

1.2 The Financial Crisis of the Great Depression:

The Great Depression of

the 1930s was the economic event of the 20th century. The history of the depression is fascinating because it is a reference point for economic misery and fear. When people make

financial planning decisions and politicians set policy the depression experience is, or maybe should be, in the back of everyone's mind as a worst case scenario. The depression is also interesting because, in hindsight, the downturn could have been much shall owner had policy makers not made certain mistakes. Some of these mistakes have been very well researched by economists over the years and are highlighted here. There are also lessons to be had from the depression on human behavior and society in general. Lessons such as how blind and greedy we become when swept away by delusions of grandeur, only to flagellate ourselves when our dreams don't work out. And how our initial reaction to fear is to create barriers between others and ourselves resulting in added misery for everyone. If this was an article about how we recovered from the Great Depression there would also be inspiring stories of leadership and daring generosity among all kinds of people. How facing extreme difficulties put people in touch with a wealth that was beyond their empty bank accounts. At least in part, the Great Depression was caused by underlying weaknesses and imbalances within the U.S. economy that had been obscured by the boom psychology and speculative euphoria of the 1920s. The Depression exposed those weaknesses, as it did the inability of the nation's political and financial institutions to cope with the vicious downward economic cycle that had set in by 1930. Prior to the Great Depression, governments traditionally took little or no action in times of business downturn, relying instead on impersonal market forces to achieve the necessary economic correction. But market forces alone proved unable to achieve the desired recovery in the early years of the Great Depression, and this painful discovery eventually inspired some fundamental changes in the United States' economic structure. After the Great Depression, government action, whether in the form of taxation, industrial regulation, public works, social insurance, social-welfare services, or deficit spending, came to assume a principal role in ensuring economic stability in most industrial nations with market economies.

1.3 The Financial Crisis of 2007-2009: The ultimate point of origin of the great
financial crisis of 2007-2009 can be traced back to an extremely indebted US economy. The collapse of the real estate market in 2006 was the close point of origin of the crisis.[12] The failure rates of subprime mortgages were the first symptom of a credit boom tuned to bust and of a real estate shock. But large default rates on subprime mortgages cannot account for

the severity of the crisis. Rather, low-quality mortgages acted as an accelerant to the fire that spread through the entire financial system. The latter had become fragile as a result of several factors that are unique to this crisis: the transfer of assets from the balance sheets of banks to the markets, the creation of complex and opaque assets, the failure of ratings agencies to properly assess the risk of such assets, and the application of fair value accounting. To these novel factors, one must add the now standard failure of regulators and supervisors in spotting and correcting the emerging weaknesses. For many months before September 2008, many business journals published commentaries warning about the financial stability and risk management practices of leading U.S. and European investment banks, insurance firms and mortgage banks consequent to the subprime mortgage crisis. Beginning with failures caused by misapplication of risk controls for bad debts, collateralization of debt insurance and fraud, large financial institutions in the United States and Europe faced a credit crisis and a slowdown in economic activity. The crisis rapidly developed and spread into a global economic shock, resulting in a number of European bank failures, declines in various stock indexes, and large reductions in the market value of equities and commodities. Moreover, the de-leveraging of financial institutions further accelerated the liquidity crisis and caused a decrease in international trade. World political leaders, national ministers of finance and central bank directors coordinated their efforts to reduce fears, but the crisis continued. At the end of October a currency crisis developed, with investors transferring vast capital resources into stronger currencies such as the yen, the dollar and the Swiss franc, leading many emergent economies to seek aid from the International Monetary Fund. 1. Imprudent Mortgage Lending: Against a backdrop of abundant credit, low interest rates, and rising house prices, lending standards were relaxed to the point that many people were able to buy houses they couldnt afford. When prices began to fall and loans started going bad, there was a severe shock to the financial system. 2. Housing Bubble: With its easy money policies, the Federal Reserve allowed housing prices to rise to unsustainable levels. The crisis was triggered by the bubble bursting, as it was bound to do. 3. Global Imbalances: Global financial flows have been characterized in recent years by an unsustainable pattern: some countries (China, Japan, and Germany) run large surpluses every

year, while others (like the U.S and UK) run deficits. The U.S. external deficits have been mirrored by internal deficits in the household and government sectors. U.S. borrowing cannot continue indefinitely; the resulting stress underlies current financial disruptions. 4. Securitization: Securitization fostered the originate-to-distribute model, which reduced lenders incentives to be prudent, especially in the face of vast investor demand for subprime loans packaged as AAA bonds. Ownership of mortgage-backed securities was widely dispersed, causing repercussions throughout the global system when subprime loans went bad in 2007. 5. Lack of Transparency and Accountability in Mortgage Finance: Throughout the housing finance value chain, many participants contributed to the creation of bad mortgages and the selling of bad securities, apparently feeling secure that they would not be held accountable for their actions. A lender could sell exotic mortgages to home-owners, apparently without fear of repercussions if those mortgages failed. Similarly, a trader could sell toxic securities to investors, apparently without fear of personal responsibility if those contracts failed. And so it was for brokers, realtors, individuals in rating agencies, and other market participants, each maximizing his or her own gain and passing problems on down the line until the system itself collapsed. Because of the lack of participant accountability, the originate-to distribute model of mortgage finance, with its once great promise of managing risk, became itself a massive generator of risk. 6. Rating Agencies: The credit rating agencies gave AAA ratings to numerous issues of subprime mortgage-backed securities, many of which were subsequently downgraded to junk status. Critics cite poor economic models, conflicts of interest, and lack of effective regulation as reasons for the rating agencies failure. Another factor is the markets excessive reliance on ratings, which has been reinforced by numerous laws and regulations that use ratings as a criterion for permissible investments or as a factor in required capital levels. 7. Government- Mandated Subprime Lending: Federal mandates to help low-income borrowers (e.g., the Community Reinvestment Act (CRA) and Fannie Mae and Freddie Macs affordable housing goals) forced banks to engage in imprudent mortgage lending. 8. Financial Innovation: New instruments in structured finance developed so rapidly that market infrastructure and systems were not prepared when those instruments came under stress. Some propose that markets in new instruments should be given time to mature before

they are permitted to attain a systemically significant size. This means giving accountants, regulators, ratings agencies, and settlement systems time to catch up. 9. Complexity: The complexity of certain financial instruments at the heart of the crisis had three effects: (1) investors were unable to make independent judgments on the merits of investments, (2) risks of market transactions were obscured, and (3) regulators were baffled.

1.4 Financial Crisis and Financial Regulation: The rest of this essay spells out
these misconceptions. In each case, there is a contrast between the myth and reality. 1: Banking regulators were in the dark as new financial instruments reshaped the financial industry. The decade leading to the financial crisis saw the development and growth of many innovations in the financial industry. These included collateralized debt obligations, creditdefault swaps, special-purpose vehicles, and private-label mortgage securities. Without getting into the specifics of these innovations, their overall net result was to create what is now referred to as the shadow banking system. They allowed banks and other institutions to finance their mortgage security holdings with short-term debt. This meant that the financial institutions lacked the liquid reserves to withstand a change in market perceptions of the risk of such assets. It also meant that they lacked sufficient capital to cover losses when the housing market deteriorated. The dramatic structural changes that took place in the financial industry were not noticed by the general public, and received little coverage even in the financial press. However, it is a myth that financial regulators were unaware of these developments. 2: Deregulation allowed the market to adopt risky practices, such as using agency ratings of mortgage securities. The myth is that, as one prominent policy paper put it, Market discipline broke down as investors relied excessively on credit rating agencies. The reality is that it was regulatory policy, not markets that drove the use of credit agency ratings. Bank regulators, especially with a rule that took effect on January 1, 2002, gave breaks on capital requirements to banks that held assets with AA and AAA ratings from credit rating agencies.

The market was not nearly as obsessed with ratings as were the regulators. Many rated securities were not even traded in the market. Instead, banks obtained ratings for the sole purpose of engaging in regulatory capital arbitrage, meaning that they were able to reduce capital requirements for a given risk. 3: Policy makers relied too much on market discipline to regulate financial risk taking. Many experts, including former Federal Reserve Board Chairman Alan Greenspan, have voiced the complaint that the market proved less rational than expected in its management of risk. The implication is that markets are too unreliable and that stronger regulation is the answer. It is certainly true that some financial executives made serious miscalculations. They themselves greatly underestimated the risks of a housing market decline and overestimated the insulation from risk that could be obtained by using sophisticated financial models and structured finance. However, the greater flaw was in the regulatory structure, and in particular the capital regulations for banks, investment banks, and the mortgage agencies Freddie Mac and Fannie Mae. There was an absence of market discipline at these firms in large part because such a large share of the risk that they took was borne by taxpayers rather than by shareholders and management.

4: The financial crisis was primarily a short-term panic. The financial crisis has four components: Bad bets, meaning unwise decisions by developers to build too many homes, by consumers to purchase too many homes, by mortgage lenders to make unwise loans, and by financial institutions that incurred too much exposure to credit risk in housing. Excessive leverage, meaning that the debt-to-equity ratio was so high at some key firms, such as Freddie Mac, Fannie Mae, and Bear Stearns, that only a small drop in asset values could bankrupt the firms.

Domino effects, meaning the ways at which problems at one firm could spill over to another firm. 21st-century bank runs, in which institutions that were using mortgage securities as collateral for short-term borrowing from other firms found that their counter-parties were reluctant to extend their loans. The first two components reflect fundamental problems that developed over a period of at least a decade. The last two components reflect a financial panic that emerged abruptly in 2008. Too many policy makers are focused only on the financial panic. For example, when Bernanke, offering a retrospective on the crisis at a conference at Jackson Hole in August of 2009, used the word panic more than a dozen times, but the phrase house prices only twice and the phrase mortgage defaults just once. 5: The only way to prevent this crisis would have been to have more vigorous regulation. There is a myth that financial firms were like teenagers who started a terrible fire because of a lack of adult supervision. In fact, Congress and regulators were doing the equivalent of handing out matches, gasoline, and newspapers. Housing policy was obsessed with increasing home purchases. This was pushed to the point where, given the lack of any down payment, the term home ownership is probably a misnomer. If the goal was home ownership, then the actual result was speculation and indebtedness. The easiest way to have prevented the crisis would have been to discourage, rather than encourage, the trend toward ever lower down payments on home purchases. Maintaining a requirement for a reasonable down payment would have dampened the speculative mania that drove house prices to unsustainable levels. It would have reduced the number of mortgage defaults. Another way to have prevented the crisis would have been to rely on something other than risk buckets and credit agency ratings to regulate bank capital. A better approach would have been to use stress tests, in which regulators would specify hypothetical scenarios for interest rates or home prices, with bank capital adequacy measured against such stress

10

tests. Another approach, noted earlier, would have been to require financial firms to issue unsecured debt. Such debt would help insulate deposit insurance funds from fluctuations in asset prices. Moreover, if such debt is traded, then its price can be used as a market indicator of risk, giving regulators an early-warning system for problems. Chapter 2

2.1 Impact of Financial Turmoil (2007-2009) on Bangladeshi Economy:

Since the collapse of the United States subprime mortgage market and the subsequent international global crisis, many developed and developing countries have been plunged into deep recession. Bangladesh though has found itself in a slightly different position. Its economy is not so dependent on international capital and foreign investment, which has helped to lower the immediate impact of the crisis. Despite this the Bangladesh government has formed a high-level technical committee and taskforce to monitor and advice on the crisis, and ministries and financial institutions have taken several precautionary measures. Importantly in October 2008 Bangladesh Bank withdrew 90 % of its total investment from foreign banks which has helped to further shield the economy, so that it is only now that the effects of the crisis are being felt. Additionally the Bank has taken measures to stabilize the exchange rate, provide extra liquidity to the financial sector and raised the limit on private foreign borrowing. It has also relaxed the conditions for opening fresh letters of credit (L/Cs). In February 2009, the Finance Minister AMA Munity admitted that the global financial crisis was having an impact on trade in Bangladesh. In April the Government announced their stimulus package with 65 million dollars directed to assist exports. This though falls short of the 877 million dollars needed according to industry experts (Yahoo news, 2009). During 2008, 57% of Bangladeshs economy was involved in the global economy and this is increasing. This indicates that the country might be progressively more affected should the crisis continue for an extended period. Trade, migration and remittance are the most likely sectors to be impacted as 43.3% of Bangladeshs openness is related to trade and 10 % to remittance. Overseas Development Assistance (ODA) and Foreign Direct Investment (FDI) may also be vulnerable in the longer term but to a lesser extent due to only 3.2% integration with the global economy (CPD and ILO, 2009).

11

Bangladesh is captive to what transpires in international markets and economies of leading countries. Against the background, Bangladesh cannot be immune from the global economic slowdown and is most likely to be adversely affected sooner or later. Why this crisis? To put it simply, it has been argued the whole meltdown of the financial system was Made In America for having relaxed rules of providing loans to jobless people with no income for buying houses, called sub-prime housing loans or now known as toxic loans or assets amounting to about $2.1 trillion dollars.

Banks and financial institutions that bought security-paper have lost money. In its latest calculations, the IMF reckons that worldwide losses on toxic assets originated in America will reach $1.4 trillion and so far $760 billion has been written down by banks and financial institutions. Normally the banks and financial institutions lend and borrow money and the money market works well. During the crisis, money markets ceased to function as investors and banks who ordinarily arrange foreign exchange swaps among themselves for a set time period are nervous about the risk that their counter-party will go bust because of liability of toxic assets while the swap is being put into place and so have shied away from such deals. Thus the global money market was closed and a severe credit-crunch was felt across the world.

Conclusion

Financial Crisis: A situation in which the economy of a country experiences a

sudden downturn brought on by a financial crisis. An economy facing an economic crisis will most likely experience a falling GDP, a drying up of liquidity and

rising/falling prices due to inflation/deflation. An economic crisis can take the form of a recession or a depression. Also called real economic crisis. The term financial crisis is applied broadly to a variety of situations in which some financial institutions or assets suddenly lose a large part of their value. In the 19th and early 20th centuries, many financial crises were associated with banking panics, and many recessions coincided with these panics. Other situations that are often called financial crises include stock market crashes and the bursting of other financial bubbles, currency crises, and sovereign defaults

12

Impact of global financial crisis on the economy of Bangladesh

Since the collapse of the United States sub prime mortgage market and the subsequent international global crisis, many developed and developing countries have been plunged into deep recession. Bangladesh though has found itself in a slightly different position. Its economy is not so dependent on international capital and foreign investment, which has helped to lower the immediate impact of the crisis. Despite this the Bangladesh government has formed a high-level technical committee and taskforce to monitor and advise on the crisis, and ministries and financial institutions have taken several precautionary measures. Importantly in October 2008 Bangladesh Bank withdrew 90 % of its total investment from foreign banks which has helped to further shield the economy, so that it is only now that the effects of the crisis are being felt. Additionally the Bank has taken measures to stabilize the exchange rate, provide extra liquidity to the financial sector and raised the limit on private foreign borrowing. It has also relaxed the conditions for opening fresh letters of credit (L/Cs). In February 2009, the Finance Minister AMA Muhith admitted that the global financial crisis was having an impact on trade in Bangladesh. In April the Government announced their stimulus package with 65 million dollars directed to assist exports. This though falls short of the 877 million dollars needed according to industry experts (Yahoo news, 2009). During 2008, 57% of Bangladeshs economy was involved in the global economy and this is increasing. This indicates that the country might be progressively more affected should the crisis continue for an extended period. Trade, migration and remittance are the most likely sectors to be impacted as 43.3% of Bangladeshs openness is related to trade and 10 % to remittance. Overseas Development Assistance (ODA) and Foreign Direct Investment (FDI) may also be vulnerable in the longer term but to a lesser extent due to only 3.2% integration with the global economy (CPD and ILO, 2009). Whilst the longer term nature of FDI commitments has kept the net inflow of investment relatively stable, the sluggish growth of rich countries may eventually slow it down. Aid receipts (excluding dollars) are providing less in local currency due to unfavorable exchange rates and future aid commitments from donors may be in jeopardy if the downturn continues.

13

14