Economics - Financial Institutions and Markets - Research Paper Example

? Financial s and Markets of the of the number Table of Contents 3 Thesis ment 4 Introduction 4 Financial system in the United States 5 Systemic risk in the financial market 7 Financial integration in the globe 9 The repo market and ‘safe harbor’ 9 The financial crisis of 2008 12 An evaluation of the intervening activities of the Federal Reserve 14 Proposed alternatives and remedies for the problem 16 Repo resolution authority 18 Conclusion 19 References 20 Abstract The structure and functioning of the financial system has been a serious issue in the current economic scenario. The financial system of the United States has undergone structural changes at different points of time and these changes have affected the financial health of the economy significantly. Not only have these effects brought massive alterations in the operations of the big commercial houses and individuals in the economy, they have also affected the entire global economy. This paper looks at the collapse of the repo market and the effect of ‘safe harbor’ facilities provided to the lending institutions in the derivatives market. Arguments have been made that the use of collaterals have made more harm than benefit to the economy and hence alternatives have been discussed to eliminate these facilities from the market. Thesis statement The aim of this paper is to investigate the causes of failure of the financial institutions in the United States. The research is specifically directed towards the study of the structure of the US financial system and the role of safe harbor in the failure of major financial institutions in the country. Introduction The global financial collapse has been one of the most significant incidents in the history of the world and it has raised significant research and debates on the factors that led to a financial breakdown of such a measure. There is considerable debate on the causes of this phenomenon and researchers have not been able to come to clear consensus about the actual causes of the incident. However, a stream of events has been identified, which are considered to be the possible factors that led to the downfall of the financial institutions and ultimately caused the crisis. Among several failures that have occurred since the turn of the twenty first century is the regulatory focus that had been maintained on the activities and movements of “the individual, rather than systemic risk of financial institutions” (Acharya & Oncu, 2013). Changes in the financial structure of the economy caused a regulatory change and since then focus was maintained on the “systemically important assets and liabilities (SIALs)” (Acharya & Oncu, 2013) rather than the individual institutions that participate in the financial transactions across the economy. The structure of the financial system of the Unites States has been evolving over the years. When the US economy entered a period of recession following the financial crash during the 2007-2008, the structure of the financial system in the country underwent further noteworthy changes. The financial disorder that arose in the middle of 2008 created severe stress on the financial markets in the United Sates. The derivatives markets faced significant changes due to the alterations made in the Bankruptcy code of 2005. Although the Code had been revised with the aim of protecting the repo market from falling prey to instabilities entailed in risky lending procedures, some scholars claim that collateralized interbank lending has a detrimental effect on the long term risk management capabilities of the firms. Failure of some of the major and most influential banking institutions in the United States during the 2008 recessionary phase proved this fact to be true. In this paper the structure and characteristics of the US financial system has been studied, which would help in understanding the reasons behind the failure of the financial institutions in the country. Financial system in the United States The financial system of an economy (Popper, Bankes, Callaway & DeLaurentis, 2004) is a ‘heterogeneous medium’ through which the economic agents within the country can set up a channel across the economy for exchanging both rewards and risks of financial transactions. This medium allows the agents to buy, sell and lend various financial instruments, such as securities, commodities and others, with the purpose of fulfilling their individual objectives while following a standard set of policies and rules. This medium is heterogeneous due to the fact that all economic agents are free to enter this market and optimize their business objectives within the set of standard rules. These agents include the government and private institutions within the economy as well as private institutions operating from abroad and individual investors. Knowledge about the financial system of the country is essential for identifying and studying the issues arising in the financial system within the country. Therefore, this section explains the basic structure of the financial system within the country. The financial system in the United States consists of three different levels: the regulatory authorities, the market agents and the external financial entities in the economy (Khashanah and Miao, 2011). The figure given below shows the simplified structure of the financial system of the US economy. It depicts the architecture of the system, its current hierarchy, system of cash flow, the decision support mechanism, information systems, regulatory bodies and market participants. Figure 1: Structure of the U.S. financial system (Source: Khashanah and Miao, 2011) A series of complex adaptive systems (CAS) operates at each level within the structure of the system. Since it is a heterogeneous system, it is dynamic and is floating continuously depending on the type of objective maximization of the economic agents participating in the market. Therefore, the concept of equilibrium is applicable only at the local level of the structure, and not to the entire system as a whole. There exists a non linear relationship among the variables in this financial system in the free competitive market. This relationship depends on the status of the different components of the financial market. Systemic risk in the financial market A "sale and repurchase agreement" (Acharya & Oncu, 2013) popularly known as ‘repo’ is a transaction between two different parties for a short duration. One of the parties offers loans and the other party borrows cash from the lender. Against the loan amount the borrower pledges some form of financial security known as collateral. Systemic risk refers to the probability that the financial system in entire market system in the economy might collapse. This collapse might be the result of the risks associated with the different components of the system, the individual entities, the groups or the government (Kaufman, 2000). Any kind of failure of one single entity of the market or a cluster of different entities might potentially result in a series of cascading failures (Douglas & George, 2005). Such an incidence can be powerful enough to bring down the whole system and potentially bankrupt the big financial institutions in the economy. In this context, it can be asserted that systemic risk occurs when sizable financial conflicts arise within the economy due to turmoil rooted deep into the activities and transactions within the economy. The level of financial disturbance is proportionate to the capitalization rate of the system (Edward, 2012; Mayer, Morrison, & Piskorski, 2009). Studying the financial system of the country helps in quantifying the level of interdependence among the various components of the system, which determines the flow of information across the different sections of the market. This influences the speed of transmission of financial disturbances across these market components. The recent financial crisis has demonstrated to the world the impact cast by systemic risk on the financial system of the entire global economy. This implies that understanding the level of interdependence amongst the financial components is crucial. Therefore, the study of these components and the structure of the financial market is important to assess the magnitude and significance of the problems currently arising in the global financial markets. In the financial world, “efficient-market hypothesis” (Khashanah & Miao, 2011, p. 322) emphasizes on the fact that prices of assets traded in the market (such as, property, stocks and bond) are nothing but a reflection of symmetry of information in the market and the rapidness with which the market components can reflect to the change in information. According to scholars, the hypothesis states that all financial markets are efficient, although the level of efficiency depends on the rate of information transmission among the market components. Hence, no particular institution within the market would be able to outperform the overall level of performance in the market. This is because all information flows within the market uniformly. On the other side, it also implies that any dysfunctional behavior by any of the market components would be transmitted to the other sections of the market with little effort. Financial disturbances within the market therefore do not remain contained within the institution or the group of institutions in which the disturbance originally occurred. Financial integration in the globe The process of capital transmission within the financial system engages a long chain of factors: credit facilities provided by various financial institutions including banks, rate of exchange, and price level of assets in the economy. In this system, one important position is taken by cash flow channel within this system, and it influences the level of integration of the financial markets in the different parts of the economy. According to a recent research conducted by Evans & Hnatkovska (2005), it has been found that capital flows in the international financial system are generally of large size and are also quite volatile. In the beginning of the 1980s, financial integration in the US was in its early stages and the bulk of international asset trading was concentrated within the buying and selling of bonds. However, with the turn of the century, the financial markets in the world started to become more and more integrated and apart from the private investors, households also gain better access to the equity markets of the world. This has caused a dramatic decline in the rate of flow of bonds in the international market and reduced the level of volatility in these markets. On the other hand, the size of equity flows in the international market increased significantly, which led to an increase in the volatility level in international equity markets. The repo market and ‘safe harbor’ There are certain legal foundations on which the failures of the financial institutions occur. The act of revising the bankruptcy code is considered one of the major reasons that acted as catalyst for the incidence of failure of financial institutions. The purpose of the Bankruptcy Code of 1978 in granting safe harbor to the derivatives market and repo market was to provide protection to the financial system of the economy from all possible kinds of systemic risk (Morrison & Riegel, 2005). When a bankruptcy court locks any kind of collateral, it implies that the collateral cannot be brought to the derivatives market for further lending or selling. In the financial markets, all over the world, collaterals are considered liquid asset. The recipient of the collateral has the right to sell it or offer it for borrowing. The recipient has the compulsion to replace the item with something that is equivalent to the collateral. Therefore, it is imperative to note that the collaterals are not an item of trust but are accepted as a temporary asset for the recipient entering a derivatives contract, which the recipient might further trade off in future. When the collaterals are locked by the bankruptcy court, these can no more be considered as assets, and these would not be available for further exchanges in future. Therefore, such an act causes serious problem for the financial firms. Due to this reason, a firm that has a claim on any collateral tied up with the bankruptcy court faces serious problem in the financial market with regard to availability to liquid asset. Such a firm would not only face market risk due to the decline in the value of collateral but also suffer a falling value of the liquid assets possessed by the firm. It would occur as a result of the immobility of the collateral due to its tie up with the bankruptcy court. The fall in liquid asset would make the firm unable to repay its lenders or other bills, which might subsequently cause a new reason for filing bankruptcy. Furthermore, fall in the value of collateral during its period of tie up with the bankruptcy court would also cause other losses to the already bankrupt firm. This is a lengthy chain of events, but, as a summary, the grant of safe harbor as a part of revising the bankruptcy code raises concern about a series of subsequent derivative market failures. In order to analyze the impact of amendments made to the safe harbor and to assess whether they boost up systemic risk further, one has to get deeper understanding of the lending operations of the banks and other financial institutions. Banks are able to lend money to the other financial institutions on either a secured basis or on an unsecured basis. When the banks can offer loan to other institutions on a secured channel of lending, they are certain that they would be protected from all losses, if any, incurred due to the transactions made with the counterparties. On the contrary, if banks are required to offer loans to other banks or financial institutions on unsecured basis, these are not provided cover for the risks involved in these transactions. The lending banks then make all transactions with the risk of incurring losses. Therefore, any sign of poor management on part of the counterparty would convey the first impression on the lender bank that there are chances of losses in these transactions. Hence, the level of risk is high. Thus, the amount of lending made by the banks to the unsound financial institutions on unsecured basis is lesser than that made on a highly secured basis. This implies that systemic risk would be comparatively higher in cases of lending on unsecured basis. Banks, therefore, are required to manage the risks properly so as to contain it within limits and allow it not to grow. The financial system of the unsound banks is not well equipped to manage risk entailed in financial transactions. The inference of this discussion is that if banks are accustomed to lending on the secured basis, they would rest assured that any risk incurred would not cost the firm greatly. This might allow the firm to slacken its management and reduce its risk measurement policies. This would in turn increase the systemic risk in case of interbank lending, since banks maintain different levels of security. If interbank lending in the secured phase occurs more frequently than on an unsecured basis, systemic risk would increase at a much higher proportion than if banks are accustomed to unsecured lending. This is considered as one of the reasons behind the burst of asset bubbles during 2008 and the beginning of the financial crisis. According to Sissoko (2010), secured lending among banks gives rise to a moral hazard. Since banks are given with the provision of security against losses, they would reduce or even stop monitoring the parties with which they engage in financial transaction. This paves the way for growth of high level risk and also leads to poor monitoring and management of the same. Risks in lending made throughout the economy in turn breed systemic risk. In this context unsecured lending across banks increases credit risk that the banks are aware of and therefore, compels them to scrutinize as well as maintain strong monitoring of the counterparties with which the banks interact. Thus, it leads to the fundamental theorem of financial market transactions - “the principal banking function is to manage credit risk” (Sissoko, 2010, p. 16). Following this policy, it is established that the approach of banking in which safe harbor exemptions are provided (according to the revised Bankruptcy Code of 1978), in effect increases systemic risk by encouraging banks to reducing monitoring of their functions as well as that of their counterparties. The other impact would be that, since banks would be accustomed to the secured basis of lending, they would be unwilling to provide loans on unsecured basis. This would further hamper proper maintenance and functioning of the financial system within the country. Thus, if any financial disturbance occurs, these institutions would left devoid of any kind of security system and would easily fall prey to the disturbance. Since all the banks are interconnected through the system of interbank lending, financial problem of any single institution would spread to all other institutions. It is quite potential to disrupt banking activities; in fact, the mere anticipation of such a financial issue regarding a bank might take the form of shape-changer for the entire financial market. The financial crisis of 2008 The beginning of the financial instability in the US began with rumors swirling in the financial markets regarding the dwindling condition of one of the leading banks in the country, Bear Stearns. In March 2008, instability in the repo market became evident. Counterparties engaged in business with this financial institution showed lack of confidence in this bank and refused to hold any collateral of the Bear Stearns. This was associated with the fear and risk of collaterals being locked under bankruptcy code. Therefore, the banks refused to provide loans to the counterparties except when they received the collateral of the proven highest quality. This incidence of withdrawal of credit appeared to be disastrous for the company, since more than half of the balance sheet of Bear Stearns was financed on repo market. As credit in the repo market fell short, the company faced the shortage of liquid assets that were necessary for meeting short-term obligations. In this case, anticipation that the bank might file bankruptcy in future (even before the firm actually became bankrupt) created the situation of credit withdrawal and led the company towards inevitable destruction. There is another similar case of the Lehman Brothers. In September 2008, it faced a bank run as fellow bankers issued collateral calls and withdrew credit to the bank (Mollenkamp, Craig, Mccracken & Hilsenrath, 2008). With two of the biggest banks’ collapse during the year 2008, the financial market in the US became hugely unstable. Speculation started about the health status of the other banks. Counterparties became skeptic about accepting collaterals from the banks and began to withdraw credit facilities from the bank. During the Lehman failure, Merrill Lynch also faced this risk. However, the bank was saved at the last moment through the purchase of its collaterals by the Bank of America. Along with Lehman’s failure, two other banks faced the risk of failure. They are Morgan Stanley and Goldman Sachs. In order to save them from failing, the Federal Reserve speedily approved that the bank should be transformed into “bank holding companies” (Sissoko, 2010, p. 25). On doing this, the institutions would receive full support of the Federal Reserve, as is the case of commercial banks. The banks that relied heavily on the repurchase agreements made between the banks during interbank transactions have low access to liquidity facilities provided by the Federal Reserve. When these banks were faced with bank run, they either disastrously failed or were rescued by the Federal Reserve at a critical position. In this context, it becomes imperative to note that the safe harbor rules placed on the agreements of repurchasing collaterals can only make the institutional structure of the company prone to a bank run. This is because repurchasing agreements are made only on the collaterals that are backed by securities. In case of lending activities on an unsecured basis, whenever there arises a likelihood that some particular firm might announce for filing bankruptcy, huge speculation starts and the counterparties seek to protect themselves from all kinds of possible losses. As a reaction to the failing financial status of the institutions, these banks withdraw credit facilities that the firm enjoyed previously. These activities make the repo markets fundamentally unstable and further push the weaker institutions into bankruptcy. An evaluation of the intervening activities of the Federal Reserve Evaluation of the appropriateness of the role played by the Federal Reserve is necessary to assess the current state of the repo market and to determine whether these markets need reformation. As a response to the instability of the repo markets, the Federal Government utilized the emergency powers vested into it to initiate two new programs. These programs had been launched with the aim of dealing with the collapse of the repo markets in which less liquid securities are traded (Hance, 2008; Irwin, 2009). As the repo markets failed, the Federal Government found itself in the obligation of intervening into the market in order to prevent the collapse of the entire financial system of the economy. So the Federal Reserve allowed the investment banks to exchange risky assets used as collaterals in the repo market for cash dollars or government Treasuries. In the mid of 2008 the Federal Reserve launched the “Term Securities Lending Facility and the Primary Dealer Credit Facility” (Sissoko, 2010, p. 26). The first program named the Term Securities Lending Facility provided the investment banks with a temporary facility to deal in private sector debts of high values and exchange them for Treasury securities. Under the second program, Primary Dealer Credit Facility, the Federal Reserve provided loans to the investment bank in exchange for “investment grade collateral” (Sissoko, 2010, p. 26). Both of these programs helped in dealing with the decline of repo markets. The Federal Reserve also provided additional loans to banks to enable them to purchase off the financially unstable banks (IMF, 2007). For instance, the Federal Reserve provided the J.P. Morgan Chase with a ‘non-recourse loan’ of US $29 billion. This loan was non-recourse in the sense that the bank might decide to walk away from the amount of loan and pay the Federal Reserve with only the collateral. The bank used this loan for purchasing Bear Stearns after they failed. Once the repo markets failed miserably in March 2008, the Federal Reserve was burdened with a huge amount of “private sector credit risk” (Sissoko, 2010, p. 26). Within the next six months the Federal Reserve was found to hold US $100 billion worth of private sector assets. All these assets had been temporarily traded for the government Treasuries. The Federal Reserve also decided to act as the lender of last resort for the repurchase of repo agreements. Under this act, the Federal Reserve bailed out the banks one after the other that were in a severe financial condition. Hence the Federal Government became increasingly pressurized under the burden of providing huge amounts of bailouts (Lubben, 2008). However, there are certain causes that mirror the importance of the Federal Reserve’s intervention. The crisis of the year 2008 shows clearly that even though the institution to which a bank is providing loans is a large and established financial institution, the process of collateralized interbank lending cannot protect the lending bank from losses. In the situation that was created in the US financial market, intervention by the Federal Reserve was inevitable. The Federal Reserve entered the repo market as the lender that willingly accepted such collaterals that no other lender was accepting due the risk associated with the collateral. Without its intervention, a number of the largest and most influential participants in the repo market participants would have no other option but to sell the collaterals for meeting their payment obligations (Gorton, 2008; Gorton, 2009). Such forced sale would drive the price of assets to a level much lower than the price level observed in 2008. This would ultimately imply that the extent of loss incurred by the major players in this market would have been much higher than the actual amounts posted by them. This fact vividly supports the interventions made by the Federal Reserve into the repo markets. Proposed alternatives and remedies for the problem Some scholars make a strong claim that interbank lending on a collateralized basis should be discouraged. This is because collateralized interbank lending is one of the major causes of the systemic risks arising in the financial institutions. There is all in level of security planning in these institutions and overall risky transactions rise (Garbade, 2006). Borrowing as well as lending on collateralized basis should be greatly discouraged and reduced in quantity. For instance, the big banks and other lenders participating in the market might be forbidden from engaging into “over the counter derivative contracts” (Sissoko, 2010, p. 27) that would necessitate the posting of collaterals. Then, the counterparties would be compelled to make a strict monitoring of the borrower firms and evaluate the risk involved in offering loans to them before entering any contract with them. If this act is implemented, all counterparties (on considering that they are economically rational) would prefer to trade with those financial institutions that have proven record of creditworthiness in the market (Garbade, 2006). This would once again enable the proper functioning of the market forces that would encourage the firms to improve their management procedures and enhance their image of creditworthiness in the market. This would in turn facilitate the growth of these firms. This argument is further supported by the fact that collateralization is not a necessary ingredient for the functioning of derivative markets in the country. According to Sissoko (2010), collateralization had been introduced into the derivatives markets for over the counter transactions during the 1990s. However, currency swaps and the market interest rate had already grown to a worth of more than US $10 trillion (in nominal value) before collaterals in the derivatives market started to be commonly used. This shows that the market operated efficiently and in a stable manner without the use of collaterals. Nonetheless, it has to be taken into consideration that the use of collateral is inherent to the US financial market structure. It is generally used for repurchasing agreements. This practice is too widespread in the financial market to bring it to a halt by prohibiting the big financial institutions from participating in the market (Cassano & Dooley, 2007). Therefore, other alternatives have to be found out to deal with the problem. Researchers agree on the reality that the collapse of the repo market convinces the fact that the safe harbor on derivatives and repo market and collateralized lending practices actually played a big role in the failure of the most influential financial institutions in the country. Therefore, they argue that the “safe harbor protection” (Sissoko, 2010, p. 27) has to be removed from the repos pertaining to the relatively less liquid assets. It has been recommended that the revised section of the Bankruptcy Act of 2005 that includes the safe harbor proposition (applying to the repurchase agreements) has to be annulled. According to research results, the repo market functioning deteriorated significantly after the inclusion of more risky and less liquid assets. After the 2005 safe harbor law was passed, the repo market actually ‘imploded’. Arguments by scholars have been made on the ground that the assets that are more risky are normally the first assets to be rejected by the repo counterparties (Edwards & Morrison, 2004). Therefore, the Bankruptcy Code of 1984 is a safer standard for following. The narrow privileges provided for repurchase of agreements under this law are more efficient in maintaining a stable financial market than the wide pool of unsafe privileges that are provided by the Bankruptcy Act of 2005. Repo resolution authority The repo resolution authority is proposed as a potential authority that would aim at bringing reformations in the repo market. The proposal to resolve the problem of repo runs involves the creation of a "Repo Resolution Authority" (Acharya & Oncu, 2013) in each of the jurisdictions that reflect significant repo transactions. Following this process, the repo resolution authority keeps a check on the credit risk faced by the repo financiers. The authority would make efforts to manage the risk of credit extension and to ease out moral hazard bearing on behalf of the repo financiers. It would keep control on the quality of the collateral as well as charge a stipulated amount in the form of “ex-ante fee for the liquidity enhancement”. This is done to balance the residual credit risk undertaken by the firm after evaluating the nature of credit risk borne by the lender due to the transaction. The authority also checks eligibility of the repo financiers; it presets conditions for the solvency criteria and imposes an upper limit on the concentration of individual repo finances that the institution can make within a stipulated period of time. This limit is set on the basis of the size of the company’s overall portfolio. Conclusion In the last few decades, significant changes have occurred in the structure of the financial markets operating globally. The institutions in the United States have also undergone massive changes. Some of the major developments are growth in the capital markets in the world (financial institutions other than banks have been developed in the country as an alternative to the transactions made with the banks), increased level of competition within the intermediaries operating internationally as well as domestically (Bradley, 2009). However, many of these factors have adversely influenced the level of transparency in the operations of the country’s financial institutions. One of the most influential factors in this era of changing financial system of the economy is the level of transparency in the monetary policies adopted by the Federal Reserve of the United States. Lack of transparency has disturbed the normal functioning of the financial institutions, disrupted the asset markets and gradually affected all the spheres of the economy. This paper has provided a detailed discussion of the factors that have led to the collapse of the derivatives market in the US. Financial firms, both small and large have been affected by this crisis. However, reversion of the Bankruptcy Code to its 1978 version along with a stringent monitoring of credit risk in the repo market is expected to prevent chances of such occurrences in future. References Acharya, V. V. & Oncu, T. S. (2013). A proposal for the resolution of systemically important assets and liabilities: The case of the repo market. Retrieved from: http://www.federalreserve.gov/Events/conferences/2012/cbc/confpaper6/confpaper6.html . Bradley, R. (2009). Drew Gilpin Faust and the incredible shrinking Harvard. Retrieved from http://www.bostonmagazine.com/scripts/print/article.php?asset_idx%C2%BC251494 . Cassano, J. & Dooley, W. (2007). American International Group Inc. Financial Products unit (AIGFP). Retrieved from http://www.cbsnews.com/htdocs/pdf/collateral_a1.pdf . Douglas, D. E. & George, G. K. (2005). Derivatives and Systemic Risk: What Role Can the Bankruptcy Code Play? 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