Financial Market Liberalisation Wealth and Consumption - Literature review Example

1. Introduction. The objective of this paper is to employ the operational characteristics of the credit market to critically examine why financial liberalisations continue to bring financial crisis rather than efficiency to systems. The paper also aims at providing a discussion of the reasons for the credit crunch in the United Kingdom and the United States of America. The rest of the paper is organised as follows: in section a discussion of financial liberalisation including its history and goals is provided; section 3 provides a discussion of the reasons why financial liberalisation continue to lead to financial crisis; section 4 provides possible explanations for the credit crunch in the United Kingdom and the United States of America; and section 5 provides some conclusions and recommendations. 2. Liberalisation of financial markets The last two decades have witnessed substantial deregulation of the financial services industry across the globe. (Boone et al., 2001). The liberalisation of financial markets took place during the 1970s and 1980s and was characterised by the abolition of credit and interest rate ceilings, the abolition of controls on international movements of capital, as well as the abolition of regulations affecting a wide range of financial activities in a significant number of OECD countries. (Blundell-Wignall and Browne, 1991). Boone et al. (2001) outlines the different approaches adopted by the G7 nations towards financial liberalisation as shown in the table 1 below: Table 1.: Measures of Financial Liberalisation for a selected number of G7 Nations. Country Measures of Financial Liberalisation United States of America -Securitisation in 1971 -Interest rate deregulation, phasing out Regulation Q over the four years starting in 1980; -Elimination of portfolio restrictions for thrifts in 1980. Japan -Bank specialisation requirements reduced in 1993; -Interest rate deregulation completed in 1994. France -Bank Specialisation requirements reduced in 1984; -Elimination of credit controls in 1987; -Securitisation introduced in 1991; -Implementation of Second Banking Directive (89/646/EEC) into law in 1992. Italy -Interest rate deregulation in 1983; -Credit ceilings eliminated in 1983 and temporarily re-imposed in 1986-87; -Implementation of the Second Banking Directive (89/646/EEC) into national law in 1993; -Separation of long-term and short-term credit institutions abolished in 1994. United Kingdom -Credit controls "the corset", eliminated in 1980; -Bank of England's minimum lending rate abolished in 1981; -Banks allowed to compete with building societies for having finance after 1981; -Building societies allowed to expand their lending business after 1986; -Withdrawal of guidelines on mortgage lending in 1986; -Securitisation introduced in 1987; -Implementation of the Second Banking Directive (89/646/EEC) into national law in 1993; Canada -Elimination of ceilings on interest rates on bank loans in 1967; -Restrictions on banks' involvement in mortgage financing abolished in 1967; -Banks allowed to have mortgage loan subsidiaries in 1980; -Securitisation in 1987. Source: Boone et al. (2001). One can observe from table 1 that most of the reforms took between the 1970s and 1990s and mainly involved the elimination of interest rate ceilings and credit limits. Banks were also given more freedom to engage in mortgages. Financial liberalisation has also been characterised by securitisation1. Financial liberalisation has been successful in that it has encouraged the formation of stock markets where they did not exist and has encouraged their deepening where they predated the reforms. (Grabel, 1995). For example, there has been an impressive expansion of stock markets in less developed countries (LDCs) following the adoption of financial liberalisation in these countries. For example, Grabel (1995) notes that LDC stock markets listed some 5,531 domestic companies and had a market capitalisation of US$86,125million and an annual trading volume of US$23,672million in 1980. By 1992, 36 LDCs had stock markets listing a combined total of 13,217 individual domestic companies with a combined market capitalisation of US$774,093million as well as an annual trading volume of $594,685million. (Grabel, 1995). Financial liberalisation can be distinguished from financial repression, which according to McKinnon (1973) and Shaw (1973) is the "indiscriminate distortions of financial prices including interest rates and foreign exchange rates". Financial repression reduces the real rate of growth as well as the real size of the financial system relative to nonfinancial magnitudes. (Fry, 1997). According to Shaw (1973: pp. 3-4) financial repression gravely retards the development process. The deregulation has been in part to improve efficiency in the financial system as well as improve the impacts on the business cycle and the transmission mechanisms of monetary and fiscal policies. (Boone et al., 2001). Financial liberalisation has also been aimed at increasing competition in the financial services sector, through rapid expansion of credit, which in turn eased liquidity constraints facing households, thus raising targeted levels of consumption. (Boone et al., 2001). This in turn increases aggregate demand, and thus real GDP and economic growth. 3. Reasons For Financial Crisis. According to Fry (1997) Several interest-rate liberalisation experiments have failed to produce positive outcomes. This is because there is a perverse reaction to higher interest rates by insolvent economic agents, governments, firms, or individuals. (Fry, 1997). An insolvent borrower is considered some one whose liabilities exceed his/her assets. Such borrower is not deterred from borrowing more to finance his/her losses no matter what interest rates may look like. Loans to insolvent borrowers therefore continue to increase because the borrower is not concerned about the level of interest rates. Fry (1997) asserts that such agents even tend to exhibit loan demand functions that respond positively to interest rate. This indicates that as interest rates rise, the borrower increases his debt capacity at the expense of the lender which in turn triggers a financial crisis. According to Fry (1997) citing Stiglitz and Weiss (1981); McKinnon (1993 p. 38-41); Fry (1995, pp. 305-6); Rojas-Suarez and Weisbrod (1995) inadequate prudential supervision and regulation enable distress borrowing to crowd out borrowing for investment purposes by solvent firms, so producing an epidemic effect. "Funds continue to be supplied because of explicit or implicit deposit insurance. The end result is financial and economic paralysis". (Fry, 1997). Although it has been argued by most commentators that the explosion of equities markets has been an unmitigated benefit for LDCs, other researchers have taken a contrary view. For example Singh (1993) Calamanti (1983), and Samuels and Yacout (1981) argue that from a Keynesian perspective, the expansion of stock markets in LDCs threatens to induce speculation and financial crisis and a misallocation of savings and investment, to the detriment of real sector growth and stability. Grabel (1995) notes that although proponents of financial liberalisation suggested that it would produce a virtuous cycle of increased savings, and investment and growth (citing McKinnon, 1973; 1991; Shaw, 1973). LDCs that followed the McKinnon-Shaw model suffered financial instability and crisis, reduced savings and disappointing growth. The Asian Financial Crisis and a number of other global crises can be attributed to improper financial liberalisation. Radelet and Sachs (1999) argue that each of the five mostly affected economies had growing problems that could be understood as side effects of the region's very success. There were widespread financial liberalization policies in each of the crisis economies in the late 1980s and early 1990s that culminated to a very rapid expansion of the financial sector, as well as to enthusiastic lending by foreign creditors. (Radelet and Sachs, 1999). The requirements for operating in the financial services industry were relaxed, which enabled led to the formation of new private banks. A much greater leeway was provided to banks in their lending decisions, and stock and bond markets began to grow and develop. (Radelet and Sachs, 1999). In addition, banks and financial institutions were provided the freedom to raise funds from abroad. There was also the development of new institutions, e.g., the Bangkok International Banking Facility (BIBF) designed to offer new financial services and to attract investment. In addition, the institutions were encouraged to borrow from abroad. (Radelet and Sachs, 1999). This resulted to a rapid increase in both offshore borrowing and domestic lending, with a resulting investment boom. Domestic banks and other financial institutions borrowed from abroad and provided loans to domestic corporations thus contributing to the build-up of foreign capital inflows. (Radelet and Sachs, 1999). Chang et al. (1998) suggests that the Korean financial crisis resulted from uncoordinated and excessive investments by private sector, financial and imprudent amounts of short-term foreign debt, which in turn had been made possible by rapid and ill-designed financial liberalisation (especially capital account liberalisation) as well as a serious weakening of industrial policy. 4. Reasons for Financial Crisis in the UK and U.S.A The most recent crisis in the UK and the United Kingdom can also be attributed to poor financial liberalisation which has led to the increase in non-performing loans. In particular the financial crisis of the United States and the United Kingdom can be attributed to falling house prices. Banks became victims in that they continued investing in structured mortgaged products. Residential and commercial properties which have been pledged as collateral for these mortgaged loans suddenly lose their value. As a result the loan-to-value ratio became greater and as such borrowers saw no need for repaying their mortgages. A mortgage borrower defaults on his/her debt, the highest the bank can do is to repossess the property securing the loan. The borrower therefore has a put option (the right but not the obligation to repay the loan). Borrowers are more likely to default if the value of their property is significantly lower than the value of the loan. After all, all the bank can do is to repossess the property. This in turn causes losses to the bank. House prices in the U.S and U.K began falling in 2007. Banks that had invested heavily in mortgages suffered significant losses as borrowers decided to engage in foreclosures. The mortgagee is entitled with the right to foreclosure in the event where the mortgagor defaults on payment. (Bhattcharya et al., 2001: p. 3). In the United Kingdom for example, Northern Rock found turned out to be the most significantly affected by the sub-prime mortgage crisis. For example, Hall (2008); Chambers (2008); Llewellyn (2008); Keasey and Veronesi (2008); Mainelli (2008); Hallsworth and Skinner (2008) all blame the failure of Northern Rock to its business model, which was based solely on raising funds from the wholesale market by originating and distributing sub-prime mortgage loans. In addition, Northern Rock failed to hedge against potential default on the sub-prime loans in its possession. (Hall, 2008; Hallsworth, 2008; Keasey and Veronesi, 2008; Mainelli, 2008; Hallsworth and Skinner, 2008). In the United States, major financial institutions such as Lehman Brothers and AIG have found themselves seeking for a bailout package from the government owing to their unscrupulous business models. 5. Conclusions and Recommendations One can observe from above discussion that although financial liberalisation has brought about liquidity through the easing of credit restrictions, interest rate ceilings, international capital controls and other financial repressive measures, it has also contributed significantly to a number of global financial crises. As a consequence, Fry (1997) notes that the international experience over the last 2 decades indicates that there are five prerequisites for successful financial liberalisation citing from Fry (1995, pp. 454-60). These include: (1) Adequate prudential regulation and supervision of commercial banks, implying some minimal levels of accounting and legal infrastructure. (2) A reasonable degree of price stability. (3) Fiscal discipline taking the form ofa sustainable government borrowing requirement that avoids infiationary expansion of reserve money by the central bank either through direct domestic borrowing by the government or through the indirect effect of government borrowing that produces surges of capital infiows requiring large purchases of foreign exchange by the central bank to prevent exchange rate appreciation. (4) Profit-maximising, competitive behaviour by the commercial banks. (5) A tax system that does not impose discriminatory explicit or implicit taxes on financial intermediation. (Fry, 1997). BIBLIOGRAPHY Boone, L., N. Girouard and I. Wanner (2001), "Financial Market Liberalisation, Wealth and Consumption", OECD Economics Department Working Papers, No. 308, OECD Publishing. doi:10.1787/586625524684. Bhattacharya A. K., Fahozzi F. J., Chang S. E. (2001). Overview of the Mortgage Market. The Handbook of Mortgage Backed Securities. Eidted by Frank J. Fabozzi. 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(1995), "Assessing the Impact of Financial Liberalisation on Stock Market Volatility in Selected Developing Countries", The Journal of Development Studies, Vol. 31, No. 6, pp. 903-917. Published by Frank Cass, London. Chang, H., Park, H., Yoo, C. (1998), "Interpreting the Korean crisis: financial liberalisation, industrial policy and corporate governance", Cambridge Journal of Economics 1998, 22, 735-746. Fry, M. J. (1997), "In Favour Of Financial Liberalisation", The Economic Journal, 107 [May), 754-770. Royal Economic Society 1997. Published by Blackwell Publishers, 108 Cowiey Road, Oxford OX4 iJF, UK and 350 Main Street. Maiden, MA 02148, USA. Radelet S., Sachs, J. D. (1999). What have we Learned so far from the Asian Financial Crisis Available online at: http://www.cid.harvard.edu/archive/hiid/papers/aea122.pdf Read More