Financial Crisis and the Role of Banks - Assignment Example

Assignment 5: Financial Crisis and the Role of Banks Table of Contents 3 Introduction 3 Literature Review 5 Financial crisis of US bank 5 Global European banks and financial crisis: Comparison with US banks 5 Economic developments of Saudi Arabia during 2008 and 2009 7 The strength of the banking sector of Saudi Arabia 8 Data and methodology 8 Results and discussion 8 Conclusion 9 References 11 12 Abstract The world economy was hit by a severe financial crisis which resulted in the worst global economic downturn for over 60 years. The US housing market triggered difficulties which led the banks and other lenders underestimating the real risks for a longer period. The crisis spread throughout the global financial markets which destabilized the banking systems around the world. The impact spread beyond the financial system hitting the prosperity, economic growth and jobs throughout the world. The crisis was caused due to the failure of many banking sector across the world. The firms which had failed in UK allowed their businesses to overextend through risk taking and excessive leverage, over dependence on risky product streams like derivatives or buy-to-let mortgages, poor decisions of management in respect of acquisitions, over reliance on wholesale funding. Introduction Unprecedented innovation and growth have been seen in the financial sector over the past two decades as new products and higher returns have been sought by the investors in the era of low interest rates. Banks also had an obligation to understand the risks to which they are exposed. The complexity of certain financial instruments and the interconnected developed global market often did not provide well understanding of the dangers involved with the banks, its investors and boards, central banks and regulators (HM Treasury, 2009). The risk models of banks were proved as flawed which was based on incomplete application of principles of finance. It was believed that risks had been widely distributed throughout the financial system by the method of securitization but it proved as mistaken and risks posed by global increase in leverage were under-estimated. The remuneration policies of banks have contributed to the riskiness of financial system as they focused too much on short term profit. Market discipline also proved as an ineffective constraint on risk taking in financial markets (Independent Commission on Banking, 2011).There were certain deficiencies in the corporate governance of banking institutions. The board of banks failed to understand this and they got prone to the risk management processes of their firms. The senior management also did not question on the sustainability and nature of achieved higher returns. Many institutional shareholders were not able to monitor the effectiveness of senior management of banks nor did they challenge the decisions of board of bank. Generally, the banks and investors rely on the assessments of credit rating agency but they did not supplement the ratings with conclusions from the view point of their own analysis. The central banks and regulators, commentators and other authorities underestimated the risks built up in the financial system. The banks were exposed largely to the vehicles of off-balance sheet financing and lack of transparency. Financial intermediaries bring together borrowers and lenders in financial markets. It does so by interacting with savers and borrowers simultaneously and by producing a set of services facilitating the transformation of liabilities into assets like transforming deposits into loans. This function of transformation is termed as intermediation. Through this process, financial intermediaries facilitate savers and borrowers to have indirect lending and borrowing. Financial intermediaries can be banks, building societies, financial advisor or broker, insurance companies, life insurance companies, mutual fund and pension fund. Firstly, national bank served as a financial intermediary by accepting deposits and placing in various securities and mortgage loans. By doing this, individual investors are linked by banks with financial markets and demanders of credit. The intermediaries actually act as a middleman between firm raising funds and investors (Rampini & Viswanathan, 2012, pp.1-2). Literature Review Financial crisis of US bank The global economy was experiencing unprecedented level of financial turbulence. This was triggered by a downturn in US housing market, particularly the sub-prime end of the market. The instability grew steadily following the collapse of Lehman Brothers, an US investment bank. Initially, the investors realized that they have misjudged the risk in securities linked to low quality US sub-prime mortgages. Consequently, prices fall leading to heavy losses to the holder of assets. Then the investors became concerned about which of their counterparties are exposed to these losses and began to charge a higher risk premium to roll over the inter-bank exposures. The financial institutions reported losses for their holdings of impaired assets and investors questioned if full losses had been revealed (Lagos, 2006). This uncertainty and slowdown in major advanced economies raised concerns for solvency of a number of financial institutions. This led to higher funding costs to all institutions. The failure of Lehman Brothers undermined confidence in banking system as a whole. There was a lack of transparency in balance sheet of banks. The use of capital by banks is pro-cyclical with fluctuations in perceived riskiness of lending. The pro-cyclicality of capital of bank is led by lack of transparency in balance sheets of bank (Llewellyn, 2010). Global European banks and financial crisis: Comparison with US banks The analysis of crisis in euro zone is the hypothesis of three interlocking crisis, firstly, an economic recession called growth crisis, secondly, a banking crisis and thirdly, sovereign debt crisis. Unlike Asian and Latin American countries, whose external debt was not denominated in their domestic currency, the debt obligations of troubled countries of euro zone is held in Euros. While the debt obligations of Latin American and Asian economies were held outside the respective countries, the public and private debt obligations of troubled countries of euro zone were held by creditors in other parts of euro zone. In spite of all the turmoil in debt markets, the depreciation in euro is not close to that witnessed in Asia and Latin America. The crisis in global economy as well as in euro zone was preceded by global imbalances in current accounts and big deficits by a number of industrial economies (Financial Services Authority, 2009). The peripheral southern European countries Italy, Greece, Spain and Portugal ran up current account deficits. The cause for boom and bust scenario in housing in many deficit countries is the availability of cheap credit. A global saving glut (GSG) attributes this availability of cheap credit to events outside US borders. The growth in global capital flows among the developed countries has dwarfed the positions of current account. The European banks accompanied boom in lending with greater risk taking due to the factors that easy monetary policy lowers the funding cost for banks, adoption of regulatory structure allowing higher leverage and boom in asset price and real appreciation of currency strengthening the balance sheet position of borrowers (Kane, 2010). Further, cheap funding in US money markets allowed an expansion of balance sheet of global European banks unprecedentedly. In conjunction with the liability side, the asset side of global European banks focused on US securities. The consolidated banking statistics has shown that European banks had high foreign claims on US counterparties. Global European banks also fulfilled maturity transformation by borrowing funds from US money market and then utilized these funds to invest in securities created by the shadow banking system of United States (Mistral, 2013). In the process of increasing maturity transformation, the global European banks expanded their balance sheets and increased the leverage to an extent which was not witnessed previously under the regime of regulated banking. The differences between the leverage ratios of European banks and their US counterparts were noticeable. Two factors are attributable to these differences: the differences in regulatory landscape for banks and adoption of different accounting standards (Savona, Kirton and Oldani, 2011, p.98). The regulators in both Europe and United States have allowed banks to increase leverage but the incentives in Europe were stronger because of the practices of permissive bank risk management in the proposals of Basel II. European banks gravitated towards assets carrying low risk weight which allowed them to have strong capital ratios under the risk weighted framework of Basel II. On the other side, in United States, the emphasis beyond Basel I were on leverage ratios, banks focuses more on assets carrying attractive returns (Obstfeld, Cho and Mason, 2012, p.85). The global European banks also did not restrict their lending to United States. The introduction of euro and its appreciation as compared to other major currencies lead to reduction in risk premier for these banks which increased lending both within and outside Europe. Further, the European corporations’ reliance on bank funding was greater than that for US corporations. An example of how a Middle Eastern gulf country handled the global crisis: Economic developments of Saudi Arabia during 2008 and 2009 During the five year period 2004-08, the economy of Saudi Arabia fared well by international standards reflecting 4.4% growth rate in real GDP and 19% average surplus in government fiscal. All economic sectors were propelled with this, especially the banking sector which showered great benefits. In 2008, growth in real GDP was 4.5% with 4.8% growth in oil sector. In 2008, current account surplus was 28% of GDP and trade surplus recorded as 45% of GDP. No external government debt remained with the country. Inflationary pressures declined from with 9.87% inflation in 2008 to 4.4% inflation in September 2009 (Rivlin, 2009). The strength of the banking sector of Saudi Arabia Saudi banking sector showed strong growth and profitability during 2008 and 2009. Rate of return on average equity was 20% which stood at 16% by September 2009. Well capitalized by international standards, Saudi banks showed 16% of capital adequacy ratio in 2008, almost all being Tier I capital. Banks assets were strong with non-performing loans as 1.4 % of total loans and advances during end 2008, which were below 3% during September 2009. Data and methodology Analysis has been made on the data depicting the financial position of European banks and banks of United States during the period of global financial crisis. The financial position of various European banks and banks of United States have been attached in an excel file. On the basis of that data, the financial position between European banks and banks of United Sates has been compared. Results and discussion The cooperative bank of Belgium in 2002 has been showing total assets of 506 million USD whereas its commercial bank is showing total assets of 1028 USD. Further, the specialized bank of Belgium in 2005 has been showing total assets of 341mn USD whereas its savings bank is showing total assets of 2mn USD. In case of liquid assets, Belgium cooperative bank has liquid assets of 40mn USD in 2005 while the commercial bank has liquid asset of 25mn USD. Belgium specialized bank has liquid assets of 27mn USD in 2005 while its saving bank has no liquid assets. The commercial bank of US is showing liquid asset of 15mn USD in 2002 while in 2005 it is showing liquid asset of 325mn USD. The net interest margin of Belgium cooperative bank in 2003 is 3.95% while the net interest margin of US commercial bank in the same year is 3.07%. Again, the return on average assets in Belgium commercial bank during 2005 is -0.63% whereas the same for US commercial bank in 2005 is 1.59%. Conclusion The financial crisis was the result of human inaction and action and not of computer models and Mother Nature. The captains of finance and public stewards of financial system ignored warnings and failed to understand, question and manage the evolving risks within a system that is essential to the well-being of public (Nanto, 2009). The securitization and risky subprime lending exploded with an unsustainable increase in prices of housing, reports of predatory lending practices, and increase in household mortgage debt, unregulated derivatives and exponential growth in trading activities of financial firms. The widespread failure in financial supervision and regulation was devastating the stability of financial market of nation. The risk management and failures of corporate governance at many financial institutions were a prime cause to this crisis. A combination of risky investments, excessive borrowing and lack of transparency led the financial system on the course of collision with the crisis. There was a systemic breakdown in ethics and accountability. The collapsing standards of mortgage lending and the mortgage securitization spread the crisis. Finally, it can be concluded that the financial intermediary is perhaps a firm of special kind but nevertheless a firm. Through bank-like intermediation, securities which are issued by intermediaries are bought by household; the money is then invested as lending to borrowers. Its functioning of bringing together economic agents with shortage of funds, intending to borrow and with surplus of funds, intending to lend ensures direct contact with capital market between household and firms dominating one. With this, the importance of financial intermediary in financial market is quite justified. References HM Treasury, (2009). Reforming Financial Markets. London: The Stationery Office. Independent Commision on Banking, 2011. Final Report Recommendations. London: Domarn Group. Lagos, R., (2006). Inside and Outside Money. Minneapolis: New York. Llewellyn, D., (2010). Post Crisis Regulatory Strategy: A Matrix Approach. Dublin: Central Bank and Financial Services Authority of Ireland. Financial Services Authority, (2009). A regulatory response to the global banking crisis. United Kingdom: The Turner Review. Kane, E., (2010). Redefining and containing systemic risk. Boston: Atlantic Economic Journal. Mistral, J., (2013). Global Financial Crisis. [online]. Available from http://www.brookings.edu/research/topics/global-financial-crisis. [Accessed on April, 8, 2013]. Obstfeld, M., Cho, D. and Mason, A., (2012). Global economic crisis: Impacts, Transmission and Recovery. UK: Edward Elgar Publishing Limited. Nanto, D., (2009). The global financial crisis: Analysis and policy implications. United States: Congressional Research Service. Savona, P., Kirton, J. and Oldani, C., (2011). Global financial crisis: global impact and solutions. USA: Ashgate Publishing Company. Rampini, A. A. & Viswanathan, S. (2012). Financial Intermediary Capital. [Pdf]. Rivlin, P., (2009). The impact of Global Economic Crisis On The Arab World. [online]. Available at: http://www.jewishpolicycenter.org/967/global-economic-crisis-arab-world. [Accessed on 23 Feb, 2013]. Read More