The Global Financial Crisis - Essay Example

?“The repeal of the US Banking Act 1933 (commonly known as the Glass-Steagall Act) was a substantial cause of the global banking crisis of 2007/08.” Critically analyse the validity of this proposition Introduction The Global Financial Crisis popularized as the Global Banking Crisis was one of the greatest economic meltdown the world experienced in almost 70 years. Nobel laureate Paul Krugman who predicted a series of depression in his book Return to Depression Economics has compared the magnitude of this recession with the Great Depression of the forties. Termed as the Great Recession, it affected the lives of millions of people around the world and saw the fall of several financial institutions. Stock markets in most of the countries plunged and there was widespread inflation everywhere. Food and oil prices rose to an all time high. Oil price went as high as $147 a barrel. (Oil and Gasoline, April 6, 2011). Lack of purchasing power led to a fall in demand for goods and as a result several industries suffered. International institutions like IMF and European Union outlined several corrective policies and advised nations on adopting more risk aversive regulatory measures for the national financial institutions. All over the world the governments dished out policies and bailout programs for the citizens and institutions to tackle problems like inflation and unemployment. Most of the countries spent huge amount of money from their federal reserve’s in an effort to bring them back to the path of sustained growth. German government helped Hypo Real Estate with $50 billion (Bettinga and Parkin, September 29, 2008). Investors from UK had huge losses in the London Stock Exchange. On October 2008 the British government announced a plan worth $850 billion to rescue its banks from going into insolvency. (Nanto, 2010, p.58) The US government adopted the Troubled Asset Relief Program in 3rd October 2008 to rescue the distressed homeowners and also lent to $182 billion to AIG to prevent it from going down (GAO, 2009; The Troubled Asset Relief Program, n.d.). In total they pledged $700 billion to fight the recession in their country. The bailout though saved the economy for the time being, a lot of senators argued that these monetary assistance from public money cannot chart long-term growth stability for the country. They emphasized on the need for the Glass- Steagall Act that was enacted at the time of the Great Depression to be reinforced. In this paper we shall try to address the issue concerning whether the Glass-Steagall Act was needed to prevent the Financial Crisis. About the Act United States experienced worst recessions in its history during the 1930s. One of the primary reasons behind the recession was that the bankers and brokers of the nation were guilty of dubious financial practices like using their customer’s deposit to invest in stocks and securities. Also they used their financial might to inflate the prices of the securities and did not have enough capital cushions to back up their investments. So when the public got scared and wanted to withdraw their deposits a large number of banks went insolvent. A large number of small banks filed for bankruptcy and the nation faced an extreme crisis. Under such circumstances the US Banking Act of 1933 also called the Glass-Seagull Act was enacted under President Roosevelt to prevent the country from further such disasters. The Glass-Steagall Act had two main components. They are as follows: Setting up the Federal Deposit Insurance Corporation (FDIC) to insure the deposit of the customers and secure their deposit: This was done firstly, to restore the customers faith in bank deposits and secondly, to collect money so that the banks can be assisted in terms of liquidity crisis. A lot of banks were saved from bankruptcy by receiving capital from the FDIC. Separating the commercial banking activities from the investment banking activity: Firstly, this would prevent the banks from using the saving of their customer to indulge in buying stocks and bonds. Secondly, it would also help in controlling the unregulated speculation that can make the countries capital markets volatile. In this way the commercial bank could no longer sell securities or participate in either underwriting or stock broking activities. However in order to enable the banks to capitalize on the improving money market opportunities that opened up in the seventies and eighties, there was a demand from time to time from the financial corporation to rule out or relax the Act. By 1996 with the backing of Alan Greenspan, the chairman of the Federal Reserve Board a rule was passed that the banks could trade in some forms of securities like mortgages. But there remained the condition that revenue from investment banking has to remain within 25% of the total revenue. Finally the Clinton administration on repealed the act. (“The Long Demise of Glass-Steagall”, May 8, 2003) After the repeal big American banks and financial corporations went into mergers and started to offer a large basket of financial products. On April 7th, 1998 New York Times reported the biggest merger in the history between Travelers Group (which has already acquired Salomon Smith Barney) and Citicorp in a $140 billion deal. (Martin, 2005) Citigroup, thus formed offered a wide variety of financial services like banking, insurance and investment. Similarly Morgan Stanley Group Inc joined the Dean Witter Discover & Co to offer services such asset management, underwriting and stock broking. The rise of these conglomerates was well appreciated by Wall Street. (“The Long Demise of Glass-Steagall”, May 8, 2003) Emergence of the Debate for Reinforcing the Glass-Steagall Act After the recession policy-makers and experts have discussed various methods and policies to bring the countries back to the path of stable and sustained growth. One of the reforms that have been widely debated is to restore the US Banking Act of 1933 more famously known as the Glass-Steagall Act. As one of the remedial measures, US senators John McCain and Maria Cantwell advocated the reenactment of the law that prevented the commercial banks of the country from taking part in riskier investment and stock broking business and thus secured the deposit of the public. (Vekshin, December 16, 2009) They also proposed a year’s deadline for the banks to pick whether to go for commercial banking or investment banking. Let us Risky Financial Practices of the US Banks that led to the Financial Crisis The financial crisis was caused by the liquidity crunch in the United States banking system. Profit driven motives prompted the US banks and financial institutions to take more risk while investing especially in securities and mortgages. In order to encourage borrowing they reduced interest rates that were so far capped under the Glass-Steagall Act. They also introduced several methods so that taking a credit became easy through mortgages, credit cards etc and relaxed the criterion for taking a loan. Huge competition among the banks led to a decrease in the interest rate. As more and more people borrowed a trend of debt financed consumption developed. At the same time real estate industry was booming in many places around the world including United States, Brazil and India. Particularly in the United States the real estate industry was experiencing a boom and many people assumed that it will continue to grow at the same rate. So it was considered a safe industry to invest. Investment agencies and financial institutions from wanted to reap the benefits and invested heavily in the industry. Even foreign investment agencies and banks started investing heavily in these sectors thus creating more competition for the local banks. Most of the Investment agencies and hedge funds relied on the real estate sector as a safe sector for investment. As a result there was a large inflow of foreign exchange. The commercial banks in USA facing competition turned to easier and more attractive terms of lending. To encourage people wanting to buy houses either to stay or for investment the banks indulged in a practice called Adjustable Rate Mortgage (ARM). The other financial instrument that was heavily relied on was the Credit Default Swap and Securitization. We shall explain the three processes explicitly to understand the intrinsic risk in these products. Adjustable Rate Mortgage (ARM) is a variable interest rate offered for mortgaging. By this practice the interest rate on the mortgage is revised from time to time based on some specific index at specific intervals. Some lenders modified the system into option ARM. In this system the borrower for the initial period of loan has to pay a certain amount which is less than the interest he actually has to pay. The actual payment starts after a certain period of time or when the debt rises to some preset level. (Kolb, 2010) Securitization of mortgage is the process by which banks can sell illiquid assets such as mortgages to investors and thereby gain liquidity. They made a pool of mortgages and sold them as securities or shares. The investors receive a return on the principal and the interest. (Kolb, 2010) Credit Default Swap is another financial instrument by which the buyer pays the seller money on the speculation that the credit will default within a specific time period. In case of the default the seller pays the buyer a certain amount of money. For example, if a buyer enters into a contract worth $10,000 for 5 years at a premium of 5% then the buyer will have to pay $500 every year for 5 years. But in case of a default within the contract period the seller will pay the buyer $10,000. All these were based on the speculation that a mortgage would default within that certain period. A lot of big financial companies like Lehman Brothers and AIG bought CDS. In ten years the CDS market grew from zero to double the size of the US stock market, all unregulated. The security market also underwent a similar growth. (Kolb, 2010) The Unregulated Money Market and the Banking System Default rate was quite high and there were many instances of delinquency. Yet the commercial banks continued giving credit. The system was further jeopardized by the banks due to Securitization of mortgages, Credit Default Swap and other uncollateralized debt obligations. The money market funds provided a higher return on investment than general savings in bank accounts. United States had not experienced a major recession since the Great Depression and hence unlike the bank savings these money market products were not insured by the government. Taking advantage of the unmonitored situation the investment banks started putting their money in uncollateralized debt obligations like sub prime loan funded mortgages. According to Joseph Mason, a former economist at the U.S. treasury Department the sub prime loan debts are not a safe instrument for investment. (Evans, 2007; Smith, 2007) The firms had no compulsion to have capitals to secure their loans invested freely in swaps. This was not possible under the Glass-Steagall Act. Other Factors That Contributed To the Financial Crisis Firstly, the competition drove the financial companies to forego proper risk assessment and a lot of low quality mortgages underwent the process of securitization. Secondly, the big players of the market made large number of issuance and that had an impact on the nature of credit rating. Under the Glass Steagall Act the securities were monitored. The problem was aggravated by the large number credit rating agencies who sometimes gave biased ratings financial products. Moreover, the investment banks bought ratings from agency that gave the highest rating. In this way sometimes a product got a higher rating than it deserved. Since the number of companies offering issuances are limited they could act as a monopsonist and thus get favorable ratings. The problem was heightened by improper regulation that inflated the demand for securities as was evident in the case of Fannie Mae and Freddie Mae (Vekshin, December 16, 2009). This deliberate demand inflation would have been regulated under the Act. But some experts holds the opinion that when the Security and Exchange Commission relaxed the cap on leverage an investment bank has to maintain it made the banks more fragile. The banks became more inclined on leverages to increase their profit margins. Reliance on debt-financing and high rate of leverage mostly short term debts drove big corporations to bankruptcy. Advocators of the Glass-Steagall Act argue that under the regime of the act the cap on the interest rate would have prevented the bankruptcy. (EIR, 2011) Also closer monitoring of many of the large financial corporations that went insolvent would have ensured they had sufficient capital to justify the risks undertook. That could have saved the bank from going insolvent. Conclusion Many Economists and political experts have pointed out that one of the major reasons behind the risk-loving behavior of the big corporations has been the knowledge that individually they have a huge impact on the economy of country. So the government cannot let them fail and will have to rescue them in case of a fund crunch. Enforcement of the Glass Steagall Act would ensure that their operations are separated and individually they will cease to have so much impact. They are strongly against using public money to bail out the large corporations and mistakes they make. On the other hand noted general counsel of the FDIC, John Douglas argues that the change in the act came about because of the growing demand from the large corporate clients to have several banking operation under one roof (Vekshin, 2009). To conclude we can say that even if the large corporations are checked the problem of shadow banking that has plagued the US banking sector cannot be checked because most of these agencies do not fall under the Glass-Steagall Act. Moreover a large number of securities, as mentioned earlier have already had been relaxed. But he also maintains that the big player surely had a part in encouraging this shadow banking system and so reining them in would certainly help to tackle the problem. But other regulatory mechanisms also needed to be in place to actually check the problem. References 1. “Oil and Gasoline”, (April 6, 2011) Energy & Environment, The New York Times, available at: http://topics.nytimes.com/top/news/business/energy-environment/oil-petroleum-and-gasoline/index.html (accessed on April 6, 2011) 2. Evans, D. (2007) Unsafe Havens, Bloomberg, available at: http://www.bloomberg.com/apps/news?pid=nw&pname=mm_1007_story2.html (accessed on April 6, 2011) 3. EIR (February 18, 2011), The Angelides Report: The Moral Test, available at: http://www.larouchepub.com/lym/2011/3807angelides_rpt_moral_test.html (accessed on April 6, 2011) 4. 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