Global Banking Crisis of 2007/08 - Essay Example

? Was the repeal of the US Banking Act of 1933 a substantial cause of the global banking crisis of 2007/08? United s Congressional, regulatory agencies and international authorities must remember that history will be repeated when fragmented regulatory environments allow multinational corporations to pursue profits by all available means necessary. The pursuit of profits by corporations and banks in an unregulated system led to the 1929 stock market crash and the resulting global depression. President Franklin Delano Roosevelt implemented a regulatory environment in response to the banking crisis during the Great Depression era. Multinational corporations, in pursue of profits, lobbied for deregulation during the last twenty years of the twentieth century, and as a result, the global banking crisis of 2007 – 2008 occurred. Global regulatory agencies, in response to the banking crisis, instituted global regulations in the global banking environment. This paper will examine the regulatory measures of the United States Banking Act of 1933, the process to repeal the Glass-Steagall Act, and the international aspects of banking regulations. Glass-Steagall Act Before the stock market crash of 1929, bank activities and investment activities were sometimes identical. During the Great Depression after the 1929 crash, Congress analyzed the mingling of commercial funds and investment assets in the banking system that transpired during the 1920s. Legislation prior to the 1920’s created the banking environment that led to the crash. The National Bank Act of 1863 launched a national banking arrangement regulated by the Comptroller of the Currency that allowed banks to take on activities through operating subsidiaries (Wilson, G 1995). The National Banking Act of 1863 permitted the configuration of private banking firms that could invest some of their assets in bonds of the United States ('National bank' 2010). Meticulous underwriting of stocks and bonds by the investment subsidiaries of some banks was a leading cause to the speculative stock buying of the 1920s and proceedings disclosed fraud and conflicts of interest with commercial banks investment activities (Angermueller, H, & Taylor, M 1977). President Franklin Delano Roosevelt, in response to the banking crisis, implemented the Banking Act of 1933 that created the Federal Deposit Insurance Corporation and called for the Federal Reserve to monitor proceedings of banks (Wilson, G 1995). The Glass-Steagall Act enforced the separation of commercial banking and investment banking (Wilson, G 1995). The Glass-Steagall Act forbade banks from underwriting and disseminating company stocks but allowed underwriting of municipal bonds and United States bonds. Congress was worried by numerous bank procedures concerning speculative investments with bank assets. There were concerns financial institutions were investing customer deposits in high-risk securities and they were also manipulating the stock prices of corporations contained in the bank’s portfolios (Norton, SD 2010). Glass-Steagall changed the regulatory structure in the banking environment. It barred commercial banks from consorting with a corporation whose activities predominantly involved the distribution, underwriting, or public marketing of stocks, bonds, or any other type of securities (Norton, SD 2010). It also barred Federal Reserve member banks to associate with any firm that is enlisted primarily in underwriting or distributing securities and it made it illegal for investment firms to accept deposits (Barth, ,, Brumbaugh Jr., R, & Wilcox, J 2000). As a result, some large investment corporations, like Morgan Stanley & Co. and First Boston Corporation were created when security firms made a decision to stay in the securities industry and terminate their commercial banking relationships (Angermueller, H, & Taylor, M 1977). Banks attempted to work around the Glass-Steagall apparatus by forming bank holding companies that could permit a bank to possess a traditional bank and investment bank under one corporate umbrella. The Bank Holding Company Act 1956 necessitated corporations operating a bank to file with the Federal Reserve and it instituted measures for activities by these corporations that were similar to banking (Wilson, G 1995). In essence, the Bank Holding Company Act was employed in response to banks forming bank subsidiaries to own both banking and nonbanking businesses.  This Act prohibited a bank holding company from engaging in most nonbanking activities or acquiring voting securities of companies that were not banks. Repeal of Glass-Steagall Act The Banking Act of 1933 and the Bank Holding Company Act of 1956 restrained the capacity of banks to perform fiduciary actions associated with investment companies, insurance firms, and other financial organizations. Bank holding organizations were considerably restricted in their power to get into the securities markets through their subsidiaries (Barth, ,, Brumbaugh Jr., R, & Wilcox, J 2000). Foreign financial competitors transacting business in the United States were permitted to operate outside of a regulatory structure and thus were able to provide consumers with low cost financial products and activities (Wilson, G 1995). United States banks were at a competitive disadvantage and, with influential members of the government, began to lobby for a repeal of the regulatory measures imposed by the Banking Act of 1933 and the Bank Holding Company Act of 1956. A series of legislative deregulatory reforms allowed the banks to engage in both traditional and investment activities. Wilson (1995) indicated the Community Reinvestment Act of 1977 allowed insured banks to provide lending services in the communities where the bank transacted business. Banks lowered their quality underwriting standards to provide risky mortgages in low and moderate income communities. This was the beginning of the creative mortgage products that would eventually lead to the subprime mortgage crisis because the risky loans were secured with credit default swaps. The International Banking Act of 1978 resulted in foreign banks having to comply with the federal regulatory structure, specifically, the legislation created a mandatory requirement for international bank branches that offered retail deposits in the United States to have deposit insurance. The Competitive Equality Banking Act 1987 redefined the meaning of a bank under the Bank Holding Company Act (Wilson, G 1995). The Federal Reserve permitted bank holding corporations to set up investment subsidiaries for limited underwriting and selling in municipal bonds and mortgage linked securities (Barth, ,, Brumbaugh Jr., R, & Wilcox, J 2000). Congress approved the entrance of several competitors in the banking environment that were free from the Glass-Steagall Act and Bank Holding Company Act limitations. Congress, as a result of the Competitive Equality Banking Act 1987 allowed many renowned corporations, such as, General Electric, Fidelity Investments, Prudential Insurance, American Express, Merrill Lynch, and AT&T to offer full banking services without enduring any confinements (Wilson, G 1995). The major corporations began to acquire firms throughout the financial industry so they could extend banking, insurance, and investment services to their customers. The Gramm-Leach-Bliley Act of 1999 was the last major deregulatory legislation to do away with the remaining regulatory measures of the Glass-Steagall Act of 1933 and the Bank Holding Company Act of 1956. The Gramm-Leach-Bliley Act allowed bank holding companies to present banking services, investment, and insurance to customers, which was similar to the bank holding companies that had the same offerings before the Great Depression (Barth, ,, Brumbaugh Jr., R, & Wilcox, J 2000). The Gramm-Leach-Bliley Act made the United States bank policies nearer to the banking legislation of most other foreign countries (Barth, ,, Brumbaugh Jr., R, & Wilcox, J 2000). The Gramm-Leach-Bliley Act authorized the configuration of the financial holding corporation, which permitted corporations to possess banks as subsidiaries and additional subsidiaries that take on all other financial actions. The financial processes of the new financial holding companies included underwriting and trading of financial assets, insurance activities, and commercial banking (Barth, ,, Brumbaugh Jr., R, & Wilcox, J 2000). Although the Gramm-Leach-Bliley Act open the doors for the financial holding companies to mix commercial banking and investment activities, the United States banks still faced restrictions that European banks did not have to endure. The banking crisis of 2007 – 2008 was a culmination of deregulatory legislation of the financial industry. Financial holding companies produced creative financial instruments, which allowed the banking corporations to assume greater risks with their assets. The financial crisis that involved the worldwide banking industry between 2007 and 2008 was caused by numerous factors. Banks had been securitizing subprime mortgage assets and created bonds which attained higher ratings by the ratings agencies in the deregulatory environment than would have occurred in the regulatory environment before the demise of Glass-Steagall and the Bank Holding Company Acts (Norton, SD 2010). International banking regulations The international banking regulations were implemented by Basel I in 1988 and Basel II in 2004. Basel I centered primarily on credit risk and became legally enforceable in the G10 countries in 1992 and Basel II placed measures on the quantity and utilization of a bank’s capital to address the risks they encountered (Basel Accords - Financial Glossary 2011). The Basel III accords forced banks to hold much more capital to prevent a repeat of the financial crisis. Under the Basel III regulations banks had to increase their core tier-one capital ratio to 4.5%, hold a counter-cyclical asset preservation buffer of 2.5%, and any organizations that neglects to adhere to the new obligations will be prohibited from paying dividends and bonuses until they improve their balance sheet (Wearden, G. 2010). The subprime mortgage crisis resulted in lending problems in several international financial markets (LaBrosse, J 2008). The banking crisis was a result of risky credit and borrowing practices, imprecise credit ratings, credit default swap contracts, exuberant individual debt because of the housing bubble and corporation debt structures. The Basel II Accord’s principal belief was that banks should be allowed more freedom to decide their individual risk levels but the theory was placed in jeopardy because of the subprime mortgage crisis. Global banking corporations underestimated the risks associated with assets related to subprime mortgage obligations (Petersen, M, Senosi, M, Mukuddem-Petersen, J, Mulaudzi, M, & Schoeman, I 2009). The Basel II Accords required banks to communicate their day-to-day market risk appraisals at the beginning of each trading day (Jimenez-Martin, J, McAleer, M, & Perez-Amaral, T 2009). The worldwide financial crisis had strengthened the beliefs regarding the weaknesses of the Basel II Accord. The main imperfections of the Basel II Accords that was revealed by the financial crisis, was the dependence on global rating agencies and the utilization of self-regulating by banks to define capital requirements (Moosa, I 2010). The International Association of Deposit Insurers was created to enhance deposit insurance efficiency by encouraging direction and global collaboration. International Association of Deposit Insurers attempt to handle in a judicious and efficient method the impact of bank failures and banking crisis’s (Su, W 2006). In March 2008, the International Association of Deposit Insurers issued twenty-one core principles for efficient deposit insurance practices for the welfare of nations contemplating a deposit insurance system (LaBrosse, J 2008). One of the components of a fiscal safety net is the condition of some security to those customers who place savings in banks. The financial security for depositors may include giving savers legal priority when banks fail or reparations with a deposit insurance system (Campbell, A, & LaBrosse, J 2006). Global banking crisis The worldwide banking crisis of 2007 occurred when the financial holding companies faced short-term funding troubles. Many financial firms that used short-term financing had already begun undergoing problems with renewing of their short-term funding needs. Britain’s fifth largest mortgage lender, Northern Rock, had very few subprime mortgages, but it used short-term funding in their daily banking operations. Northern Rock informed the Financial Services Authority regarding their short-term funding troubles. As a result of their liquidity concerns, Northern Rock experienced a bank run reminiscence of the Great Depression bank runs. The bank run was the result of customer’s withdrawal of substantial deposits, which caused increase media reporting that led to more customers withdrawing their funds (LaBrosse, J 2008). Television and newspaper accounts reported pictures of depositors standing outside Northern Rock’s bank branches to withdraw their money (Shin, H 2009). In one day depositors withdrew an estimated $1 billion (Petersen, M, Senosi, M, Mukuddem-Petersen, J, Mulaudzi, M, & Schoeman, I 2009). Before the bank run and in an effort to preserve capital, Northern Rock applied Basel II rules and the bank declared that it would increase its shareholder dividend by 30% despite regulators warnings that such a move could decrease its capital reserves to a dangerous level. Based on the Basel II rules, Northern Rocks CEO defended the dividend increase because of the high credit level of its mortgage loans, and as a result, the bank would require less capital to protect possible losses. To fund its operations, Northern Rock began to borrow in global markets instead of depending on bank deposits. Northern Rock’s deposits to total liabilities and equity ratio had declined from 63% at the end of 1997 to 22% at the end of 2006, which meant that Northern Rock had insufficient cash when the global short term money market troubles began (Petersen, M, Senosi, M, Mukuddem-Petersen, J, Mulaudzi, M, & Schoeman, I 2009). In the United States, the housing bubble can be attributed to creative and risky mortgage lending. Subprime mortgages were a financial invention intended to make home ownership available to riskier applicants. Subprime mortgages were for borrowers who were supposed to be riskier than the typical borrower because of a poor credit score (Gorton, G 2009). To cover the risk involved with subprime mortgages, financial institutions securitized the mortgages and other financial firms purchased the risky mortgages. As a protection for purchasing the risky assets, credit derivatives were granted to the securitization purchaser, but when the housing bubble collapsed and borrowers could not make payments, financial institutions could not cover their losses. When the financial entities faced losses from the credit swaps, many financial firms had liquidly problems. The collapse took place because the financial condition of several large financial organizations was jeopardized by massive losses in complex financial securities. The banking crisis that started in 2007 kindled a worldwide recession with huge results for economic and social benefits (Lang, W, & Jagtiani, J 2010). This was a result of fears regarding the solvency of several of the world’s biggest financial corporations that endured ruinous losses because of the mortgage crisis. The global banking crisis has forced international governments to implement measures to address problems in the financial banking industry. As a result of the Northern Rock Bank experience, Britain is now developing a course of actions to reform its deposit insurance system and instituting a public authority for bank resolution (Adler, J 2008). The United States President, Barack Obama, signed the Helping Families Save Their Homes Act, which lengthens the short-term increase in the deposit insurance amount from $100,000 to $250,000 per depositor until December 31, 2013. (FDIC: FIL-22-2009) The governmental regulations to address the 2007 -2008 banking crisis are similar to regulations enacted during the Great Depression era. Great Britain and the United States implemented measures so the public can maintain their confidence in the banking sector. Conclusion International governments and regulatory agencies during the Great Depression implemented a regulatory structure to address the banking and investment activities that led to bank failures and subsequent bank runs by depositors. United States banking authorities wanted to level the competitive advantage against internationally owned bank holding companies by eliminating the Glass-Steagall and the Bank Holding Company Act. The repeal of these two legislations created a deregulatory environment and allowed financial holding companies to be self-regulated and, as result, engage in risky activities. The risky activities led to a global banking crisis that the international finance communities have not witnessed since the Great Depression. International regulatory agencies are implementing similar regulatory measures to address the 2007 – 2007 crises as was used to address the concerns of the Great Depression. Bibliography Adler, J 2008, 'Group to Finalize Deposit Insurance Guidelines', American Banker, 173, 208, p. 5, Business Source Premier, EBSCOhost, viewed 3 April 2011. Angermueller, H, & Taylor, M 1977, 'Commercial vs. investment bankers', Harvard Business Review, 55, 5, pp. 132-144, Business Source Premier, EBSCOhost, viewed 2 April 2011. 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FDIC: FIL-22-2009: Extension of Temporary Increase in Standard Maximum Deposit Insurance Amount . [ONLINE] Available at: http://www.fdic.gov/news/news/financial/2009/fil09022.html. [Accessed 03 April 2011]. Gorton, G 2009, 'The Subprime Panic', European Financial Management, 15, 1, pp. 10-46, Business Source Premier, EBSCOhost, viewed 3 April 2011. Jimenez-Martin, J, McAleer, M, & Perez-Amaral, T 2009, 'THE TEN COMMANDMENTS FOR MANAGING VALUE AT RISK UNDER THE BASEL II ACCORD', Journal of Economic Surveys, 23, 5, pp. 850-855, Business Source Premier, EBSCOhost, viewed 3 April 2011. LaBrosse, J 2008, 'Time to fix the plumbing: Improving the UK framework following the collapse of Northern Rock', Journal of Banking Regulation, 9, 4, pp. 293-301, Business Source Premier, EBSCOhost, viewed 3 April 2011. Lang, W, & Jagtiani, J 2010, 'The Mortgage and Financial Crises: The Role of Credit Risk Management and Corporate Governance', Atlantic Economic Journal, 38, 3, p. 295, MasterFILE Premier, EBSCOhost, viewed 3 April 2011. Moosa, I 2010, 'Basel II as a casualty of the global financial crisis', Journal of Banking Regulation, 11, 2, pp. 95-114, Business Source Premier, EBSCOhost, viewed 3 April 2011. 'National bank' 2010, Columbia Electronic Encyclopedia, 6th Edition, p. 1, Literary Reference Center, EBSCOhost, viewed 2 April 2011. Norton, SD 2010, 'A comparative analysis of US policy initiatives and their implications in a credit crisis: The Depression Era of the 1920s in a twenty-first century context', Journal of Financial Services Marketing, 14, 4, pp. 328-345, Business Source Premier, EBSCOhost, viewed 2 April 2011. Petersen, M, Senosi, M, Mukuddem-Petersen, J, Mulaudzi, M, & Schoeman, I 2009, 'Did Bank Capital Regulation Exacerbate the Subprime Mortgage Crisis?', Discrete Dynamics in Nature & Society, 2009, pp. 1-34, Academic Search Premier, EBSCOhost, viewed 3 April 2011. Shin, H 2009, 'Reflections on Northern Rock: The Bank Run that Heralded the Global Financial Crisis', Journal of Economic Perspectives, 23, 1, pp. 101-119, Business Source Premier, EBSCOhost, viewed 3 April 2011. Su, W 2006, 'General guidance for the resolution of bank failures', Journal of Banking Regulation, 8, 1, pp. 85-112, Business Source Premier, EBSCOhost, viewed 2 April 2011. Wearden, G. 2010. Basel III rules will force banks to hold more capital. [ONLINE] Available at: http://www.guardian.co.uk/business/2010/sep/12/banking-basel-capital-requirements-raised. [Accessed 03 April 11]. Wilson, G 1995, 'Getting beyond Glass-Steagall', McKinsey Quarterly, 2, pp. 108-115, Business Source Premier, EBSCOhost, viewed 2 April 2011. Read More