Causes of Crisis in Financial Markets - PowerPoint Presentation Example

FINANCIAL CRISES Table of Contents Introduction 3 Types of Financial Crisis 3 Causes of Crisis in Financial Markets 5 Responses by Governments 7 Implications of Financial Crises on Other Economies 8 Conclusion 12 References 14 Bibliography 16 Introduction The financial system at the centre of market in economy. An ideal system will allocate scarce resources to most appropriate avenues so as to maximise profits and productivity of the economy. When the financial system crashes the whole economy suffers as it is very critical component of the system. Almost every financial crisis in the past was either resultant of failure bank or resulted in bank runs (Diamond and Dybvig, 1983, pp.401-419). Very recently the US economy has started to rollback its quantitative easing programme as the economy is struggles to recover from recession. The purpose of this study is to explain the main types and causes of crises in financial markets and analyse the responses (such as quantitative easing QE) to them by the governments. Types of Financial Crisis The types of financial crisis can be primarily classified into banking crisis, international financial crisis, wider economic crises, and speculative bubbles and crashes. Crisis in banks occur due to sudden withdrawals by depositors probably due to unexpected panic looming over the market. The basic business model in any bank will reveal that the main earnings of the bank are generated from the difference between interest earned from investment in profitable projects and the interest paid on deposits. As the banks lend out the majority portion of cash they receive on deposits in avenues of optimum investment, any sudden demand for pull back of money by the depositors will make the bank insolvent because of the fact that no banking organisation has the liquidity to repay their demand and time deposits at the same time. This causes some customers to lose their money on deposits and the panic quickly spreads over the market causing depositors in other banks to pullout money from banks. This creates a cyclical chain reaction in the financial markets that adversely affects investor sentiments and thereby creating banking financial crisis. This phenomenon is also called the ‘bank run’. Example of such banking financial crises or bank run includes the Northern Rock bank run in 2007 and the legendary run on banks of United States in the year 1931. International financial crises occurs when a country that previously maintained fixed exchange rate regime is abruptly forced to adopt floating rate system. This generally requires devaluation of currency due to market speculation. This type of crisis is also known as the balance of payment crisis or the currency crisis. The origin of the crisis lies with the difference in relative exchange rate between the currencies. Consider a scenario where a country fails to repay it sovereign debt then such situation is also known as the sovereign default. Some analysts and economists argue that both decision of defaulting and devaluation are voluntarily taken the by the government, other perceive it to be involuntary changes in economic conditions due to changes in investor sentiments leading to sudden halt in capital infusion thereby causing panic in the market and creating financial crises. In the year 1992-93, several currencies in United Kingdom were forced to withdraw or devalue their existing exchange rate policies and adopt European Exchange Rate Mechanism. Another such similar crisis took place in Asia during the year 1997 and 1998. Many countries in Latin America also defaulted on their sovereign debt in the early 80s. The Russian financial crisis in 1998 was also consequences of devaluation of Russian currency Rouble that forced Russian government to default on their sovereign bonds. A speculative bubble is caused due to sustained overpricing of securities or assets. The main reason that have been found to be the main contributing factor for bubble is the tendency of the buyer who procure assets exclusively based on the hope that they will be able to resell it in future at an higher price instead of estimating the ability of the asset to generate future potential income. Hence, the bubble is caused from ‘inflated’ expectations of the buyers. The main risk associated with bubble is the high risk of a asset price ‘crash’ that is inherently associated with it. The market participants will go on buying when there is an expectation the market for longing any particular class of asset and conversely they will short when the prices of assets would fall. But as it is very difficult to predict whether an asset price really equals to its intrinsic value, the reliability of asset bubble prediction becomes uncertain. Historically, some of the most well known examples of asset bubble includes the crash of Wall Street in 1929, the crash of dot-com bubble in 2000, and the US housing bubble that triggered subprime crisis in 2007-08. Another type of financial crises is the wider economic crisis which is originated whenever the gross domestic product (or GDP) of the country turns out to be negative for a prolonging period of time, such as more than two quarters. This phenomenon is called recession and severe recession prolongs for significant long time horizon then it could turn into a depression where the economic growth stagnates. Majority of the economists have argued that many recessions in the past have been the basic cause of financial crisis. To illustrate this argument one could refer to the Great Depression that preceded from stock market crashes and bank runs in many countries (Ahmadi and Ritschl, 2009, pp.1-6). Even the subprime mortgage crisis and burst of housing real estate prices in late 2008-09 lead to recession in US and UK. Causes of Crisis in Financial Markets Some of the most important causes of crises in financial markets are discussed as follows: Asset-Liability Mismatch – This situation arise when the risk associated with debt of an institution is not appropriately aligned with assets. The most simple example of asset-liability mismatch could arise from the deposit schemes offered by commercial banks. These deposits can be withdrawn at anytime and the banks use the proceeds to make investment in long-term assets. The mismatch between bank’s deposits (short-term liabilities) and loans (long-term assets) is the main cause for bank run. For instance, Bear Sterns became insolvent in 2007-08 as it was unable to restructure its short-term liabilities that it used to finance long-term investments in mortgage based securities (Derakhshan, 2008, p.26). Regulatory Failure – The governments of many countries have attempted to mitigate or eliminate financial crises by intervening and regulating the financial sector. the main goal of regulation is creating transparency which requires companies to follow standardised financial accounting and reporting procedures. Other areas of regulation includes maintaining sufficient assets, capital reserves and imposed restrictions on the extent of leverage. Some financial crises have blamed insufficient regulatory system. To illustrate, many economists have blamed Dominique Strauss-Kahn for the financial crisis of 2008, who was then the Managing Director of IMF. He was blamed for taking excessive risk and failure to manage financial system once the crisis started. Conversely, excessive regulations have also been the cause for financial crisis. For instance, the Basel II was criticised because it required banks to increase capital requirements when risk arise. This is the reason as to why the banks decreased their lending to customers at the time of crisis that created scarcity of capital in the markets (Acharya et al, 2009). Contagion – This term is used to refer to the spreading of financial crisis from one institution to another and consequently spread to other economies. Whenever bank run occurs in one banks the market sentiments changes suddenly creating confusion and panic. People starts to lose confidence on financial system and decide to pullback their money from banks and stock markets which contingently crashes stock markets in other economies as well. One of the most well known contagion was the 1997 Thai crisis that spread to counties like South Korea (Ozkan and Unsal, 2012, pp.4-6). Leverage – It refers to borrowing money with the objective to make financial investment to earn profits. Historically it has been cited as one of the most frequently and common contributor to financial crises. While on one hand leverage magnifies potential return on investment, at the same time its risks are unlimited and could ultimately lead to bankruptcy. To illustrate, the leveraged investments in stock markets prior to 1929 was the main reason for the Crash of Wall Street (Blundell-Wignall, Atkinson, and Lee, 2008, pp.1-19). Responses by Governments The responsibility of monetary policy rests on the shoulders of Federal Reserve (FED), which is the nation’s central bank. By implementing monetary policy, FED ensures financial stability, availability of money and credit in the economy. Traditionally, the FED mostly relied on three ways to contract or expands credit and money in the economy. The first method is called the open market operation that involves buying of US treasury securities. In the second method FED can change reserve requirements of deposits in banks. In the third method institutions can borrow their reserves requirement directly from FED at discounts on overnight basis (Gourinchas, 2010, pp.3-6). During the mid of September 2012, FED announced quantitative easing 3 (QE3) in order to address continuous high unemployment and inflation. Through QE3 policy, FED started purchasing assets such as mortgage backed securities, government sponsored enterprise, coupled with purchase of monthly treasury securities. The program started with purchase of bonds worth $85 billion per month and would continue until the economic growth in US revives and sufficient employment is generated. The total spending has been reduced to presently about $65 billion per month. The characteristic feature of QE3 is that FED had not announced end date for purchases. The Federal Reserve chairperson, Janet Yellen has mentioned in her quarterly policy review that the US central banks would adjust policy in response to movements of economy towards revival of growth. At the same time she also mentions that policies must formulated in such a manner so as to accommodate unforeseen economic challenges. Yellen points out that Federal Reserve in the past has faced many challenges to recover the economy from the Great Recession and if it is unprepared in future to face any financial crises then another great recession cannot be avoided (Bernanke, 1983, pp.257-276). Implications of Financial Crises on Other Economies The global financial crisis had a severe impact in many Asian countries during the late 1997. Most of the East Asian nations were at the center of the crisis for several years. Before the crisis period, these countries were known for their successful growing market economies and the rapid growth in the standard of living of their populations. The effective fiscal policies and higher private savings of these countries were considered as models for other countries in the world. But in the post war period, these countries became the victim of the worst financial crisis. There are several factors that are responsible for sudden deterioration of these countries. The success of these countries had influenced the foreign investors to overlook their economic problems. Large scale financial investments were encouraged by the economic success but at the same time the demand was increasing for institutions and policies to protect the financial sector but it has been that the institutions and policies were not sufficient to meet the demands. Thus when the crisis appeared, the fundamental weakness of the policies and the institutions came out. The following table shows the gap between the demands and failure of the policies and the institutions. There are several internal and external factors which might have reduced the interest of foreign and internal investors to invest in these countries- The excessive pressure had increased the external deficits and the price of the property. It had also increased the value of the existing stocks in the market. Apart from this, long time was taken to fix the exchange rates which complicated and delayed the action of monetary policies to control the excessive pressure. As a result it increased the external borrowing and led to massive exposure to the foreign exchange risk in the international market. The slow implementation of the rules and regulations and improper supervision of the financial structure had reduced the quality of the loan portfolios provided by the banks. The limited amount of available information and low transparency in the financial sector acted on the performance of the investors and restrained them from having a realistic view of the financial market. Along with this, there were other problems in the economy due to the unstable political and governmental decisions which further reduced the confidence of the foreign investors, led them to take short term loans and increased the pressure on the sto9ck and currency markets. Apart from this, external factors also played a crucial role in the crisis which caused loss to many foreign investors. Foreign investors had over looked the risks and continued to search for only higher returns as because eta that time, investment options were not profitable in Japan and Europe due to their low interest rates and slow economic growth. As most of the exchange rates of East Asia were fixed to the rate of U.S. dollar thus fluctuation in the dollar and yen exchange rate influenced the crisis by proving the unsustainable competitiveness of these countries in the international market. Foreign investors like investment banks and commercial banks and the domestic investment banks tried to hedge the exposure of foreign currency in those markets. The countries had introduced some corrective measures to overcome the damages in the economy. During the late 1997 and early 1998, the International Monetary Fund had offered $36 billion to fund the reform activities in the most affected countries like Korea, Thailand and Indonesia. The IMF had provided this support to the countries as a part of the $100 billion international support package. The wrong decision and hesitation to introduce the reforms of the authorities of these countries led to extreme part of crisis and reduce the value of currency in the financial markets. As a result value of the foreign debt increased rapidly and it had also increased the uncertainties in those countries (IMF Staff, 1998, pp. 18-19). In the month of January in 1998, the terrible dimensions of the financial crisis had affected other countries also. Due to the rapid downfall of the stock market and currency market and a $1 dollar investment in Singapore stock market in 1997 had a value of $0.49 in the same market in 1998 and $0.25. One dollar sunk into the stock exchange of Jakarta in June was worth around a dime in mid-January and just a week later. By method for complexity, a dollar which was invested into the Taiwan stock exchange still had a worth of $0.75 in mid-January 1998. Although the subtle elements fluctuated from nation to nation; by first half of the year 1997 few financial institutions which were sharing similar characteristics were remarkable over the four distressed countries (Gillis, No Date,pp. 255-256). 1. Financial organizations just as of late discharged from long-standing shackles, commonplace under regulated credit frameworks, were completely ill-equipped to capacity in a recently globalized world economy. Profoundly inserted managing an account polishes in show with the most noticeably bad types of rent-looking for conduct prospered. 2. There was a plenitude of short term borrowings by the bank and non banking financial institutions private companies who were having strong political connections lent on the long term ventures (Dornbusch, 1998). 3. A great part of the credit made conceivable by substantial fleeting seaward getting had been directed to exceptionally levered neighborhood customers (Krugman, 1998). 4. It has been seen that inflation were increasing in the local financial market – particularly for lands and real estates. Thus, this gave a premise to further getting through swelled qualities for insurance (Krugman, 1998). Apart from the above factors, it must be included that the lemming-like inclinations of far away like domestic investors, and particularly nearby conditions. For example, political uncertainty and severe drought in Indonesia, a sharp decrease in case of export of oil prices, influencing basically Indonesia, heinously unseemly approach reactions in Malaysia, and questionable matters originating from races in Korea in December 1998. In each of the four of the tormented countries, debilitating monetary standards started to convert just negligible credits into non-performing ones. By November, bad debts of East Asian banks, as stated by the Economist, represented in excess of 15% of the total loans in Korea, Malaysia, Indonesia and Thailand. Conclusion From the above study it can be said that past financial crises have delivered a few recommendations to diminish the extent of future emergencies. A considerable lot of these plans center upon changes looking for another worldwide budgetary construction modeling. While a few changes in the mission or the structure of the Bank and the Fund may help to improve some future emergencies, developing countries are generally encouraged to likewise devise measures to ensure themselves. Some banks have focused on the need to control hazard at the global level. Dornbusch has given a decent suggestion that might give opportune aid to nations who conform to a hard composed and examined plan obliging more stupendous consideration regarding accounting reports, with support restrictive upon agreeability with strict capital benchmarks for banks (Dornbusch, 1998). Greenspan has recommended a comparable methodology (Greenspan , 1998). Some contend that more stupendous liquidity is the way to such confirmation toward oneself (Feldstein, 1999). Others stretch the need for satisfactory supporting of bank obtaining commanded in remote cash (Lal, 1998). References Gourinchas, P., 2010. U.S. Monetary Policy, ‘Imbalances’ and the Financial Crisis. [Pdf]. 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