The Effect of Housing Bubble - Case Study Example

To what extent was the crash of 2008 due to al factors which gave people inappropriate incentives? How successful will the reforms that have been proposed so far be in preventing this from ever happening again? Introduction The effect of Housing Bubble originated in the USA has been felt by the whole global community as it has grown to the global crisis of 2008-2009. There are many different opinions, suggestions and interpretations of the roots and causes of the financial crisis of 2008. The main initiators of this financial collapse are considered to be the American financial institutions, including investment banks, commercial banks, rating agencies and funds1. Some experts and theorists explain that deregulation of the financial institutions have contributed substantially to the collapse of the financial system. Liberalization of financial institutions and low interest rates reinforced the development of new financial products that were made attractive for different categories of borrowers. The aim of this research is to analyze to what extent the institutional factors which gave people inappropriate incentives contributed to the crash of 2008 and to evaluate critically the reforms that have been proposed so far in preventing this from ever happening again. In order to prevent the financial collapse similar to the crisis of 2008 in the future, it is necessary to understand the root causes and sources of it. Roots of the Financial Crisis of 2008 There are many different versions explaining and interpreting the causes of the US financial crisis of 2008. However, the majority tend to connect this economic collapse with the series of institutional failures to govern properly the industry of financial services2. There are three major issues that are considered to be the roots of the crisis: financial innovation and move towards self-regulation and liberalization of financial markets; ultra low interest rates as incentives for households and financial institutions to encourage borrowing; deluded belief that asset prices would not decline3. Financial innovation and move towards self-regulation and liberalization of financial markets During the last quarter of the twentieth century regulation of the banking and financial markets has been transferred to the hands of private parties. Financial institutions were allowed to determine their optimal scope and size as well as to introduce financial innovations to the market due to reduced interference of regulatory bodies4. Such a deregulation has enabled institutions to provide borrowers with greater access to the capital. Ultra low interest rates Deregulation of the financial market has been followed by introduction of the ultra low interest rates. The Federal Reserve has lowered credit rates for short term loans from 1.75% in 2001 to 1.0%. While these interest rates were negative, they were extremely attractive for financial institutions. In order to generate higher returns, financial institutions have developed and introduced a new range of products and made it available to the public and other investors5. This has fueled the demand for cheap credits, as even those people who might not consider taking a loan were encouraged and incentivized to take it. Deluded belief that real estate prices would not decline Cheap credits and launch of new financial products both have contributed to the development of the real estate bubble. There was a deluded belief that real estate/ housing prices could not decline and this gave more confidence to the potential borrowers to take credits. Moreover, there were introduced securitization structures which also have contributed to the growth of the real estate bubble6. Further, when the prices of asset growth slowed, securitization activities have become a source of the financial collapse7. While there are some other opinions on the reasons and causes of the crisis, there are no doubts that institutional factors have contributed substantially to the financial crash. More detailed overview of the role of Institutional factors in the crisis 2008 is provided in the next section. Financial institutions and their role in economy Institutions provide to the societies a systemic frame which allows people to act with confidence and move in a consistent direction. Moreover, institution’s role also includes maintenance of the continuity of actions of the people by assuring that each action fits with other people’s actions8. This approach is especially applicable to the capitalism, as it is a social structure is characterized by a domination of economic relations. These economic relations depend on the financial structure of the economy, where monetary and financial institutions play a significant role9. This is the way the institutions form the society’s behavior. Various researchers and economists have long assumed that the performance of financial markets was highly correlated with the institutional configuration of these markets10. Campbell has devoted the whole article to the problem inter-dependence of institutional influences on people’s behavior. In the professional world such interdependence is known as the “institutional complementarity”11. Institutional complementarity is recognized to be an important factor in the country’s economic performance. While some researches indicate that there is no relationship between the performance of national economies and consistency of institutions’ messages and incentives, other researches illustrate obvious interdependences between these two aspects12. Institutional Factors Boitan & Dardac have defined some of the institutional factors that are common contributors to the financial collapse. These factors include: inadequate preparation for financial liberalization; involvement of the government in the banking industry combined with low control of “connected lending; and asymmetric information13. Below is provided a brief overview of these factors. Inadequate preparation for financial liberalization One of the key factors is inadequate preparation for financial liberalization14. As it has been discussed in the beginning of the paper, active liberalization process in the USA was followed by an extensive expansion of credits with low interest rates. Experiences of the Latin America’ and Asia’ financial liberalization also have shown that it precedes the financial/banking crisis15. Involvement of the government in the banking industry combined with low control of “connected lending Another institutional factor referred to the collapse of the financial system is considered to be involvement of the government in the banking industry combined with low control of “connected lending”16. These factors imply the greater risks that either management of the banks will follow their personal/corporate interests or the government will pursue its political objectives. Thus, lending decisions ignore the creditworthiness of the borrowers and encourage credits in order to pursue personal objectives and interests17. Campbell also has explored the institutional factors and its influence on the crisis. As Campbell explained, risk taking in the financial services industry was reinforced by institutional complementarities. All this has led to booming markets for mortgage-backed securities and various investment products, including credit default swaps. However, compensatory institutions failed to counterbalance these risky behaviors and all this contributed to the collapse of the economy in 200818. He believes that these factors are closely interrelated with both financial services industry and the mortgage markets19. In case of the crisis of 2008, the institutional reforms have been creating and reinforcing incentives which increased significantly the risk of financial crash. Considerable share of inappropriate institutional incentives could be referred to encouraging and reinforcing risky credits to various groups of borrowers. This behavior is also known as connected lending, whereas financial and banking institutions granting credits lack objectivity and fail to consider credit risks20. Thus, for example, people were encouraged and incentivized to take mortgage debts. Such a behavior has led to an increase of household debt from 40% in 1975 to 80% by 200021. This behavior has led to the “credit/lending boom” which is defined as “the rapid expansion of lending compared to the rate of economic growth”22. Asymmetric information Asymmetric information is one more important factor that has significant impact on the effectiveness of the financial/banking industry. There are two ways in which asymmetric information can be applicable to the researched topic: adverse selection and the moral hazard23. In case there are available guarantees on behalf of the international institutions or government, creditors, banks and all other parties, benefiting from these guarantees might take higher risks and ignore the borrower’s creditworthiness. Either these losses will be covered by the tax payers, depositors, insurers, or other creditors. While various institutional incentives mislead people, people were still free to make their own independent and more knowledgeable decisions24. However, taking into consideration the typical behavior of borrowers where people tend to get money if they can and invest in certain project 25(for instance, mortgage), the idea of financially responsible behavior of individuals becomes less viable. Thus, it is possible to state that institutional factors in a form of inappropriate incentives have made a substantial contribution to the crisis. The proposed reforms and its effectiveness In order to prevent the financial collapse similar to the crisis of 2008 in the future, policy makers have introduced some reforms. There is a large number of these reforms applicable at both domestic and international levels26. Some of these reforms include the following: adoption of Basel III capital requirements as an attempt to institute prudential instrument on the macroeconomic level; adoption of one liquidity standard (the Liquidity Coverage Ratio); introduction of enhancements the securitization structure; reduction of some big institutional players power and imposing of greater regulation upon the domestically important banks; adoption of principles aimed at avoidance of perverse incentives for risk-taking; and integration of collection process of data on credit risks of key systemic banks, etc.27 While all these reforms and policies are aimed at preventing the crisis of 2008, there should be more focused made on the improvement of incentives not only for all direct market participants, including creditors, owners, managers and traders of financial and banking institutions, but also to the final users of financial services, including corporations, households, sovereigns, etc.28 All these shareholders and third parties should understand what are the gains and losses of their financial activities, and what responsibility they should take for it. Such incentives would make agents and other players consider risks associated with their financial activity. Currently, the modern financial system does not cover all the incentives and motivations of all of the above mentioned groups. Incentives of the direct participants have direct impact on the financial system. Therefore, these should be introduced proper policies and regulations altering these incentives29. Conclusion The research was aiming to analyze to what extent the institutional factors which gave people inappropriate incentives contributed to the crash of 2008. The research has shown that the performance of financial markets and institutional configuration of these markets are interrelated concepts. To demonstrate this interdependence there have been discussed several institutional factors that have played a significant role in the collapse of the financial system in 2008-2009. Some of the key institutional factors included: inadequate preparation for financial liberalization; involvement of the government in the banking industry combined with low control of “connected lending; and asymmetric information. The institutional reforms have been creating and reinforcing incentives which increased significantly the risk of financial crash. Thus, it is possible to draw a conlcusion that institutional factors in a form of inappropriate incentives have made a substantial contribution to the financial crisis of 2008-2009. In order to prevent the financial collapse similar to the crisis of 2008 in the future, policy makers have introduced some reforms. However, in order to succeed, there should be made greater focus on the improvement of incentives not only for all direct market participants, but also to the final users of financial services. Therefore, these should be introduced proper policies and regulations altering these incentives. References Boitan, I., & Dardac, N., ‘Banking Crises’ Triggering Factors--Lessons from Past Experience’. Икономически Изследвания, Vol 3, 2010, pp. 3-33. Boyd, J., Gomis, P., Kwak, S., & Smith, B. ‘A user’s guide to banking crises’. Manuscript, University Of Minnesota, 2001, p. Campbell, JL. The US Financial Crisis: Lessons for Theories of Institutional Complementarity, Socio-Economic Review, vol.9, no. 2, 2011, pp. 211-234. Claessens S. and Kodres L. ‘The Regulatory Responses to the Global Financial Crisis: Some Uncomfortable Questions’, IMF Working Paper 14/46, 2014, pp.1-39. Leicht, K. T. and Fitzgerald, S. ‘Postindustrial Peasants’, New York, NY, Worth, 2007, ch.3 Quinn, B. ‘Failure of Private Ordering and the Financial Crisis of 2008’, The. NYUJL & Bus., 5, 2009, pp. 1-67. Rapoport, A., & Gerts, A. ‘The Global Economic Crisis of 2008-2009. Problems of Economic Transition’, vol.53, no.6, 2010, pp. 45-62. Simkovic, M. Competition and Crisis in Mortgage Securitization, Indiana Law Journal, vol. 88, no. 1, 2013, pp. 213-271 Ülgen, F. ‘Institutions and Liberalized Finance: Is Financial Stability of Capitalism a Pipedream?’, Journal of Economic Issues, vol. 47, no. 2, 2013, pp. 495-503. Read More