Financial Crisis: Monetary Institutions and Entities Assets Decline in Value - Essay Example

Financial Crisis: Monetary Institutions and Entities Assets Decline in Value Introduction Monetary excesses characterised by a period of boom and bust that precede financial turmoil in many economies inevitably cause financial crises. In the aftermath of a financial crisis, governments are forced to come in and intervene to protect the interests of depositors and to instil discipline in the errant financial institutions. Governments have across the world being forced to enact new regulations, bail out the large organisations often regarded as ‘too big to fail’ due to the repercussions on other sectors of the economy, and generally ensue stability is enhanced in the financial sector which is the backbone of the economy. Nevertheless, critics and exponents of the laissez faire have castigated the efforts of the authorities as being counterproductive and detrimental to capitalist ideals. Proponents’ have however argued that without government intervention, the consequences will be far much catastrophic to the economic system being protected. According to Keen (2009), the scale of the current financial crisis is deeper due to the latent exposure to all sectors of the economy, unlike previous financial crisis that mostly affected banks and their borrowers as in the great depression 1930s. Financial crisis occur when monetary institutions and other entities assets decline in value. These include banking crisis, foreign exchange crisis, sovereign debt non-payments and the bursting of other monetary bubbles. Banking crisis is often typified by ‘bank run’ whereby depositors all at once rush to retrieve their savings. Brunnermeir (2008) has described a bubble as situation whereby the cost of an item surpasses the current worth of the potential earnings receivable on maturity as exemplified in the dot-com burst in 2000-2001. Currency crisis however occurs when nations are forced to devalue their fixed exchange rates due to speculative attacks resultant in a balance of payment crisis. Laeven and Valencia (2008, pg.6 describe a ‘currency crisis’ as an ostensible decrease of the currency by a minimum of 30 percent with additional appreciation by ten percent rate in depreciation. Sovereign debt crisis occurs when nations default in the payment of their debts. In Russia, the devaluation of the ruble and government default on bond payments resulted in an exchange crisis whereas similar scenarios were enacted in Asia in 1997-98 financial crises. Sovereign debt crisis have nevertheless been acerbated by depreciation of local currencies in those countries that have borrowed internationally pegged on either dollars or Euros currency. This has led to their debt burden appreciating as their local currencies decline in value (Pearlstein, 2009). According to Laeven and Valencia (2008), credit booms averaging approximately 8.3 percent annually in private credit to GDP growth frequently herald banking or financial crisis. The underlying causes of global financial crisis is attributed to poor macroeconomic policies that lead to established excess liquidity triggered off by low interest rates as set by central banks. In the United States, the current private debt stands at $41 trillion, which is nearly triple, the $14 trillion in GDP while the government debt burden is $9 trillion. Institutional flaws by many governments have periodically acerbated the problems as disclosure and accounting guidelines are sparsely enforced while the judicial system further aggravates the problem through endless litigations. Reinhart and Rogoff (2008) characterise the aftermath of financial crisis into three major categories. Firstly, hefty depreciation in the asset markets whereby housing prices fall by an approximately 35 percent for a period of six years whereas equity prices fall over 55 percent in a span of three and half years. Secondly, banking crisis induce waning production and employment, with the unemployment rate appreciating by seven to nine percent lasting over four years. Lastly, ‘the real value of government debt explodes’ appreciating to over 86 percent occasioned mostly by the loss of tax revenues and consequent amiable fiscal policies employed to stem the declines (pg.3). In the current global crisis, Taylor (2008) provides empirical evidence that suggest that if the government had applied more prudent fiscal polices with interest rates that are more cautious, the calamity could have been avoided. Taylor uses regression techniques to simulate empirical connection linking the interest rates and housing statistics to estimate a counterfactual incident where prudent fiscal policies are applied. [See Figure 1] Figure 1 It is estimated that over 40 percent of world wealth has been decimated by the current global crisis. According to Nanto (2009), the financial crisis has ‘exposed fundamental weaknesses in financial systems worldwide, demonstrated how interconnected and interdependent economies are today, and has posed vexing policy dilemmas’ (Pg.3). The London G20 Summit grouping suggested a strengthening of the IMF as an oversight authority alongside the newly created Financial Stability Board while also calling for regulations that are more rigorous and strengthening of the international financial architecture in conformity with global economies. Laeven and Valencia (2008, pg.4) argue that the incidences of bailouts or forbearance exhibited by many governments during moments of financial crisis are often counterproductive. They allege the principal characteristic consequence are depreciation of the same banks net worth, crippling tax loads on the public to fund the bailouts, low credit supply reduction and economic turn down which would have otherwise have been avoided without the clemency. Nevertheless, they acknowledge the consequences of inaction may be catastrophic. Laeven and Valencia (2008, pg.10) have listed four immediate policy measures typically undertaken by governments to stem financial crisis. These include: Deferment of convertibility of savings, thus thwarting bank depositors from claiming reimbursement from depository institutions Regulatory Capital Forbearance, that permits banks to circumvent expenditure of fiscal observance (including permitting them to inflate their equity funds sequentially to evade expenses in tightened credit supply), Emergency capital shore up to financial institutions Central Banks guaranteeing depositors’ funds. Carrera (2009, pg.3) argues that all major financial crisis in the last 100 years have led to the restructuring of the International Financial Architecture (IFA). This is the loose association of financial organizations; guidelines (both embedded and unambiguous) and conduct are based in accordance to the pecuniary and economic associations to the public and personal representatives of diverse countries. Ferguson (2009) asserts those financial crises are historical cyclical events that will keep on recurring irrespective of the numerous fiscal and monetary policies employed. There were 59 bank failures between 1976 and 1996 among the developing countries costing over $250 billion while 104 were recorded in the developed countries between 1976 and 1993. In the US, 1,150 financial institutions collapsed between 1983 and 1990. Carrera (2009), Rogoff et al (2008) and Rosengren (2009) assert that without tangible fiscal policies, financial crisis cannot be averted, hence deride advocates of liberalization of the financial sector as being myopic. [See Figure: 2] Figure 2 Source: IMF, 2008 Nanto (2009) however argues that irrespective of the hefty bailouts and forbearance, the lack of applicable regulatory and institutional adjustments to the underlying issues in the shadowy banking system will not stop the crisis from recurring. This was evident in Japan’s banking crisis where bailouts only served to temporary slowdown the crisis by un-emphatically dealing with the toxic assets and other nonperforming loans. The US government launched a $700 billion Troubled Asset Relief Program (TARP) aimed at restoring financial stability in the country (Rosengren, 2009). In Europe, the EU through the de Larosiere Report has also taken measures aimed at stabilising the financial sector. However the report criticized the prevailing and ‘inadequate crisis management infrastructure within the EU’ that would be sufficient to have long-term impact on the financial sector. This is manly due to protracted protectionist regimes maintained by member countries. In the UK, the government through the Stability and Reconstruction Plan provided $850 billion in a composite arrangement to the banking sector. Carrera (2009) and Nanto (2009) have called for the strengthening of the G20 group of countries as the premier regulatory organisation in the wake of ineffective leadership from the IMF and WTO. However, Zhou Xiaochuan, the Governor of the People’s Bank of China, argued for a uniform international currency rather than relying on the unstable dollar in the London summit of the G20 group (Carrera, 2009, p. 19). Origin of Current Crisis The current financial crisis can be traced to the collapse of the US residential housing sector particularly the subprime mortgage division. This crisis has been traced to the lowering of interest rates from 2001, which generated excessive money circulation hence prompting lending institutions correspondingly lower their lending rates and requirements. The emergence of mortgage backed securities (MBS) and collateralized debt obligations (CDO) largely derived from the unstable subprime loans was a consequence of the greed of Wall Street financiers and other investors clamouring for the high yield securities (Martin et al, 2008). According to Jacques de Larosière, a former IMF director, the current credit crisis was occasioned by an accrual of various factors, including surplus capital leading to lowered interest rates, of a heightened chase for the high yield risky investments, low risk premiums, occasioned by insufficient comprehension by the stakeholders (Larosière, 2008). The collapse of the internet based listed companies, dubbed the dot-com bubble burst in 2001, coupled with the terrorist attacks of 9/11 the same year propelled the regulators to lower the interest rates as evidenced by the Federal Reserve lowering to 1 percent, the lowest level in long time (BusinessWeek, 2007); (Ashbaugh, 2008). This elevated liquidity coupled with flattering housing policies led to high demand for residential houses which then made their prices to double appreciably between 2000 and 2006. However, with the first signs of the housing crisis meltdown in 2006, the US Federal Reserve adjusted the interest upwards 17 times from 1 percent to 5.25 percent (Watkins, 2008). The growth of the subprime loan sector was exceptionally fuelled by the need for home ownership, deregulation of the financial markets, and the greed of the mortgage brokers and lenders. [See Figure 1 below] Figure 1 Regulators have been accused of conniving with the major lending institutions as they laid out a series of complex financial web full of legal entities known as ‘structured investment vehicles’ which tended to mask the exposure of the firm hence making investors experience unwarranted risks (Bloomberg.com, 2006). In the aftermath of the bursting of the ‘housing bubble’, other financial instruments used to propagate insecure investments like derivatives have been highly criticised. These include derivatives used as credit default swaps (CDS) which are employed to hedge against other credit risks. The quantity of the outstanding CDS has been approximated to escalate to US$47 trillion by 2008 (Forbes, 2008). Revered financial guru Warren Buffet had as early as 2003 described them as ‘financial weapons of mass destruction’ (The Economist, 2003); (BBC, 2003). Krugman (2009) alleges that ‘the shadow banking system expanded to rival or even surpass conventional banking in importance’ (Pg.14), terming the deficiency in control by regulators as a ‘malign neglect’. A ‘commodity price bubble’ was consequently created including an escalation of oil prices from $70, August 2007 to over $140 in July 2008 (Taylor, 2008). The subprime mortgage crisis was therefore an inevitable outcome after the bursting of the housing bubble (BusinessWeek, 2007). The subprime loans were intricately structured in a layered complex financial model that revolved around many individuals and institutions unlike the traditional ‘prime’ loan that were more conservatively structured. [See Figure: 2] Figure 2: Comparison of Prime and Subprime Mortgage Models Source BBC.Com/Business - 21 November 2007 Conclusion Financial crisis emanate from avaricious practices by errant custodian of financial institutions as were as the consequences of poor fiscal policies by the regulators. Although proponents of laissez faire frequently advocate for more liberalisation of the sector, Keynesian adherents maintain calls for more stringent regulations of the financial sectors, to check on the excesses of the system. Despite the efforts of both, crises have cyclically recurred as neither system has been properly practised. An integrated regulatory system is clearly needed in view of the cataclysmic effects of these crises with more global outlook. To be effective, the regulations must be enforced internationally to deter incidences of ‘save havens’ where individual institutions can continue shadowy banking practices. References Arrington, M. (2008). How the U.S. Goverment Engineered the Current Economic Crisis. Retrieved January 3, 2010, from Techcrunch.com: Brunnermeir, M. (2008). 'Bubbles' in The New Palgrave Dictionary of Economics. 2nd Ed. Carrera, J. (2009). The G20, the Crisis and the Redesign of the International Financial Architecture. Buenos Aires, Argentina: Working Paper 2009 | 45, BCRA Investigaciones Económicas. Dybvig, D. D. (2000). Bank Runs, Deposit Insurance, and Liquidity. Federal Reserve Bank of Minneapolis Quarterly Review , Vol. 1 Pg.14-23. Ferguson, N. (2009). How the Financial Crisis Happened. Retrieved January 3, 2010, from CNN Money: http://money.cnn.com/news/specials/crisiswallstreet/2008/index.html Forbes.com (2009) Geithner's Plan for Derivatives. Retrieved January 2, 2010, from Forbes Online: Keen, S. (2009). The Financial Crisis Explained: Goverment Resources 'Puny' Compared to Market Bubble. Retrieved January 3, 2010, from The Australian: Krugman, Paul (2009) The Return of Depression Economics and the Crisis of 2008. W W Norton Company Limited ISBN: 978-0-393-07101-6 Larosière, J D (2008) Analysis of the 2007 Financial Subprime Crisis, by Jacques de Larosière. Retrieved January 2, 2010, from Canal Academie: Marin, J. (2002). Sustainability of Public Finances and Automatic Stabilisation Under a Rule of Budgetary Discipline. Frankfurt: European Central Bank: Working Paper Series No.193. Nanto, D. K. (2009). The Global Financial Crisis: Analysis and Policy Implications. Washington DC: Congressional Research Service. Pearlstein, S. (February 20, 2009). Asia, Europe Find Their Supply Chains Yanked. Beware the Backlash. The Washington Post , Pg D1, D3. Rogoff, C. M. (2008). The Aftermath of Financial Crises. American Economic Association (pp. 1-12). San Francisco: Harvard University and NBER. Rosengren, E. S. (2009). Addressing the Credit Crisis and Restructuring the Financial Regulatory System: Lessons from Japan. Institute of International Bankers Annual Washington Conference. Boston: Federal Reserve Bank of Boston. Samson, A (2008) A Post-Keynesian Analysis of the Subprime Crisis. Bard College: National Economic Policy Stegman, M A (2005) Study: Predatory Loan Terms Increase Risk of Subprime Mortgage Foreclosure by up to Half. The Center for Community Capitalism: The University of North Carolina at Chapel Hill , 1-3. Taylor, J. B. (2008). The Financial Crisis and the Policy Responses: An Empirical Analysis of What Went Wrong. San Fransisco: Hoover Institution: Global Markets Working Group. The Economist (2003) Derivatives-A Nuclear Winter? Retrieved January 2, 2010, from The Economist Online: Valencia, L. L. (2008). Systemic Banking Crises: A New Database. Brussels: International Monetary Fund, IMF Working Paper 08/224. Read More