Managing Systemically Important Financial Institutions - Assignment Example

Executive summary Despite the fact that there is no common definition of Systematically Important Financial Institution, a myriad of policy makers regard it as a financial institution which is so important to the economy such that its failure can result to serious economic and financial crisis. When they exit the market, it is likely that they will cause a serious disruption to the economy. According to The Financial Stability Board, Systematically Important Financial Institution is “financial institutions whose distress or disorderly failure, because of their size, complexity and systemic interconnectedness, would cause significant disruption to the wider financial system and economic activity”. A number of recessions or financial crisis that has been witnessed across the globe is as a result of the Systematically Important Financial Institutions. It is axiomatic to argue that the financial crises of 2007/2008 just like the financial crisis of the 1930’s post a great dilemma for many observers and the world at large. Whether unprecedented or otherwise, the truth is that it brought with it great damage to the society. (Taylor, 2011) Adopting some of the best priorities to deal with the issues and avoid a repeat of the same is the main focus of different policy makers globally. The first section of the paper discusses the Systematically Important Financial Institution and threat they pose to the economy. The second phase looks at the 2007/2008 economic crisis and how the Systematically Important Financial Institution was responsible for it. It goes further to recommend some of the best ways to deal with the problem in the future. The nature of ‘systemically important financial institutions’ (SIFIs) and explains why and how such institutions posed, and may pose, a threat to the financial system and to the economy The definition and structure of the Systematically Important Financial Institution is dependent on the potential of the institution to cause financial destruction. An institution becomes more relevant when it has a high level or probability to cause serious destruction to the economy. On the positive side, Systematically Important Financial Institution is defined going by their relevant viability in leading to a smooth growth and functioning of an economy. Therefore the positive looks at the good part with regards to positive effects to the entire population. Both negative and positive sides reflect the question on whether the Systematically Important Financial Institution are necessary and are indispensable to any financial system or whether they are dangerous and should be done away with. In other words, Systematically Important Financial Institution can create some of the best sides of the economy and in some cases cause some of the worst instances to the growth of any economy. Policy makers hold that they are very important to the functioning of any financial market and the entire economy given the financial contributions which they make for the economic good of an economy. In the United States and the European Union, the financial claims that come from the Insurance Corporations, banks, investment funds, pension are regarded as some of the highest financial resources which are included when calculating Gross Domestic Product. The impact of a systematic risk triggered by an ailing financial institution is shown in its liabilities to the entire financial market which trickles down to the entire economy. Therefore a risk that is posed by a single a single institution can result to a systemic risk through the entire financial system. Banks for instance can reduce the potential risk by diversifying various activities they engage in. However, the problem with diversification of portfolio is that it becomes so big and therefore becomes hard to manage. (Anwar, 2012) The complexity of an institution arises when the normal transaction goes past its normal operation procedures like saving, lending or over counter transactions. What makes the financial institutions riskier is the shadow banking which entails portfolio diversification, cross border transactions and investment. Whether bad or good, the entire functioning of the SIFIs affects the entire economy. If it is doing well, it is likely that it will contribute to the entire welfare of the economy. An ailing SIFI is likely to cause financial distress to the entire economy. To understand the systematic risk of the SIFI, this paper will consider the case study of Lehman Brothers which is a perfect model on how a SIFI can affect the entire economy. Lehman Brothers is one of the most famous cases of the bank failure that had an impact on the global economy resulting into a serious financial crisis. Lehmann Brothers Holdings International (LBHI was one of the main banks in the United States of America. It was an investment bank with a unique diverse portfolio having a reported asset of about $700 billion. The company was in a position to establish 433 subsidiaries in more than 20 countries within a short period of time. The investors in the company included government institutions and private sectors like institutions, big corporations, and individual investors. Its operation transactions included mortgaged backed securities, insurance, commercial banks, business investments and various trading activities such as hedge funds and money market funds. The combination of the above contributed to complexity when it comes to the cross-border transactions. The Lehman Brothers bankrupts were the consequence of excess risk which the bank took and leverage, over speculation of the business and manipulation of the balance sheet. Taking into consideration that they maintained an asset of almost USD 700 Billion which were however long term assets compare to the huge liabilities it had. It continued with its daily transactions with funding coming from counterparty monies and short‐term repo* markets. Given the cross border characteristic and the international representation, the failure of the financial institution caused serious financial crisis across the globe. Despite the fact that Lehman brothers is not one of the SIFIs which are bailed out by its government priority on how to regulate financial institutions by the authorities was a priority for a number of governments. Another threat posed by the Systematically Important Financial Institutions is the rapid growth of the credit. In the cases of the housing market for incidence, the Federal Reserve flow of funds data shows a serious growth in credit that cannot be sustained by a number of economies across the globe. The institutions give the option of free credit and readily available to most people who are attempted to borrow beyond what they can afford or what an economy can sustain. Another potential problem with the Systematically Important Financial Institution is the issue of Substitutability. When a firm plays a fundamental role in the provision of services to a business segment or line of the global market, the chances that its operations will disrupt the global market operations will be high. This problem shows that when one firm fails, there is high likelihood that other banks will fail in the global economy. There is an interlinking between various Systematically Important Financial Institution which impacts market in one way or another. Different methods should be adopted to deal with any possible threat. If a crisis happens in a country, there should be low chances that other countries will be affected by poor decisions or policies that are taken by other companies. There is also the issue of complexity of Systematically Important Financial Institution as they are used by various actors in the economy. When the institutions are very complex, they become quite difficult to manage and deal with. It is quite tricky to capture the systematic risks when the financial institutions are complex. Extent to which financial institutions as opposed to regulators were responsible for the 2007/08 global financial crisis and the measures and actions taken since then by national and international regulators to prevent and contain the consequences of the failure of SIFIs. There was no discretion during the crisis; instead it affected all major financial institutions and markets across the globe. In 2007, a number of banks in the US and Europe were seriously affected by the collapse in the value of the mortgage-backed securities. To the surprise of a number of people these poisonous securities became the main portion of the ultimate asset base of the organization. Analysts fostered the credit crunch given that major financial institutions hoarded cash and also required very wide premiums before it lent to another bank. (Gravelle and Li, 2013) Given the severity of the crisis major brokerage and investment banks hemorrhaged about $175 billion of capital between 2007 and 2008 with the Bear Stearns being rescued by the JP Morgan Chase with a guarantee of $29 Billion from the Federal Reserve. Other banks that survived sold better part of their chunks of the preferred stock with guaranteed premium rates of return of some foreign funds from South Korea, Abu Dhabi and Singapore. It became self evident that Banks and other financial institutions that had for quite sometimes been perceived as custodians of their customers saving s and deposits were doomed to compulsive debt. This aspect manifested itself in the fact that their earnings dropped significantly both in mutual funds and pension. It became clear that the crisis was as a result of the banks insider practices that are not evident to the public and that any keen person would have fore seen the eminent challenge years before it took place. (Ingves, 2012) The bank’s actions were not easy for anyone to know given that they were only registered in the banks like the shadow banking system and the invisible balance sheet. The management also conspired in undermining some of the traditional policy tools which were used to regulate the market. The catastrophe of the crisis was preceded by a scenario where it turned beyond the comprehension of the Low interest rates by the banks between 2001 and 2006 were very lucrative to a myriad of investors across the globe and therefore they were pushed to borrow funds. This resulted to people taking more debt, improve business terms and to expand their volumes. The banks sponsored private equity buyouts and hedge funds, arranging bond insurance, packaged their own mortgage-related financial instruments, and also furnished their credit lines to their internal structured investment vehicles. The conditions and actions proved that there was negligence ion the Federal Reserve and the government institutions in analyzing the mortgage plans. The right institutional framework was ignored which meant that the financial institutions failed to adopt some of the best financial practices. The highly trained financial experts should have identified some of this weakness and warned the bank in time, they however deceived their legerdemain. In simple terms, the mischief proved that the banking institutions had become cheating hubs of other different investment agencies. (Dudley, 2013) It was clear that there was a clear break of the financial procedures and the system which should be guiding the operations. The ethics and professionalism faded away. Another contributor to the predicament was the market ignorance. As the party lasted, some of the main banks were not able to acquire enough mortgages. The frenzy of accessing mortgages became serious that they used brokers in skimping the credit checks required. The management of some of the private institutions such as Lehman Brothers was resilient on short term financing sources. The dependence of the short term funding was not sustainable given that the lending could be curtailed with more funds being withdrawn and more collateral being demanded. This action put the financial institutions into an awkward position given that there was reduced market confidence on them. By the end of quarter one in 2008, there was about $7.8 billion of commercial paper and $197billion of repos which was very tricky for the economy. Lehman brothers alone maintained $700 billion of the total assets which were corresponding to the total liabilities on its capital. A number of liabilities it held were short term while assets were long run and therefore markets, short term repo had to get billions of money from its partners to be able to run. The financial ratios of the firm at the point meant that it was not in a position to meet its short term obligations given that a number of people wanted their money, something Lehman brothers could not afford. (Brunnermeier, and Pedersen, 2009) Another role played by the private sector is the role of some organizations which should act as watchdogs and provide information when they detect any strange operations in the company. Ernest and Young auditors for example detected an additional 50 billion added to the balance sheet but did not raise an alarm. It is still strange why they failed to advise Lehman Brothers but instead gave unqualified report as the financial position n of the company. Being auditors and financial advisors if they had advised Lehman executive rightly then they could have not plunged into their problems which later lead to their down fall. (Haldane, 2012) Despite the fact that private institutions had a role to play during the financial crisis, there were a number of loopholes which were witnessed from the government sectors perspective. For instance, there were two gentlemen; Robert Rubin and Henry Paulson. Robert who was a director at Citi could have reduced the financial exposure to the risky instruments which were being used. Being at the forefront of the financial revolution during the 1980s, he could have offered the best advice that could have either reduced the impact of the crisis. Paulson being a Goldman helped the bank to emerge unscathed from the financial crisis debacle. While at the treasury, there was no substantial action which was taken to deal with the catastrophe. (Financial Stability Board 2011) It is axiomatic to argue that financial institutions play a fundamental role in the growth of any economy across the globe. Given the impact of the Systematically Important Financial Institution on the global economy and on the lives of the people, it is important that necessary actions are taken to deal with the problem and mitigate possible future crisis. Some of the steps that can be taken to deal with the issue include; Use some of the existing prudential authority to ensure that all the regulated firms that issue credit to the public use sound credit practices which is acknowledged across the globe. For instance, if the supervisors realize that the existing no-document loans are liars by nature, loans, then the supervisors can adopt the mechanisms of ensuring that the regulates are restricted in making of the no-documentation loans. The second prudent way arises when the supervisors observe that the SIFIs are making loans whose main performance mainly depends on the rising collateral values. In such a scenario, the supervisor can design a stress test scenario that helps in measuring large bank organizations and the dependence of the FSOC designated nonbank financial firms on constant increasing collateral values. The results could lead to the policy makers being able to get some supervisory policies which include the policy on whether to accept the capital loan of the firms. (Adrian and Brunnermeier, 2011) The third possible way of dealing with the problem is to address the build-up of risks outside prudential supervisory framework. There should key players to handle the issue of stress testing. Another option is to address the potential risks through the aspects of the market that are not connected to the regulated financial system. For instance, the hedge funds are not subjected to the prudential regulation. (Cunliffe, 2014) The forth way of dealing with the issue is to deal with the application of tools which are intended for other purposes to support the financial stability of the economy. For instance, the Federal Reserve has some regulatory powers over some of the housing finance which is part of the ability to write the regulations to protect the consumers. References Adrian, T. and M. K. Brunnermeier. 2011. “COVAR.” National Bureau of Economic Research Working Paper No. 17454 Anwar, Y. 2012 Managing systemically important financial institutions (SIFIs) [pdf]. Available at: http://www.bis.org/review/r120615k.pdf?frames=0 [Accessed: 29 August 2014]. Brunnermeier, M. K. and L. H. Pedersen. 2009. “Market Liquidity and Funding Liquidity.” Review of Financial Studies 22 (6): 2201–38. Cunliffe, J. 2014 Ending too big to fail [pdf]. Available at: http://www.bis.org/review/r140515b.pdf [Accessed: 29 August 2014]. Dudley, W. C. 2013 Ending too big to fail [online]. Available at: http://www.newyorkfed.org/newsevents/speeches/2013/dud131107.html [Accessed: 29 August 2014]. Financial Stability Board (FSB). 2011. “Key Attributes of Effective Resolution Regimes for Financial Institutions” (October) Gravelle, T. and F. Li. 2013. “Measuring Systemic Importance of Financial Institutions: An Extreme Value Theory Approach.” Journal of Banking and Finance 37: 2196–209 Haldane, A. 2012 On being the right size [pdf]. Available At http://www.bankofengland.co.uk/publications/Documents/speeches/2012/speech615.pdf [Accessed: 29 August 2014]. Ingves, S. 2012 SIFIs: is there a need for a specific regulation on systematically important financial institutions? [online]. Available at: http://www.bis.org/speeches/sp120120.htm [Accessed: 29 August 2014]. Taylor, M. 2011 Dismantle the bloated giants. Financial World [online], April. Read More