Global Financial Crisis as an Evidence of the Failure of Regulatory Frameworks - Essay Example

? The global financial crisis (2007-2009) is an evidence of the weaknesses of the existing international and national regulatory frameworks aimed at preventing systemic risk and excessive risk-taking by financial institutions Contents Contents 2 Introduction: Global financial crisis as an evidence of failure of regulatory frameworks 3 Systemic risk 4 Excessive risk taking by financial institutions 5 Regulatory framework before global financial crisis in 2007-2009 6 Failure of international and national regulatory frameworks in prevention of risk 8 Conclusion 10 References 12 Introduction: Global financial crisis as an evidence of failure of regulatory frameworks The global financial crisis that occurred in the period of 2007 to 2009 indicated the implications of excessive neo-liberal approach of the economies which was developed by the government through policies that encourage huge spending in the economy with an expectation of growth of the national economic status. The excessive spending and the systemic risk associated due to the fluctuation of macroeconomic factors in the world economic environment exposed the investments and the subsequent lending by the financial institutions to high risks which was slowly growing into a large bubble1. Before the global financial crisis that started in US during 2007 and rippled throughout the world, the prices of the real estate was soaring very high. Thus, people could make huge profits in the short run by investing in US properties which was unmatched with any other investment in the US and the international markets. Apart from this, the national government in US also adopted the policy of property holding right for the US citizens that encouraged the financial institutions and their intermediaries to lend for the purpose of purchase of property2. However, due to the lack of tight regulatory framework, there were cases of lending and investments that could be identified as risky due to several factors like repayment capability of the investor, feasibility of the investment returns, regulatory compliance, etc3. The heavy bubble of bad lending by the financial institutions burst into a global financial crisis which was an evidence of the weakness of the national and international regulatory frameworks that were put in place for avoiding the systemic risk and the excessive risk taking of the financial institutions. Systemic risk The systematic risk is explained by the risk that arises due to the fluctuation of the macro economic factors like export-import, appreciation of depreciation of currencies, economic performance of developed countries, changes in international investments, fluctuations in the financial return and risk, etc. The global financial crisis brought out the systemic risk that started in the US and melted down globally to international economies across the world4. The inter-linkage between the houses of production, markets and the financial intermediaries led the platform where the manufacturing and the production units suffered a slowdown in the production level due to the loss of the financial intermediaries which in turn was affected due to the default risk of the borrowers who invested in the US real estate and properties5. The lack of tighter regulatory framework fuelled the investments in the US real estates. The regulatory framework for the financial institutions is also liable of not putting checks when the financial institutions relaxed their approaches on due diligence and compliance checks to find the default risk in case of lending6. The business houses were also granted loans for increasing the supply to match the rising demand. The systemic risk exposed the weakness of the regulatory frameworks when the household and the businesses defaulted in paying back the borrowed money to the financial institution and there was financial catastrophe in the US economy7. Excessive risk taking by financial institutions The global financial crisis in 2007 to 2009 could be attributed to excessive risk taken by the financial institutions looking at the rate of growth of the US economy. The US economy, the exports and imports, the rise of the developing countries, the neo-liberal policies adopted by several governments in the international stage, the high rate of exchange due to globalization led the financial institutions to venture in national and international investments as an opportunity for growth in the competitive world markets. While the financial institutions in US endorsed the policies of the government in supporting the citizens for purchase of real estate property as their fundamental right, there were lapses in the process of lending as the volume of lending began to grow. With the increase in lending, there were various financial intermediaries in the sub-prime market that offered loans to borrowers who were not eligible for loans in the main market8. The rise of financial intermediaries and the lending amounts in the financial markets began to overlook the compliance norms of lending which included assessment of repayment capabilities of the borrower, valuation of the underlying mortgages which were often the real estate properties, etc9. In order to attain abnormally high returns in short period of time, the financial intermediaries also granted loans to business who could not apply in the main market against the underlying mortgage containing the real estate properties. The regulatory framework failed to check the excessive risky lending by the financial intermediaries in the sub-prime market as well as in some sections of the main market10. As the households and the businesses started to default on repayment of the loans granted by the financial institutions, it resulted into huge losses due to the payment defaults. The value of underlying mortgages also depleted resulting into the fall of financial institutions like Lehmann Brothers and slowdown of the economy due to the financial crisis. The financial crisis melted down all over the globe as global financial institutions also held foreign investments in the US market due to the possibilities of huge return in exchange of excessive risk. Regulatory framework before global financial crisis in 2007-2009 The regulatory framework for the financial markets in the US and in other countries all over the work was established with the ideologies of deregulation of the government bodies and financial institutions. This was done with the lessons taken from the Great Depression and political voice in favour of deregulation was provided by the several governments like the US, UK, etc11. The deregulation of the financial markets led the national banks to diverse from their traditional banking activities to enter into other functions in the international markets where they could perform trading on their own account, provide underwriting services for new issue of stocks, work as venture capitalists, identifying potential sources of investments which could offer them huge rate of return12. The regulatory framework in the financial markets passed the deregulation of the national banks and the financial institutions came to be identified as the investment banks and the commercial banks which provided finances for meeting the demands of the economy. The investments banks played the role of supporting the corporations and also the government in several investment ventures by lending funds for investment and also provided underwriting services for issue of new stocks13. The commercial banks played role of accepting deposits from the households and granting loans for household investments, purchase of real estates, properties, etc. The regulatory framework allowed use of derivative instruments, credit default swaps by the financial institutions that allowed them to engage in risky investment avenues14. The use of mortgages in the lending and borrowing process in order to support investment demands in the economy led to aggressive lending and borrowing. The regulatory framework for the process of financial lending and borrowing did not emphasize any standardized criteria for the minimum liquidity and capital requirements for the lender15. The minimum requirement in the cases of sub-prime lending was relaxed in order to allow higher scope of investments in the economy. There was also no clause of mandatory supervision by the lenders in order to ensure that the lent funds are secured in terms of repayment. It has been estimated that the total assets of the shadow banking system nearly equalled that of the mainstream banking institutions. The regulatory framework did not have adequate regulatory oversight on the utilization if assets and funds in the secondary markets. Also the regulation for investor’s protection, corporate governance rules, disclosure of financial information and accountability to the stakeholders were not enforced by the regulatory framework before the global financial crisis in 2007 to 2009. Failure of international and national regulatory frameworks in prevention of risk The global financial crisis is an evidence of the failure of the international and the national regulatory frameworks that were established to prevent the systemic risk and the excessive risk taking approach of the financial intermediaries. Although the countries had their own regulatory framework in place, there was no exchange of information on the financial markets and the developments in the international economic stage that prevented the overseas financial institutions to acquire knowledge on the foreign investments in the US financial market16. Following the rising trend in the US economy and the huge returns expected over a short period of time, the banks and the financial institutions were exposed to the systemic risk of investment in the US financial markets. The regulatory framework in US was not able to limit the credit risk associated with the investments which were secured by the mortgages with real estate properties as underlying assets. The financial intermediaries that cropped up largely in the secondary markets or the sub-prime markets were not directly regulated by the existing framework and enjoyed the relaxation to make full use of the rising market demands. In order to make use of the market potential returns on investments, the large number of financial intermediaries granted huge volumes of loans to the borrowers. These borrowers were either households or the businesses that intended to increase their production levels in order to meet the demands and also increase their profits. The huge influx of the borrower in the sub-prime market in absence of direct regulatory oversight led to the lending to un-creditworthy borrowers. Thus the loans granted were exposed to huge risk of default in the wake of huge risk taking by the financial intermediaries. The regulatory framework also did not have strong hold on the extent of derivative instruments that were used by the financial institutions to hedge the default risk. Moreover, the regulatory had no guidelines for the financial institutions for disclosure of the financial information on the decisions and investments that put the stakeholder’s interest at stake. This was later enforced by the Sarbanes Oxley Act17. The Basel norms before the global financial crisis were also not stringent which led the financial intermediaries to overlook the minimum liquidity and capital requirements18. All these deficiencies in the regulatory framework and non-timely intervention on the activities that were carried out by the financial intermediaries in the sub-prime markets led to the increase in weight of the bad loans that were granted for the purpose of investments and aimed at economic growth19. The regulatory framework in the foreign countries also did not intervene on the foreign investment activities of the private banks in their countries. Later the international regulations were put in line with the norms of Basel III which was not enforced during the global financial crisis in 200720. The increase in the number of defaulter and the cascading effect of the failure of the financial intermediaries led to the deterioration of the economy of US which melted down into a global financial crisis from 2007 to 2009. Conclusion The global financial crisis in 2007 brought to light the weakness of the international and national regulatory frameworks in protecting their economy from the systemic risk and the risk due to aggressive lending by the financial institutions. The international regulatory frameworks had shown no signs of interventions or passed laws on restriction of foreign investment by the private financial institutions of their countries. There was also no exchange of information on the health of US economy. The investments on the apparent growth rate and prospects of higher returns led the financial institution and the economies to huge risk exposure. This risk exposure was due to the lack of regulatory oversight on the financial intermediaries that operated in the secondary markets of US. The lack of due diligence and credit norms in granting loans to households and corporations led to increase in bad loans and credit default risk. The increase in the number of defaulters had a cascading effect on the economy as the decline of financial institutions led to the slowdown of national and international production levels. This was supported by the fall of demand that took the shape of global financial crisis during 2007-2009. The global financial crisis, therefore, indicated the weakness of the international and national regulatory frameworks in preventing the systemic risks and the credit risks of the financial institutions. References Trebilcock, Michael. and Robert, Howse. The Regulation of International Trade, 4th Edition. New York: Routledge, 2013. Hudson, Alastair. The Law of Finance, 1st ed. New York: Sweet & Maxwell, 2009. 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