Main Causes of the Global Financial Crisis - Essay Example

Main Causes of the Global Financial Crisis What are the main causes of the global financial crisis ? What steps could the UK government take to reduce the dangers of another crisis. Discuss using the course material and your own research Introduction There have been many academic papers, professional analyses, and opinion columns in periodicals of general circulation which have expressed the varied opinions concerning the broad philosophical underpinnings as to why the crisis occurred. Prior to dealing with the general theories and ideologies, it is important to provide a rundown of the most immediate causes as determined by the events that had occurred, and thereafter proceed to the general view. Direct Causes of the Crisis 1. The U.S. subprime mortgage market bubble The present economic recession could be traced back to the subprime mortgage crisis. This refers to the class of mortgages taken out by borrowers who have low or no credit rating, and without the visible means to repay the loan. These borrowers do not normally qualify for loans with lower rates because they are considered risky and prone to default. As a matter of policy, the government mandated the mortgages firms, the Federal National Mortgage Association (Fannie Mae) and the Federal Home Loan Mortgage Corporation (Freddie Mac) to enable more people form the minorities and low income groups to obtain housing loans at the lowest possible costs. This fueled an aggressive build-up of high risk mortgages throughout the financial system (Brummer, 2008). 2. The creation of unregulated exotic derivatives Banks which carried a high level of loans were also required to maintain a proportionately high level of reserves to support these loans. Viewing these reserves as a potential source of new loans that generate interest income, financial institutions found a way of transferring the risk of these loans. The loans were bundled together and securitized into mortgage-backed securities (MBSs), collateralized debt obligations (CDOs) and credit default swaps (CDS) and traded in the open market. In this manner, the bank could take out the risk-bearing instruments from its balance sheet, freeing up the reserve capital in its vaults to generate further loans. The risk of these securities, however, is the lack of transparency concerning the ultimate borrower, making risk assessment a shot in the dark (Philips, 2008). 3. Poor regulatory performance of Basel II Basel II is supposedly the regulatory framework of the international financial system, intended to harmonize banking regulation standards and reduce the risk of cross-border fund transfers and transactions. Basel II regulation works through a system of risk-based capital (RBC) ratios, expressed as the proportion of regulatory capital (numerator) to regulatory risk (denominator). These regulations exhibited weakness, however, because the metrics used were prone to manipulation by “cosmetic adjustments” – that is, artificially increasing the regulatory capital while decreasing the regulatory risk - without significant improvement in the bank’s safety or profitability. Also, regulatory capital arbitrage or RCA, which entails resorting to securitization to transfer risk and reduce risk-based capital to within regulatory standard, also enables the bank to circumvent the strict application of the Basel II Accord (Jones, 2000). 4. Repeal of Glass-Steagall Act in the U.S. To prevent a repeat of the Great Depression of the 1930s, the U.S. Congress enacted the Glass-Steagall Act which prevented commercial banks from engaging in investment banking, and vice versa. This was to minimize the risk to depositors posed by risky investment banking and underwriting activities. It also kept the banks from expanding too much. The banking sector lobbied for the repeal of this law, however, which happened in 1999. After its repeal, banks merged into “too-big-to-fail” institutions, and a mere eight years after the subprime mortgage and financial crisis takes place (Vekshin, 2009). 5. Bank regulation in the UK and the inadequacy of FSA regulation The spread of the U.S. financial contagion in the UK is due to the heavy investment of several banking institutions on the toxic assets – the mortgage-backed securities, credit debt swaps and collateralized debt obligations – in the US market. However, much of the contagion should have been arrested had the Financial Services Authority (FSA), the financial regulator in the UK, provided a sufficiently stringent framework for banking compliance. As it is, the FSA has been implementing a rather lenient principles-based, outcomes-based approach to regulation that admittedly lacks sufficient detail. In fact, the FSA has belaboured the relative tightness of European legislation compared to the FSA’s more liberal system as a constraint to the UK banking oversight system (FSA 2006). Another constraint the FSA identified was its lack of coordination between the Financial Ombudsman Service (FOS) and the FSA, also because of the stricter approach of the FOS. The FOS and the FSA being independent in their administration, the FOS fostered a stricter approach to bank oversight than the FSA had preferred. Synthesis with the Davis study In light of the foregoing facts, this study shall provide commentary on the article by Davis (2009), The Rise and Fall of Finance and the End of the Society of Organizations. The article adopts the position that “finance shaped the transition from an industrial to a postindustrial society, in which household welfare was increasingly tied to the vagaries of the financial market” (p. 40). There are several fallacies that the logic of Davis introduces. First is that organizations and finance exist at the expense of each other. Actually, the reverse is true, that finance and organizations cannot exist without each other, and the proper management of one enhances the other. Second fallacy is that the ascendancy of services vis-à-vis manufacturing is cause for the deterioration of long-term mutual obligations and replaced by temporary relationships. In fact, the advent of new services particularly in the digital technology field, the fastest growing services arena, demands the design and manufacturing of new products and devices. In fact, our consumerist society cannot do without the constant improvements and upgrading of technological equipment that support the new services, and sales have never been as brisk as before because of the rapid evolution of technology. What Davis probably feels as the deterioration of manufacturing is actually the outsourcing of manufacturing functions to more cost-efficient developing countries from the high-cost developed countries. Thirdly, the greater participation of households as investors and borrowers in the capital markets have caused ties to corporate employers to wane. This is but the workings of a democratic society where the wealth of ownership is distributed among all economic classes. The alternative is the mindset fostered by Marxist doctrine, that labor is labor and capital is -capital, and never the twain shall meet – an unrealistic presumption in a democratic society. This mindset is absurd in light of contemporary society. Finally, there is Davis assertion that “creating shareholder value” will no longer be their animating purpose in the years to come. He quoted Jack Welch, CEO of GE: “Shareholder value is the dumbest idea in the world… Your main constituencies are your employees, your customers and your products.” Such a concept of shareholder value limits shareholder interest to the immediate profit. This is a limited and rather unfounded concept of the interest of the owners of the business in its value. In contrast, Rappaport (2006) in the Harvard Business Review. Rappaport takes a broader view of business ownership, where value is seen in the long-term viability of the business. It emphasizes the market strength of the products, customer satisfaction, and employee development, as pillars of shareholder value – not rivals, as the article of Welch implies. In contrast, the immediate causes of the financial crisis has little to do with the structure of the system as it has with the prudential regulation of such system. The public interest demands government oversight and intervention when necessary to ensure a level playing field. Germany and the other EU countries, China, India, and Asia as a whole had generally been immune to the crisis. Their financial systems remained sound, Asia in particular because of stringent regulatory reforms adopted post-Asian crisis, especially in the control of debt, the assessment of risk, and determination of accountability. Conclusion: Measures for the UK to address the crisis The foregoing discussion easily points to the enhancement of regulatory measures by the UK over its banking and financial institutions. The corporate balance sheets, as well as non-balance sheet accounts, of both banks and non-banks should be scrutinized for toxic assets and risky arcane derivatives. The FSA should rethink its policy of principles-based, outcomes-based regulation, and enhance it with greater reportorial and procedural regulatory measures. The FSA must necessarily ensure that transactions are above board, since principles could be well stated but ill-applied, and, as seen in the implementation of Basel II, outcomes could be window-dressed. The purpose is not to stifle market activity, but to ensure that transparency and prudence are exercised to the interest of the greater public. Finally, UK institutions should consider constructing a firewall that should isolate cross-border risk from its wider financial system, in the same way that the Glass-Steagall Act created firewalls between conventional banking and risky investment banking, until the walls were torn down by its repeal. The UK must not be so vulnerable to external shocks and would be justified in adopting certain protectionist policies to arrest the recurrence of the currently developing economic crisis. [WORDCOUNT = 1,500 excluding title and question] REFERENCES Brummer, A. (2008) “Where the credit crash came from”, Management Today. Haymarket Business Publications Ltd, London: May 2008. ps. 34-37 Cooper, G (2008) The Origin of Financial Crises: Central Banks, Credit Bubbles and the Efficient Market Fallacy. Hampshire, Great Britain: Harriman House Ltd Davis, G F 2009 The Rise and Fall of Finance and the End of the Society of Organizations. Academy of Management Perspectives, August, pp. 27- 44 Financial Services Authority (FSA) (2006) Principles-based regulation: Focusing on the outcomes that matter. FSA Official Website. Accessed 21 January 2010 from http://www.fsa.gov.uk/pubs/other/principles.pdf Frontline 2003 The Wall Street Fix: The Long Demise of Glass-Steagall. Accessed 28 January 2010 from http://www.pbs.org/wgbh/pages/frontline/shows/wallstreet/weill/demise.html Jones, D (2000) Emerging problems with the Basel Capital Accord: Regulatory capital arbitrage and related issues. Journal of Banking and Finance, vol. 24, pp. 35-58. Philips, M. (2008) “The Monster That Ate Wall Street”, Newsweek: Oct. 6, 2008, as seen in http://www.newsweek.com/id/161199. Retrieved 12 January 2010. Rappaport, A 2006 10 Ways to Create Shareholder Value. Harvard Business Review, Sep2006, Vol. 84 Issue 9, p66-77 Sack, J S & Juris, S M (2007) Rating Agencies: Civil Liability Past and Future. New York Law Journal, 5 Nov 2007, Vol. 238, No. 88 Vekshin, A 2009 U.S. Senators Propose Reinstating Glass-Steagall Act. Bloomberg.com, 16 Dec 2009. Accessed January 25, 2010 from http://www.bloomberg.com/apps/news?pid=20601103&sid=aQfRyxBZs5uc White, L J (2007) A New Law for the Bond Rating Industry – For Better or for Worse? New York University Law & Economics Working Papers Read More