Financial Institutions and their Role in the Recent Economic Failures - Literature review Example

Running header: Research Essay – Financial Crisis Student’s name: Name of institution: Instructor’s name: Course code: Date of submission: Introduction The world has in recent times suffered much economic turmoil. The most notable one is the recession that began in mid 2007 following the bursting of the US housing bubble that saw a fall in housing costs while banks raised interest rates. As Baker (2010, pp.1) put it: “the real story behind the economic recession is the demise of the housing bubble on whose back the economy has ridden since the last recession” The world has not really recovered from the effects of the recession. Unemployment rates in the US have not changed much. Today there is fear that such a meltdown might recur, partly as a spiral effect from the current debt crisis in the Eurozone. All these have led to dramatic rises in unemployment, public debt and insolvencies. Inspite of this, for a long time no one demanded answers for these economic failures. Fuchs & Graf (2010, pp.1) wondered why the financial crisis, referring to the recession, had not led people to question the political and economic system as well as the broader notion of political change. Occupy Wall Street now does. Indeed, this movement has put the spotlight on the banks and other major financial institutions, questioning the largely unregulated and unchecked financial markets, drawing attention to the bottom-top redistribution trends, and inherent financial market instabilities and fluctuations”. This paper takes a look at the financial institutions and their role in the recent economic failures. Then it will assess and evaluate the place of these institutions in stabilizing the economic situation. Recent Economic Crises In order to understand the significance of financial institutions in the stability or failure of world economy, let us take a critical look at the recent economic crisis. The Recession The 2007 global financial meltdown started in the financial system of the US, considered the most sophisticated in the world, and quickly spread to the rest of the globe (Pol 2009, pp.2). As 2008 came to an end, the world was in so much panic. And the main agenda in the contest for the US presidency quickly changed from war in Iraq to who could best lead the world out of the recession and avoid the potential recurrence of the style-slump of the 1930s. Generally, the financial crisis involved a combination of excess world saving, monetary excesses, that is, mistakes by the central banks that finally led to excess liquidity. Together they led to a double bubble in both housing and credit, and eventually the financial collapse. As the millennium began the surplus of savings that had been generated in some countries were neutralized by the deficits in the developed world. These surplus savings had initially expanded investment especially in information technology. But then this internet bubble drastically cut back investment. The world’s central banks adopted a loose monetary stance thereby avoiding a sharp downturn. The US Federal Reserve in particular clearly expressed its willingness to inject liquidity and reduce interest rates if there occurred a deep recession (Pol 2009, pp.3). It is the innovations in the US housing/mortgage market that provided for the debt bubble between 2001 and 2008. Take, for instance, the rise in sub-prime mortgage lending between 2005 and 2006. As they grew, the sub-prime markets permitted lenders to fund through “securitization and re-securitization” (Pol 2009, pp.6). From this, financial institutions made quick profits from fluctuations in the sentiments of the investors. Moreover, the financial institutions that operated without the regulated banking system built up financial positions by borrowing short-term and lending long-term. In the end, they exposed themselves to non-bank runs; if markets lost confidence and would not extend the short-term credits they could fail, as it did with Bear Stearns. Inspite of the uncertainties that accompanied the untested and unchecked financial products, liquid markets continued to create big opportunities for financial agents seeking profits and encouraged them to maximize profits within the shortest time. In July of 2007, difficulties in the money markets began with the hedge funds of the two Bear Stearns revealing what the sub-prime mortgages had done to their portfolios. The situation grew even worse August 9-10, 2008 when interest rates in the money markets rose significantly (Pol 2009, pp.8). This was largely interpreted as problems related with liquidity by the authorities. Banks started to fall, most notably the Lehman Brothers, a Wall Street investment bank. The crash of the mortgage bubble infected the whole financial system as there was a large amount of Collateralized Debt Obligations, the financial tools used to offer the AAA-rated bonds. As part of a remedial measure, Washington signed a $US700 billion rescue package. And in an attempt to restore confidence in the investors as part of the plan to reawaken the economy, the government cut interest rates and, through the Federal Reserve, lent directly to US businesses without security. Initially, this failed to restore confidence in investors. Pol (2009, pp.9) attributes this to two main reasons: one, it was hard to tell who deserved help and why; and two, the lack of a co-ordinated global response. As it were, the investors needed assurance that their financial institutions would get support from other governments. Although much of the weight is gone, the effects can still be felt in many places including the US and Europe. The Role Financial institutions or Bankers in the World Economy Herring & Santomero (1996, pp.1) write: “the direct effect of financial sector on the real economy is subtle and relatively minor”. However, considering the role that the banks played in causing the 2007 recession surely interrogates this statement. Nonetheless, “It is necessary for a government to maintain a stable and efficient financial system that can not only reduce the cost but also produce and trade goods and services” (Delphi International Ltd. 1997, pp.7). Generally, the role of financial institutions can be broadly categorized as: intermediation and market facilitation. As intermediaries, financial institutions: are the links between the parties involved in making and exchanging fiscal promises; offer liabilities that act as means of payment; diversify claim; diversify risk; transform illiquid assets to liquid liabilities; and manage information. Stiglitz (1998, pp.9) adds influencing ‘capital-flow patterns and composition’, among others, to the list. As market facilitators, fund managers and even other agents in the financial system (e.g. financial brokers and advisers) bring the parties involved in a promise to the market. They offer only a definite financial service package, while leaving the risks to the investors. In the end, brokers and advisers basically facilitate financial promise transactions through addressing problems of information. Areas of the financial system in which financial regulation is inadequate and why The need for regulation is based on the likeliness of market failure, which occurs when the prevailing circumstances prevent the realization of efficient market outcomes. The recession, as we have seen, is largely attributed to lack of an adequate and efficient regulatory structure to prevent excess and abuse (Mullin 2009, pp.1). Infact, the financial institutions outside the regulated financial system were the guiltiest for the unchecked chase for profits even as there was reason to fear a possible failure. They are the ones that permitted funding by securitization such as sub-primes (Pol 2009, pp.9). Some of these areas that have shown need for regulation include: Integrity of the Financial Market: Market integrity has to do with the fairness and efficiency of financial markets. Less-regulated securitization outside the regulated banking system is one of the major factors that triggered the recession. The secularization thrived on partial communication, with the institutions emphasizing its benefits while downplaying its limitations. Consumer Protection: This requires measures aimed at providing consumers with adequate information, treating them fairly and provide adequate platform for redress, and avoiding those deals that put consumers at risk. The need for these regulations is necessitated by a number of factors: one, consumer ignorance. Some consumers lack knowledge on financial matters. Since financial products are mostly complex many consumers may not understand the nature of financial promises, the expected obligations and the potential risks; and two, financial complexity may increase incidences of misunderstanding and, consequently, dispute. Lack of adequate consumer protection measures regarding the mortgage products like the sub-prime loans is also one of the factors that triggered the financial crisis (Mullin 2009, pp.4). Some consumers did not have full information on all other factors that accompanied the bubble. Financial Safety: The recession revealed risks attached to financial promises. Markets have a higher chance of failing in cases where intense promises have been exchanged. The real need for regulation here is necessitated by the inherent capacity of some financial promises to destabilize the real economy. This may lead to reduced output, unemployment and price inflation. Apparently, more complex and sophisticated economies greatly depend on financial promises, thereby exposing them to higher risks of financial system failure. This can be even worse in cases where the distressed market or institution has the ability to infect other industries and eventually disrupt the whole system. In the US, it is the banks that were first affected. Considering the centrality of banks in the financial market, every sector of the economy followed. Recommendations Having looked at weaknesses in the financial market that require the formulation of regulatory measures, this paper presents recommendations for such measures. Integrity regulations Regulations for market integrity should aim at promoting confidence in the fairness and efficiency of the financial markets. They should seek to ensure that the markets are sound and transparent. Since prices in the financial markets can be information-sensitive, providing room for the misuse and abuse of information, regulators need to impose disclosure requirements (e.g. prospectus rules) and conduct rules (e.g. prohibition of insider trading) on the participants on the financial market. Further, specialized regulatory rules that take into consideration the intrinsic risks associated with the complexities of financial markets and products are needed (Financial Stability, ECB 2009). Regulations for Consumer Protection Generally, consumer protection shares the same regulatory structure and tools with market integrity: conduct and disclosure rules. The prospectus rules can promote both confidence and in the financial market and consumer protection. Preventative regulations The most commonly used preventative regulation is the prudential regulation. These involve the imposition of prescriptive standards and rules that would govern prudential behavior of financial institutions that make certain specific types of promises (Brownbridge et al. 2002, 2). These rules would deal with specific areas of interest (e.g. standards for m minimum liquidity for those institutions that have liquid liabilities). These rules may also be generally directed at minimizing risks of failure (e.g. standards for risk management and requirements for minimum capital). How these changes would help to fix existing gaps in regulation and supervision The prudential rules transfer judgment from the hands of the institutions and customers to the regulators. This way, regulators absorb the risks that would otherwise weigh down the institutions and the customers. Prudential regulation acts like an insurer in the sense that it faces the both ‘moral hazard’ and ‘adverse selection’. The two work in different ways towards the ‘insurance’ role (Brownbridge et al. 2002, 3). Through ‘adverse selection’ a prudential regulator screens out unhealthy participants and reduces the possibilities that a regulated institution will fall. It also reduces competitive pressure on the regulated financial institutions. ‘Moral hazard’ works in more or less the same way by reducing the desire of a regulated financial institution to monitor the risks it has suffered in its day to day operations (Brownbridge et al. 2002, 3). The prudential regulator then has a leeway by which to insist on supervising the institutions. This way, the prudential regulator limits the institutions’ behavior, while also reducing the risk of exposing the regulator to failure. In the end, these rules carry efficiency costs by reducing the scope for the institutions’ commercial judgment. Conclusion: Other relevant issues Inspite of the advantages of prudential regulation, it still cannot fully avert a systemic instability. During such an instability, the restoration of stability falls into the hands of the Central bank irrespective of who carries out the prudential supervision (Brownbridge et al. 2002, 5). The central can do this by providing liquidity among other means. The government may also step in extreme scenarios. Therefore, an important factor to consider when developing a regulatory system for the financial market is the balance between prudential supervision and central banking; acting on the basis of prevention and maintaining stability with both preventative and response strategy (Brownbridge et al. 2002, 5). Bibliography Baker, D., 2010, Blame It On The Bubble. The Guardian. Viewed 24 Feb. 2012, from http://www.guardian.co.uk/commentisfree/cifamerica/2010/mar/08/financial- crisis-subprimecrisis Brownbridge, M., Kirkpatrick, C. and Maimbo, S.M., 2002. Prudential Regulation. Finance and Development, viewed Feb. 2012 from, http://www.sed.manchester.ac.uk/idpm/research/publications/archive/fd/fdbrief3. pdf Delphi International Ltd. 1997, The Role of Financial Institutions in Achieving Sustainable Development. Report to the European Union. viewed Feb. 2012 from, http://ec.europa.eu/environment/archives/finserv/fitotal.pdf Financial Stability, 2009, European Central Bank, Viewed Feb. 2012 from, http://www.ecb.int/ecb/orga/tasks/html/financial-stability.en.html Fuchs, D. and Graf, A. 2010, The Financial Crisis in Discourse: Banks, Financial Markets, and Political Responses. SGIR International Relations Conference, Stockholm, 9-11 Sep. 2010 Herring, R.J. and Santomero, A.M., 1996, The Role of the Financial Sector in Economic Performance. Centre for Business and Policy Studies: Stockholm, Sweden Mullins, L., 2009, Obama's Financial Regulation Reform: 7 Things You Need to Know. viewed Feb. 2012 from, http://money.usnews.com/money/blogs/the-home- front/2009/06/17/obamas-financial-regulation-reform-7-things-you-need-to-know Pol, E., 2009, Understanding the Global Financial Crisis. 9th Global Conference on Business & Economics, pp. 1-43. Cambridge University, UK Stiglitz, J., 1998, The Role of International Financial Institutions in the Current Global Economy. [speech] (27 Feb. 1998). Read More