Financial Crisis and Their Possible Solutions - Essay Example

? Financial Crisis and Their Possible Solutions Introduction Financial crisis affected most parts of the world. It began in the US after the Difficulties in the US submarine market that had rapidly rocketed and spilled all over the world. Bordo et al (2001) find that the frequency of the financial crisis is higher than the previous one and can be comparable only to the Great Depression. It had detrimental impacts on different sectors of the economy in all countries. The purpose of this paper is to explore the causes of the financial crisis and ways in which future crises will be reduced, as well as whether the banks would rather separate or consolidate. Through the literature on financial crisis, it severity and effects will be established. The 2007 crisis had impacts on the banking sectors, the central banks of different countries were worried with their macroeconomic policies and attempted to instil the remedy in the appalling situation so that sanity in the banking sector can be restored. Reinhart, Reinhart and Rogoff (2008a, 2008b, and 2009) have, in the past years documented the effects of the banking crisis that are typically proceeding by credit booms and asset price bubbles. They note that on average 35% real drop in housing prices stretch over a to almost six years. Equity prices fall over 55% over a period of 3 years, while output in those countries fall by 9% in two years, unemployment increases by 7% in four years while an 86% debt increase based on the pre-crisis level. Literature review Many models have documented the effects of the financial crisis. Adrian and Shin (2009), Brunnermeier (2009) have documented a thorough review of the events preceding the financial crisis in late 2007 and early 2008. They note that the seeds of financial crisis can be traced back to the low interest rates policies adopted by the Federal Reserve and other world central banks after the collapse of the technology stock bubbles. The need for the debt securities by Asian banking institutions aided in fuelling the economic crisis. Acting as financial intermediaries, banks channel funds to potential investors. Through the process of borrowing and lending, they benefit from a diversified portfolio of risk sharing. They also act as monitors (Diamond, 1984) and streamline loans to well-organized customers (Gorton and Kahn, 1994) and other vital roles in maturity transformations. This implies that in crisis, every banking institution becomes concerned. For instance, Dell Aricia and Rajan (2008) provide that banks’ grief contributes to a decline in credit and low GDP .Further evidence provides that those sectors, which heavily depend on external financing, perform relatively dismal during the banking crises. These effects are stronger and severe in developing countries. In addition, the report note that over the last two decades, banking sector continues to be complex in its modes of operations. For instance, banks use various instruments to hedge risks. However, despite the complexity banks have remained sensitive to the panics and runs. Gorton (2008) note that holders of short-term liabilities feared to fund banks as they the anticipated losses in the sector could have in their securities. The recent research proposes two theories to give a tentative explanation on the causes of the bank panics and runs. One argues that panics are undesirable events caused by random withdrawals unrelated to the changes in the real economy. Bryant (1980) and Diamond and Dybig (1983) note that agents have uncertain needs that relates to consumption. If other depositors believe and can even further establish the slightest of evidence, then all the agents will find it rational and imperative to redeem their claims from banking institutions and will cause the panics and banks’ runs. Another theory explains that banking crises are natural outgrowth of the business cycle. An economic slump will reduce the value of the bank resources, heightening the possibility that banks are unable to meet their commitments and claims. This happens when depositors receive information about an impending slump in the business cycle, they will react by withdrawing their funds and channelling to other productive sectors (Jacklin and Bhattacharya, 1988). The crises are not random events but a response of depositors to the arrival of sufficiently negative information on the unfolding economic situations. This view is consistent with Gorton (1988) in that depositors observe leading economic indicators that provide public with information about future banks asset returns. If there are high returns, depositors are willing to keep their funds in the banks. However, if there is sufficiently low returns, depositors withdraw all their funds in anticipation of low returns and there is a crisis. Chari and Chagannathan (1988) show that crises can occur not only when the outlook is poor but also when liquidity needs are high, despite no one receiving on future returns. Other studies carried out by Diamond and Rajan (2001) developed a model in which banks have special skills to ensure that loans are repaid. For instance, by issuing demand deposits on a first-come-first-served basis, banks can recommit on how to meet their loans. The following section explores the systematic risks, systematically important financial institutions (SIFIs), role of the central banks in financial crisis, both short-term and long-term solutions to the financial crisis. Two models will be explored The systematic risks According to Tarashev, Claudio and Kostas (2010), a systemic risk implies a collapse of the financial system or an entire market. However, it is opposed to one entity or individual component, for instance, an individual bank. It also refers to financial instability of a given system, potentially catastrophic, triggered by idiosyncratic events in the financial systems. For instance, consider the 2007 financial crisis that caused by a system of inter-linkages between individual components. It refers to banks’ runs that are caused by economic factors and liquidity risks. One of the liquidity risks is the lack of liquidity in the banks caused by the sudden withdrawals by depositors. This undiversified risk cannot be reduced by diversification. Hedging and avoidance are the two main models that suggest the risk mitigation measures in the financial sector. Some proposal provided by the recent research deal with systemic risks in order to strengthen the financial stability. Minsky (1986) provides that the implementation of a comprehensive, integrated and effective supervision frameworks in the industry are imminent and needed in streamlining the sector. Minsky notes that the risky management approach ensures that there is an effective risk management team to oversee and manage risks in the sector by risks experts. Third, a proper regulation and monitoring of the industry players with a key attention can restore a financial stability. A systematically important financial institution (SIFI) is the one which financial distress or disorderly failure, because of various parameters such as size, complexity and systematic interconnectedness, would cause a significant disruption to the wider financial system and economic activity (Buiter, 2008). This implies that in order to address this problem, some proposal has to be enacted to rescue the financial institutions from a further turmoil. Bernanke and Richardson (2009) and Buiter (2008) provide various policy measures that have attempted to address the problem. First, there is need to reform the national financial regimes by setting out the responsibilities, instruments and authorities to rescue the financial firms. Second, through intense and effective supervision of all the SIFIs, the refinements of the lender-of-last-resort principle can be harness with interventions of various central banks and other international financial bodies. In financial distress, the central bank intervenes and offers financial aid to the banks. Recent research by Brunnermeier and Gertler (2001) indicates that the proposal new funding liquidity and leverage for banks regulations remain imminent. Another studies show that capital surcharges are based on an institution’s likely contribution to the systemic risks. At the pinnacle of the regulatory architecture is the creation of the systemic risk regulator that will focus on the non-prudential monitoring of the financial institutions as a whole. Many models of research provide several measures to mitigate financial crisis. Acharya (2009) argues that there is need to design capital surcharges based on the banks correlation of returns. Acharya notes that this method has easily accessible data on banks returns and can be accessed by a wider users and other interested stakes. Others include the Banks of England (2009) and Brunnermeier (2009) which have designed surcharges based on measures of markets and institutions and banks movements respectively. The adoption of sophisticated technology, which enhances surveillance, and monitoring of the performance of the stock market has also aided banking institutions in dealing with volatility of demands and supply of customer deposits. For instance, by closely monitoring the demand and supply of various products in the market, banks can adequately consider when to lend and to what extent and what and who not to lend. By adoption of a selective credit control, there is a regulation of money supply thus reducing the likelihood of a systematic risk (England (2009) and Brunnermeier (2009). Identifying a degree of an institution’s systemic risks, including the sources and the terms structure of funding, the extent of leverage, relationships with other banks firms and the degree of concentration could help the banks institutions to avoid the crisis. The role of central banks in financial crisis The most effective mitigation of systemic requires a complete set of tools incorporate to strengthen the financial sector and attempt to restore sanity and trust in the industry. Therefore, the role of central banks becomes significant and critical regulator, as provided by Buiter (2008). The central banks utilize a variety of macroeconomic tools and approaches to mitigate the market risks. For instance, the adoption of monetary policy to stabilize market prices, provision of aggregate liquidity in monetary markets to increase the aggregate demand and being the lender-of-last resort to restore economic activity of banks. In addition, it can pursue that oversight of clearing and settlement of the systems to restore confidence in markets stakeholders such as investors, management and the government. Bernanke and Gertler (2001) note that the role of financial regulation can harness the central banks’ incentives to hedge systemic risks. For instance, consider the honing of their expertise in macro-financial analysis to information the design and use of the tools, thus, supporting trading the financial markets in crises. The same research also notes that reducing the chances of political pressure on the central bank during the financial crisis may reduce the frequency of crisis and its impact more effectively. Further, the success of a financial stability policy depends on a number of other variable means such as the resources assigned to these central banks, intellectual clarity on the way financial markets respond to regulatory and monetary policy, as well as the quality of leadership in the banking industry. The short-term solutions to the crises A proposal by a class of Keynesian classical economics have argued that there is need for the government to sustain the aggregate demand by increasing spending in that face of slumping of tax revenues. Firstly, they provide a back up of large budget deficit that will be desirable. Secondly, Minsky (1986) points out that government will substitute private debt for government debt which will, in turn, inflame the fiscal budgets. Thirdly, the central banks and the government will, therefore, be required to support asset prices, for instance, the stock prices. The process of deleveraging of the banking industry, that is the separation of retail and commercial banks, will be essential and pertinent macroeconomic action. This will put a downward pressure on the asset prices, thus, regulating the rate of inflation and restoration of confidence in the inventors and other market players. For example, the central banks and the government may be compelled to buy financial securities such as stocks and shares, in order to keep at check the volatility of the financial sector. The long-term solutions to the financial crisis Stopping future collapse of the banking system and revitalizing it is the major concern in the short run. However, there will be a need to formulate long-term solutions. There are two approaches to the solutions. The first one is the Basel approach and the second is called Glass-Steagall approach. In Basel approach, banks remain universal in such a manner that they perform both traditional and investment banks activities. Further, there will be a clear definition and implementation of rules governing the risks undertaken by the universal banks. Then, there is a minimal credit ratio requirement from the central bank. This prevents liquidity problems in both the short run and long run, thus, mitigating liquidity problems in the sector. However, studies show that the approach failed to bring any desirable macroeconomic outcomes in the sector. Due to failure of the Basel theory, the only solution was to introduce a workable Glass-Steagall approach (narrow banking approach). This approach provides that the financial institutions to either choose the status of commercial banks or investment banks. Only the former will attract the deposits from the public and from other commercial banks and transform into a portfolio with a longer maturity date. They will benefit from the lender-of-last-resort facility from the central bank and, subjected to the normal bank regulations and supervisions (Brunnermeier and Richardson, 2009). However, the investment banks would have to ensure that the duration of their liabilities is an average at least, as long as the duration of their assets. This also implies that since the commercial banks denied securitizing their loan portfolio, greater risks will be eliminated from the market, thus, avoiding and reducing the probability of future financial crisis. Research also indicates that when a bank securitises a loan, the credit expansion policy promoted through the process of credit issuance and loan advancement. According to Buiter (2008), the massive credit expansion endangers the balance sheet of the central banks, as it will act as lender of the last resort during the financial crisis. This also means that, by allowing the banks to securitize, they will share some substantial risks. However, the only concern put forward by the analysts is that the approach needs the cooperation and coordination of all the global partners in the banking sector. In the end, if there is no cooperation, there will be a deregulation, thus, making the banking sector more inefficient that may trigger another financial crisis. In conclusion, systematic risks can be mitigated by the degree and effectiveness of the role played by the central bank. Through thorough regulations, oversight, and implementation of the banking statues, the financial market can be restored .A further close examination of the banking institutional framework, governance and structure, its operations and most importantly, its customer service greatly affect the systematic risks in the market. The Basel theory puts forward the manner and approach of maintaining a stable financial market. In addition, Systematic Important Financial Institutions (SIFIs) play a vital role in the performance of the financial market and need to constantly monitor and regulate them. References Acharya, V. & Richardson M. (eds) (2009). Restoring Financial Stability—How to Repair a Failed System. Wiley, New York. Acharya, V. V., Pedersen, L. H., Philippon, T. & Richardson, M. (2010). Measuring systemic risk. Mimeo. Adrian, T. & H. Shin. (2009). Liquidity and Leverage. Journal of Financial Intermediation, Forthcoming. Bernanke, B. S. & Gertler, M. (2001). Should Central Banks Respond to Movements in Asset Prices. American Economic Review, Vol. 91, pp. 253–257. Bordo, M., B., Eichengreen, D., Klingebiel & M. Martinez-Peria. (2001). Is the Crisis Problem Growing More Severe? Economic Policy, April 2001, 53-82 + Web Appendix. Brunnermeier, M. K. & Pedersen, L. H. (2009). Market Liquidity and Funding Liquidity. Review of Financial Studies, forthcoming. Buiter, W. H. (2008). Central Banks and Financial Crises. Paper presented at the Federal Reserve Bank of Kansas City Symposium, Jackson Hole, WY. De Grauwe, P. & Grimaldi, M. (2006). The Exchange Rate in a Behavioural Finance Framework. Princeton University Press. Diamond, D. W. & Rajan, R. G. (2001). Banks, short-term debt and financial crises: theory, policy implications and applications, Carnegie-Rochester Conference Series on Public Policy, Elsevier, vol. 54(1), pages 37-71. Global Systemically Important Banks: Assessment Methodology and the Additional Loss Absorbency Requirement. BCBS, October 2011. Minsky, H. (1986). Stabilizing an Unstable Economy. New York: McGraw-Hill. Reinhart, C. & Rogoff, K. (2008b). Banking Crises: An Equal Opportunity Menace, NBER Working Paper 14587. Tarashev, N., Claudio, B., & Kostas, T. (2010). Attributing systemic risk to individual institutions. Methodology and policy implications. BIS Working Paper No. 308. Read More