Integrated Financial Markets and their risks

2011-01-25T06:22:00.000-08:00

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In an integrated world financial market, a financial crisis in a country can be quickly transmitted to other countries, causing a global crisis. What kind of measures would you propose to prevent the recurrence of an economic crisis?

In analyzing steps to prevent the reoccurrence of an economic crisis, two perspectives can be considered, in terms of global action which can be implemented by international institutions like IMF, World Bank and action from local governments and central banks of each country.

Introduce accounting standards for Non-depository banks

Today’s banking systems can be segregated in to two parts, one consisting of commercial banks which are highly regulated and non-banks which are otherwise called as shadow banking systems. Due to non-depository nature of the non-banks such as investment banks (Bear Sterns, Lehman Brothers) and hedge funds, they were allowed self-regulation and were not governed by tight accounting standards prior to the credit crunch which can be identified as the root cause for the failure of shadow banking system which were at the time, expanding rapidly. High variations of derivatives were introduced by these banks along with the use of suspicious accounting activities such as off balance sheet items (http://www.ft.com/cms/s/0/42827c50-abfd-11dc-82f0-0000779fd2ac.html?nclick_check=1).

In analyzing global action, international accounting standards must be developed which eliminates the possibility for non-banks to use items such as off balance sheet items in falsifying the financial results. This has been considered by G20 leaders in March 2010, and in a joint letter to G20 leaders, have introduced guidelines which bring strict policies relating to how transactions are recorded and types of over-the-counter derivatives which are to be issued in the future. In addition, they have proposed the establishment of a crisis-management group whose task is to resolve problems of cross-border financial institutions and undertaking evaluations of financial institutions for adherence with international accounting standards (http://www.iasplus.com/crunch/1003g20letter.pdf). In addition, Morris Goldstein of Peterson institute for global economics suggests introduction of clearing houses to safeguard the over-the-counter derivatives market from failure (http://www.iie.com/publications/papers/20080612goldstein.pdf).

Regulation of financial institutions

It was a prominent feature of the banks during the housing boom to increase their leverage ratios, which shows the ratio of total debt to total equity. An amount of debt which was 15 times than the equity of a bank was considered healthy, but allowing self-regulation of investment banks led to this ratio being higher than 30 by 2007 (refer figure below). The risk of high liquidity ratios for banks comes from the fact that it may lead to “wiping-off” of their liquidity even in a case of minor devaluation of its assets which are in the form of Mortgage backed securities (MBS). This was the case in 2007, where companies like Lehman Brothers were forced to issue common stock to the public as a result of devaluation of Mortgage backed securities/MBS (http://www.secinfo.com/d11MXs.t5Bb.htm#_item1a_riskfactors_003807).

FIGURE 2:

According to Joseph Stigliz (2010) and Raguram Rajan (2010), it is therefore important to regulate the leverage ratios of banks in order to avoid vulnerabilities in repayment during a credit crunch and also to avoid both dilution of control and downward pressure on stock prices of a financial institution. These regulations need to be implemented globally through the co-operation of governments (http://www.petersoninstitute.org/publications/opeds/oped.cfm?ResearchID=941).

In addition to the above, there should be more involvement of IMF and World bank in persuading the individual governments with the intention of providing feasible actions in regulating financial sector of each economy. They can also set the foundation for establishing a multinational safety net which would be able to control the spread of financial crisis across countries by providing emergency liquidity to countries in need.

In addition to the above global actions, following local level policies need to be adopted by governments around the world.

Introduce transparent mortgage products

The root cause for the recent financial downturn was the subprime crisis in the USA. Due to the housing boom, financial institutions were tempted to approve more housing mortgages to individuals who did not qualify for loans, according to Fannie Mae/Federal National Mortgage Association guidelines and carried more risk of default. In order to attract customers, banks used what is now called as teaser mortgages, which offer attractive introductory interest rates but failed to notify the customers that the rate will only be valid for a shorter period of time resulting in soaring mortgages prior to 2007.

FIGURE 3:

Those who entered into mortgages could not afford payments when the teaser rates expired which led to soaring mortgage delinquencies resulting in decline of capacity of private financial systems to support lending and slowed economic growth in USA, Europe and Japan. Therefore implementing of legislations against teaser mortgages and subprime lending may be a solution to prevent a credit crunch. This was considered in endorsement of Volker’s Rule in 2010 by President Obama as a measure of restricting speculative activity by banks. (IARCP, 2010)

In addition introducing mortgage products which require higher payments during a housing boom and less payments during a fall in housing prices would be ideal in avoiding mortgage defaults as per recommendations by Krugman (2009).

Sound monetary policies

The macroeconomic targets of a country may inversely act as a cause for economic downturn. This was evident from the USA where the housing bubble was caused due to reduction of interest rates by the federal reserve system in 2000-01, with the intention of avoiding risk of deflation in the light of 9/11 attacks and to soften the collapse of dot-com bubble in late 2000’s (http://www.federalreserve.gov/monetarypolicy/openmarket.htm). Although Ben Bernanke, the chairman of Federal Reserve argues that the inflow of capital from foreign nations caused the reduction of interest rates, the failure of monetary system to control interest rates led to rates reaching 1% by 04 (http://www.federalreserve.gov/newsevents/speech/bernanke20070911a.htm). By the time monetary action was taken to bring in the Fed rates and the 1 year ARM rates to more controllable levels, house priced decreased and interest rates became unaffordable to mortgage owners, leading to the credit crisis.

FIGURE 4:

Therefore foresight is required by policy makers in making monetary policies aimed at achieving macroeconomic targets in order to avoid unforeseen effects on the financial system and therefore on the global economic situation. It is also noted that Central banks of world superpowers put too much emphasis on inflation that they tend to ignore dangers with asset bubbles. Therefore with this as consideration, the US senate introduced ‘Restoring American Financial Stability act of 2010’.

Limiting executive incentives and dividends

A startling statistic revealed during the credit crunch was that wall-street executives received a total of $23.9 billion as bonuses in 2008 after government bailouts of banks earlier in the year (http://www.nytimes.com/2009/02/21/business/21nocera.html?_r=1&ref=business). And it was also evident that 19 wall-street banks made dividend pay-outs over 80 billion during 2008 while making losses with the fear of losing investor confidence and signalling weakness (http://uk.ibtimes.com/articles/71198/20101012/banks-dividends-tarp-citigroup-bank-of-america.htm). This acted as a choking mechanism for banks which made them vulnerable at the time of credit crunch and was subsequently needed to be bailed out by the governments.

Dietl, Duschl & Lang (2010), recommended implementation of a stronger supervisory policy from the governments which regulate the payments to both executives and shareholders during times of financial stress which would lead to lesser burden on the public eventually as bailouts are done using taxpayer’s money.

Conclusion

In analysing the causes of the recent recession of 2007-2010, it can be identified that the responsibility for controlling the root causes of a financial downturn lies mainly with the individual governments as the emergence of subprime crisis was from USA where the FED/Federal reserve system failed to regulate the financial system properly. Allowing self-regulation of investment banks was accepted as a failure by both heads of FED and Securities and Exchange Commission in a testimony before US congress (http://www.nytimes.com/2008/09/27/business/27sec.html?_r=1&em). Therefore it’s imperative, that in preventing an economic crisis, the individual governments need to undertake regulatory reform because today, due to globalization and development of technology infrastructure, the financial institutions in different countries are linked together which has formed a unitary financial system.

Risks associated with Integrated Financial Markets