Cause of the Financial Crisis: Corporate Governance Failure - Term Paper Example

Cause of the Financial Crisis: Corporate Governance Failure 1. Introduction The development of post modern society is mainly led by effect of globalization that has also influence entire human activities and their lifestyles. With this change due to globalization, the thought process of people has also significantly influenced and they have realized their priorities. In case of trade and business, the world economies have experienced tremendous growth. The policy makers realized the necessity of interdependence and co-operation in encouraging the international trade. International trade has a number of advantages like exchanges of necessary resources like capital, human resources, technology etc. The emergence of international trade necessitates the role of financial institution at global platform and now, the world economies engaged in international trade relation have the opportunity of share their risks with other economies. However, this can also be viewed as major disadvantage of international trade as crisis in the major economies soon spread over other related economies. This can be explained thoroughly using the latest evidence of the global Financial Crisis of 2008 (Mullerat, p.135-137). The Financial Crisis of 2008 was emerged in Western first world countries like United States, Canada, the European countries United Kingdom, Germany, Span, France etc and the influence of crisis in these economies soon impacted the entire international market directly as well as indirectly. There is a debate over the origin of this financial crisis and major reason behind this crisis. This paper will attempt to deal with the same by discussing on the principal cause behind the financial crisis. However, at first a brief description of Financial Crisis of 2008 and its background will be presented to understand its nature. Next, the root cause of the financial crisis will be explained followed by role of the agents of financial crisis will be explained in intensifying the crisis. Finally, the overall discussion will be summed up in the conclusion followed by a set of plausible recommendation. 2. Background of Financial Crisis of 2007-2008 A recession period can be declared by considering the depressing economic growth, reducing the market demand as well as GDP, industrial production, reducing flow of resources etc. As per the economic theory of business cycle, there are four cyclic phases of an economy i.e. slump, recession, recovery and boom and these phases including the recession are quite normal for any economy (Hubbard, p.310). However, in case of financial crisis of 2008, many scholars have defined it as unnatural crisis and did not belong to the normal business cycle as they believe due to unconventional activities of financial market this crisis was forced to impact entire world economy. The financial turmoil was first detected in the first world countries like USA, and other developed countries of Europe and these countries were the major victim of this crisis. Prior to this financial crisis of 2007-2008, the entire Western financial market was enjoying the boom period and many have identified that this global downturn was an effect of constant negligence. When it crossed the limit, a number of multinational corporate giant collapsed and its immediate effect fell on entire financial market. This global downturn is termed as the financial crisis as this recession was mainly led by financial market that caused financial crunch during 2007-2008. This crisis also termed as the sub-prime mortgage crisis as the risks due to sub-prime mortgage is the main technical reason for this crisis. “The subprime mortgage crisis is an ongoing real estate crisis and financial crisis triggered by a dramatic rise in mortgage delinquencies and foreclosures in the United States, with major adverse consequences for banks and financial markets around the globe” (UNC Department of Statistics & Operations Research, p.1). The financial institution of the Western economies started paving the way for the financial crisis since mid of 1990s. The average prices of houses in USA increased at higher rate i.e. between 93% and 137% during 1996 to 2006. On the other hand, the interest rate of house mortgage loans reduced significantly that attracted huge volume of fresh mortgage loans. Anthony Sanders has stated that during 1996 the volume of mortgage loan was nearly $800 billion, and by end of 2003 it raised up to $3.9 trillion. The following graph represents it very clearly. Figure 1: House prices and mortgage originations (Source: Sanders, p.255) The corporations were highly engaged in mortgage and they further increased the level of risk without considering consequences. Finally, the most of the corporation were collapsed and declared bailed out. American International Group and Chrysler of US declared bailed out and other giant companies like Lehman Brothers, Bears Stearns, Banco Privado Português, Bernard L Madoff Investment Securities LLC, Fannie Mae & Freddie Mac and many other financial institution were collapsed (Black, p.69-72). 3. Root Cause of Financial Crisis The pervious section has indicated the technical reasons behind the financial crisis with its background and its immediate effect on the corporate bodies and on economic. The bubble of the subprime mortgage crisis which was started to be prominent during 2006, finally busted in 2007 and 2008. While analyzing the root cause of financial crisis in technical terms, seven major specific reasons can be identified including credit crisis, mortgage crisis, lax regulation, failure of Investment Bank & commercial bank, role of government and ideologies of economic policies (Center of Concern, p.1). It is quite difficult and unviable to choose the one principal cause of financial crisis during 2008 from the above stated seven major causes as each of these causes are closely interlinked with each other. As per the above discussions, the risk level due to mortgage subprime loans increased severely and that created higher degree of risks level in the market. Due to the failure of the market, along with economy, the investors were mostly affected. Form the ethical point of view, one of the primary roles of the financial regulators of an economy is to maintain the increase investors’ trust on financial market, so that market receives significant amount of the investments for economic development. In return, investors require the market to be higher stability level so that their investments do not hurt. Considering these factors in account, the regulatory authorities must assure the proper stability of the market by enforcement of corporate governance laws. However, in case of the financial crisis of 2007-2008, the most of financial and other credit institution neglected the corporate governance compliance and increased their risks level through improper disclosure of financial statements that misguides the investors, government and other users of financial statements. On the other hand, the prevailing auditors grouped also played a major role in intensifying the overall market risks by not meeting necessary responsibilities of auditing. Moreover, the financial regulators were also proved in guiding the corporation in enforcing the higher standard code of corporate governance (Schwab, Roubini and Bilodeau, p.33). 4. Role of Financial Institutions in Neglecting Corporate Governance The financial institution including the subprime mortgage loan and credit providers have played the most crucial role in the rise of such fatal financial crisis. However, by the end of the 2008, the most of them faced the consequences like bailout or entirely washed off. The consequences were so serious and fatal that the major largest organizations along with numerous other small and medium financial institutions were collapsed. The following figure depicts bailout and losses during global financial crisis o f 2007-2008. Figure 2: Losses and Bailout for US and European Countries in Context ($ trillion) (Source: Shah, “The scale of the crisis: trillions in taxpayer bailouts”) Prior to this financial crisis, the financial institutions develop a number of loan products which were attractive in terms of profitability but highly risky. However, the market response of the new product was also very high. Gradually, using such high risky credit products, the financial institutions increased their engagement in lending and borrowing practices. Moreover, they have also sued to the used the financial instruments like securitization that helped them in presetting their multiple loans as sellable assets. Many have claimed that corporate used the securitization to manage their risks. However, in fact it misguided the market by preprinting the false portray of their financial stability and it can be defined as the corporate scandal by not complying with proper code of corporate governance code financial disclosure. In this regard, the scam of repo 105 in Lehman Brothers is the most popular example of incompliance of accounting standard as well as financial statement disclosures policies. Repo 105, “the accounting sleight of hand helped Lehman temporarily remove about $50 billion of assets from its balance sheet, helping to make it look better than it really was” (Werdigier and Merced, “The Origins of Lehman’s ‘Repo 105’”). Along with the giant corporate bodies like Lehman, many financial institutions abused the legal definition set by the government regulatory authorities. On the other hand, the management and decision makers did not take any effective steps for measuring risks the risk level which also indicted their management inefficiencies. Moreover, they constantly raised their risk level by more practicing unethical activities like loan flipping, outright frauds etc (Piera, p.7-8). 5. Role of Auditors in Intensifying the Risk level The financial crisis of 2007-2008 disclosed a number of weaknesses prevailing in the developed countries like USA and other European countries. This weakness mainly deals with the negligence of the major agents including auditors and regulatory bodies. Critics have also pointed their figure on the efficiency of the auditors groups who were responsible of verifying the financial statements of the corporate bodies. The silent behaviors of auditing firms encouraged the unethical behaviors in meeting the proper code of corporate governance. In case of the Lehman scam of repo 105, the engaged auditing firm, Ernst & Young could have prevent this corporate scandal but ultimately it failed to rectify it or neglected this scam. However, it has been quite controversial topic. The regulatory bodies of USA like SEC (Security Exchange Commission) charged Ernst & Young for its professional negligence. A report on Lehman’s prepared by the US bankruptcy courts disclosed that the auditing firm’s failure in acting over its unethical accounting practices “which allowed the bank to hide $50bn of debts, and failing to investigate the concerns of a whistleblower, amounted to "professional negligence"” (Inman “Auditors face inquiry call after Lehman revelations”). Apart from the Lehman’s case of the auditor’s negligence, other auditing firms were also involved in the similar unethical practices like providing non-auditing services which has raised the questions on auditors’ role of independence. The following table presents the list of the auditors of bailout, bankrupts and distressed corporation during financial crisis. Table 1: Auditors and distressed Banks (Source: Sikka, p.3) The above table depicts name of the auditors and enterprises of America and European countries with the auditing fees paid by the companies. Considering the above table, it can be realized that the auditing firms used to receive significant amount of incomes from their corporate clients. Therefore, the most of the auditing firms put their personal gain before the proper code of accounting policies. The financial crisis raised a number of questions on the responsibilities of auditing firms and their practices that must be taken very seriously to avoid the financial turmoil like 2007-2008 (Sikka, p.4). 6. Failure of Regulatory Authorities in Monitoring Corporate Governance The last two sections have discussed and analyzed the contribution of financial institution and auditing firms in financial crisis of 2007-2008. Both of these major agents had been able to continue the unethical practices by not meeting proper code of corporate governance just because their activities were not monitored by the responsible government authorities. The roles of the financial regulatory bodies are very crucial for the market stability and for the economic development. In case of financial crises of 2008, regulators of the suffering countries failed to meet their prime responsibilities causing fatal consequences for the entire world economy. In case of US, there are a number of government authorized bodies like Securities and Exchange Commission, Federal Reserve, Commodities Futures Trading Commission, National Credit Union Administration etc acting for the U.S. financial regulatory system. However none of these bodies were able to meet their responsibilities. In case of innovation and introduction of multiple financial products, the government did not check its viability of the economy which has encouraged the corrupt financial institutions. On the other hand government also did not take any action to look into unusual increasing lending and bowing practices. The fact is that since 1996, there was lack of proper government intervention that increased the frequencies of the corporate scams, and other unethical practices (Lazarov, p.5). The financial market regulators have given sufficient importance to the risk management which was supposed to abide by the corporate bodies. In this process, the regulatory were supposed to investigate the entire process. However, neither financial institution nor the regulatory authorities met their responsibilities. The negligence of financial market regulators raised the questions against the authentication of the corporate governance principals. The process of stress testing for measuring the risk level was not followed by any of the financial institutions. The regulators also did not take any effective actions to measure risk level of the market. Moreover, the transmission of risk information did not have any effective channels which were another issue of corporate governance from the regulators’ end. Due to such negligence of financial market regulators the entire financial market became highly risky that finally brought the global downturn (Kirkpatrick, p.9-11). 7. Conclusion The latest global financial crisis of the 2007-2008 was massive hit on the entire international financial system which was an outcome of the unethical corporate practices. As per business cycle theory is unnatural and could have been prevented if the three major agents of this financial crisis perform their respective responsibilities properly. As per the above discussions and analyses, the principal cause of this subprime crisis was the corporate governance failure. Many academics and scholars have identified the major reason of this crisis was the subprime mortgage loans and related product. However, this paper has tried to offer a deeper analysis and failure of corporate governance has been found to the prime and core factors in this crisis. The market failure of 2007-2008 was a gradual process and three agents contributed equally. However, the major responsibilities in this regard were on the financial market regulators who failed to monitor and control frequent corporate governance failure. 8. Recommendation This paper has clearly identified the corporate governance failure as the principal factors in the financial turmoil. Therefore, the prime concern in maintain a stable market is the maintenance of corporate governance. Corporate governance considers a number focuses on three major factors i.e. market stability, conflict of interest (agency theory) and maintenance of investors’ trust on financial market. These three areas are directly related to corporate ethical behaviors that guide the corporate and auditors in meeting their duties. In this process, the role of regulators is the most important to prevent such turmoil in the future. The regulators must be able to developed very specific and clear codes and these codes should be communicated properly. Next, the regulators should be stricter in enforcing the corporate governance codes. In this regard, the foremost task is to maintain a higher level of transparency so that entire activities can be monitored and controlled. Reference Mullerat, R. International Corporate Social Responsibility: The Role of Corporations in the Economic Order of the 21st Century. Kluwer Law International. 2009. Black, B. 2009. Protecting the Retail Investor in an Age of Financial Uncertainty. July 12, 2011. . Schwab, K., Roubini, N. and Bilodeau, J. The Financial Development Report 2008. World Economic Forum. 2008. Shah, A. “The scale of the crisis: trillions in taxpayer bailouts”. December 11, 2010. Global Financial Crisis. July 12, 2011. . Werdigier and Merced, “The Origins of Lehman’s ‘Repo 105’”. March 12, 2010. Investment Banking. July 12, 2011. http://dealbook.nytimes.com/2010/03/12/the-british-origins-of-lehmans-accounting-gimmick/. Inman, P. “Auditors face inquiry call after Lehman revelations”. March 14, 2010. Lehman Brothers. July 12, 2011. . Sikka, P. Financial crisis and the silence of the auditors. Accounting, Organizations and Society. 2009. doi:10.1016/j.aos.2009.01.004. Kirkpatrick, G. 2009. The Corporate Governance Lessons from the Financial Crisis. July 12, 2011. . Piera, F. D. March 18, 2008. Financial Institutions’ Responsibility in the Subprime Mortgage Crisis. July 12, 2011. . Center of Concern. October 31, 2008. Causes and Consequences of the Wall Street Crisis. July 12, 2011. . Lazarov, M. March 1, 2009. The Global Financial Crisis 2007-8: Crisis of human knowledge and government intervention. July 12, 2011. . UNC Department of Statistics & Operations Research. August 17, 2010. Subprime mortgage crisis. July 12, 2011. . Read More