Banking and International Banking System - Essay Example

?Evaluating the reasons for the recent global financial crisis The recent financial global crisis is the worst as compared to other financial crisis since the great depreciation. It started from United States and spread to other parts of the world. Millions of jobs have been lost and trillions of dollars (pounds, rupees, Yuan) in market value evaporated across the world. The global crisis shook the very foundations of financial institutions and the stock market as share prices for small and large investment banks dropped significantly between mid 2007 and first quarter of 2008. Financial institutions lost nearly a third of their value in less than one year. Major financial institutions collapsed or near collapsed and credit markets were frozen. Bear Stearns and Sachsen LB (German bank), banks fell in 2007. It was followed by IndyMac Bank in receivership and demise of Lehman Brother in the quarter of 2008 (Drea 2009). After September 2008, panic in the financial global sector escalated and spread to other sectors of the economies. Investors were shocked by losses that they incurred on assets they thought were safe. There was strong evidence that contagion was linked with global financial crisis. This happened through liquidity and risk-premium channels in the financial markets. There was clear evidence informed by research that contagion during subprime crisis was clearly shown by significance of t-statistic for lagged ABX index returns in 2006 (Longstaff, 2010). Cross-market linkages were stronger and significant during subprime crisis indicating that that 2007 subprime crisis resulted in large shifts in trading activity, liquidity and funding in the financial markets across the world. A number of reasons have been advanced concerning the recent global financial crisis. Reading from different sources and investigating events prior to the global financial crisis, most of the reasons advanced by different people and entities concerning the reasons of financial crisis is true. There is some underling truth that the recent global financial crisis was caused by inflow of foreign savings from emerging markets like China. There were net capital inflows (about $ 68 billion monthly) that flowed from emerging economies like China and oil exporting countries into the United States (Schroeder, 2007). The foreign money was savings piling up and owners wanted to invest their monies away from home where they were assured of some returns. The net inflow of foreign savings into the United States in 2006 was about 6 percent of the United States’ output. Instead of investing foreign moneys appropriately, financial institutions in the United States that received the surplus funds from Asia converted the monies to loans that were aggressively given to borrowers, especially homeowners. Mortgage market was attractive to investors because over 80 percent of mortgage market in the United States was securitized and they that their monies would be invest well (Financial Crisis Inquiry Commission, 2010). Securitization created the much needed diversification to investors and liquidity for business entities and individuals. Securitization refers to pooling mortgages together as securities. Once pooled as securities, they are sold to investors. However, investors and players in the industry lacked the business acumen to realize that securitization lacked clarity and transparency. Financial institutions also underestimated the risk associated with securitization and sold mortgage backed securities to investors across the world. The investors, which included banks, money markets, pension hedge and mutual funds, purchased the mortgage backed securities thinking they were safe. However, securitization was not able to provide protection against systematic risks. Even, credit rating agencies failed to take into account systematic risks and awarded the mortgage backed securities with AAA rating because it was considered low risk securities. Therefore, credit rating agencies could not price systematic risks into subprime mortgage pools. In fact asset backed securities were also leveraged by investors as they invested more money than the capital they had. Niinimaki (2009) confirmed that participants in the financial industry relied on credit ratings from credit rating agencies. When Credit rating agencies discovered that they had underestimated Asset backed CDOs risk, they panicked and caused financial panic everywhere and liquidity of CDO markets dried. Investors were not able ascertain the value of their financial assets anymore. Asset backed CDOs spread contagion and led to global financial crisis. Weak localised financial regulatory framework and fraudulent lending practices caused global financial crisis. Moshirian (2011) stated that global financial crisis was caused by lack of integrated global framework. This is because national rules give room to circumvent financial rules through financial innovations. According to Richard Bowen, mortgage lending practices and standards were endemic in 2006 and 2007. He revealed that nearly 60 percent of all mortgages purchased by Citi from one thousand six hundred mortgage companies did not have all necessary documents. Furthermore, Clayton Holdings revealed to Financial Crisis Inquiry Commission that 54 percent of 900,000 mortgages issued between January 2006 and June 2007 did not meet mortgage companies’ underwriting standards. In addition, 28 percent of loans issued by investment and commercial banks did not meet the minimum standards of those financial institutions. Individuals and institutions were able to get credit easily. This is because federal funds rates were lowered from 6.5 percent to 1 percent by the federal in 2000 to 2003. Federal funds rate were reduced to soften the negative impacts created by the September 2001 terrorist attacks and the dot-com bubble. At some instances, laws were changed and enforcement was weakened by regulatory authorities. The depository Institutions Deregulation and Monitory Control act of 1980 relaxed its regulations on financial institutions as it raised deposit insurance limit and broadened lending powers of financial institutions. As a result, banks were able to venture into other areas such as real estate and speculative lending. United States Securities and Exchange Commission allowed investment banks to increase the level of debt following the relation of net capital rule. This fuelled growth in mortgage backed securities that supported subprime mortgages. Shadow banking system was not regulated as other depository banks. This allowed them to lend more to their serve own interests. Citigroup was allowed by regulators to transfer significant assets and liabilities off-balance sheet into structure investment vehicles. In fact Enron’s application of off balance sheet was used as a scandal cover up. Federal Reserve through Greenspan worked hard to ensure that derivatives markets remain unregulated. Financial innovation and complexity contributed to global financial crisis. Rapid development of poorly regulated new financial products was evident before the financial crisis. This is because regulation of the sector was overtaken by events. According to Paul Krugman and Timothy Geithner, financial regulatory framework failed to keep pace with increasing financial innovation. The innovation that overtook regulation included off-balance sheet financing, shadow banking and increased importance of derivatives. Products such as adjustable rate mortgage, mortgage backed securities, credit default swaps and collateralized debt obligations also developed faster than they could be regulated. Collateralized debt obligations grew from $20 billion in 2004 to over $ 180 billion in 2007 (Financial Crisis Inquiry Commission, 2010). Some innovations such as off-balance sheet financing, shadow banking system and derivatives allowed financial institutions to circumvent regulations. In fact Timothy Geithner, the former President and CEO (the New York Federal Reserve Bank) blamed shadow banking system for contributing to the financial crisis because it was under regulation like the mainstream banks. Credit default swaps (CDS), which were suppose to insure bond investors against losses took life of their own and investors used it for speculative purposes. This is because CDS and derivatives markets were unregulated due to Commodity Futures Modernization Act of 2000. Commodity Futures Modernization Act of 2000 made it difficult for state agencies to apply necessary laws. This is an indication of poor macroeconomic policies that caused the financial crisis (Moshirian, 2011). Financial markets watchmen and regulators such as Federal Reserve, auditors, boards of directors, Wall Street analysts and career politicians failed to perform their duties. The real estate bubble also contributed to global financial crisis. Huge demand for financial assets caused real estate melt-down as speculative bubbles were used to meet the huge demand of the financial assets that could not be met normally. As a result, the price of typical houses in the United States, Britain, Spain, and Ireland increased by about 124 percent, 194 percent, 180 percent and 253 percent respectively between 1997 and 2006, (The Economist 2007). Home ownership rate increased with subprime lending in the United States as some home owners refinanced their homes with lower interest credit or second mortgage that was secured by increased prices. Consequently, it was estimated that over five million people changed from tenants to home owners. The construction of new housing units between 2001 and 2007 surpassed new household formations and housing bubble could not be further sustained. Consequently, the price of houses hit the roof and could not be sustained further as house rents declined drastically to the lowest point in real estate history in the last decade. Increase in price of houses stopped in 2006 as subprime borrowers began to have difficulty in paying mortgage payments. The house bubbles began to burst and subprime mortgage market excesses became conspicuous when subprime mortgage lenders started to declare bankruptcy in the first quarter of 2007. Though the subprime lenders began to declare themselves bankrupt, financial authorities and Federal Reserve never intervened fast because they treated the situation as an isolated case. Unfortunately, in the mid 2007, heavy losses in subprime mortgage market triggered a global turmoil. Financial institutions that were not directly linked with the subprime mortgage market were also affected. The other cause of global crisis is the predatory lending. When financial institutions received additional money that flowed from foreign countries such as China and oil exporting countries, financial institutions develop unscrupulous lending techniques that enticed borrowers to borrow money even if hey did not have the capacity to repay. Most mortgage companies advertised low interest rates mortgages and made loans subject to no or little federal regulation. Credit to individuals and entities were cheaper and easy to obtain from financial institutions as financial institutions competed for borrowers. This led to housing boom in the United States, which was fueled by increased mortgage lending. The borrowers were not vetted appropriately and money was given in disregard of borrowers’ ability to repay. This is because lenders expected the prices of houses to increase continuously, allowing the borrowers to accumulate equity for their homes. The lenders also thought that there will be adequate credit for borrowers to refinance their mortgage if needed. Mortgages were also offered to high risk borrowers at a higher cost and pooled as assets called mortgage backed securities. The mortgage was then broken into pieces, grouped and packaged with similar mortgage pieces creating financial instruments such as CMO, MBS, CDO and SIV to meet huge demand for financial assets. It was speculated that returns from securitized subprime mortgages was going to be higher. Though the loans were written into detailed contracts, it was later made into expensive loan products. In addition, borrowers were given loans at adjustable rate mortgage (ARM), which attracted higher interest rates in later years. Conversion to higher interest rates was not noticeable to consumers early. However, when the price of houses decreased, homeowners had little incentives to pay their monthly as home equity faded. Ameriquest employees admitted that they were asked to falsify mortgage documents and sell mortgages to Wall Street as to make quick profits. Therefore, predatory lending practices led to mortgage practices that cause financial crisis. The regulatory and standard setting bodies failed to play their role to instil sanity to the financial industry. Central banks found themselves in the middle of the financial storm for failing to act to contain the financial crisis. Central bank had been warned that financial system was being undervalued but they thought it was a joke. When overnight interbank rates in the euro zone reached 4.6% in August, the European Central Bank injected €95 billion into the money markets. Kolb (2010) revealed that Arthur Levitt former chairman of the Securities and Exchange Commission (SEC) indicated that Wall Street was not well monitored. He added that financial industry regulators were sleeping on their jobs. SEC failed to enforce tighter rules to regulate the industry and its staff was reduced in number. When SEC held a meeting with five major investment banks, it agreed to loosen the capital rules and allowed the investment banks to voluntarily regulate themselves under the voluntary regulatory program. However, when firms adopted the new system of regulation, it took huge amounts of debt. The leverage ratios rose significantly, for example the leverage ratio of Bear Sterna rose to 33:1 making the firm extremely risky. Consequently at that time, the mortgage industry was out of control as individuals with insufficient income were allowed to borrow beyond what they could afford. During the implementation of the new rules, FED should have stooped the risky operation of financial institutions using the power vested on it by the Home Owner Equity Protection Act. It was revealed that Washington Mutual approved nearly all mortgage requests it received. Ninja loan is an example of a loan facility that was given to people who had no income, job or assets. Though some states wanted to top predatory lending, Federal Government asked them to step back and allow banks do their work. Subprime lending caused the financial crisis because money was lend to borrowers who did not have sufficient money to pay back the mortgage and had bad credit histories. According to The Economist (2007), beginning 2006, nearly one fifth of all mortgages was subprime. Subprime mortgage defaulting rates increased from between 10-15% between 1998 and 2006 to 25% at the beginning of 2008 (Financial Crisis Inquiry Commission, 2010). The evidence that global financial crisis started from United States of America and spreads to other parts of the world is concrete. Other parts of the world suffered because toxic assets spread outside the United States and there were no good macroeconomic policies to regulate the global financial market. References ‘CSI: credit crunch; Central banks have played a starring role’ The economist, Oct. 18, viewed, March 22, 2010, . Drea 2009, 25 Biggest Bank Failures in History, viewed, March 22, 2010, . Financial Crisis Inquiry Commission 2010, Preliminary Staff Report: Credit Derivatives and Mortgage-Related Credit Derivatives, viewed, March 22, 2010, . Kolb, WR 2010, Lessons from the Financial Crisis: Causes, Consequences, and Our Economic Future, John Wiley and Sons, New York. Longstaff, FA 2010, ‘The subprime credit crisis and contagion in financial markets’ Journal of Financial Economics, volume 97 p. 436–450 Moshirian, F 2011, ‘The global financial crisis and the evolution of markets, institutions and regulation’ Journal of Banking & Finance, Volume 35, Issue 3, P. 502-511 Nanto, KD 2010, Global Financial Crisis: Analysis and Policy Implications, Diane Publishing, London. Niinimaki, JP 2009, ‘Does collateral fuel moral hazard in banking?’ Journal of Banking & Finance, Volume 33, Issue 3, March 2009, Pages 514-521 Schroeder, P 2007, ‘Capital flows to U.S. rose in Nov. to $74.9 billion, Market Watch, January 17, viewed, March 22, 2010, . Read More