The Financial Crisis and the Global Economy - Essay Example

?Topic:  Critically discuss the developments in banking regulation that have been, and continue to be, put in place as a result of the economic crisis from which the global banking industry is still recovering, and assess the likelihood of their success. Introduction The collapse of Lehman Brothers marked the start of the recent financial crisis. Lehman Brothers was one of America’s biggest investment banks. This single major debacle triggered a chain reaction of psychological, financial and economic distress, quickly turned into one of the devastating financial crisis since 1929. Taking its root from the United States of America, the global financial crisis left no state without leaving its devastating impacts on its economy. A wide spread unemployment, inflation, poverty, layoffs, financial stress were the words normally echoed on all types of media during the entire period beginning from 2007 to the end of 2009. In the same period, the rates of foreclosure were inversely attached to the housing price inflation (Taylor, 2009). Many investment banks were struggling to survive, mergers, bankruptcies, acquisitions and nationalization became common (The WTO Doha Round and Regionalism, 2009). Many causes contributed towards the development of the financial crisis. Sub-prime loans, low interest rates, financial innovations, a lack of proper supervisory and regulatory measures from the side of regulatory and supervisory authorities, and the total collapse of integrity of credit rating agencies added fuel to the fire of the global financial crisis. Additionally, many authors believe that Basel Committee on Banking Supervision was ill-equipped and confused over some of its basic definitions towards the risk management, and as a result, this also contributed its share in the global financial crisis. Soon after its impacts, the world financial and political leaders gathered to discuss and devise corrective actions in response to the financial situations. In EU, at micro and macro levels, different regulatory and supervisory sound regulations were recommended; European Systemic Risk Council (ESRC) was recommended to play it’s for the risk management. At the same time, European System Financial Supervision (ESFS) was devised to monitor the financial affairs at the micro level, while in the United States of America, Consumer Financial Protection Agency (CFPA), strong regulatory and supervisory measures for financial firms and financial markets were proposed. As the financial crisis has affected the global economy, undoubtedly, it requires the international financial institutions to coordinate their efforts, ensure transparency. And, the international regulatory convergence has become necessary to avoid such financial crisis in future. In the subsequent parts of this paper, causes of financial crisis, different interpretations over the issues are discussed after the section critically highlighting causes. Subsequent to that, in U.S. and the EU, the corrective measures are explained followed by some recommendations and proposals are provided. Then, international context and effectives of these banking regulatory measures are mentioned. Causes of the global financial crisis Many causes contributed towards the financial crisis. First, sub-prime loans and the real estate bubble were among the main causes (Lannuzzi & Berardi, 2010). Udell (2009) explains that the sub-prime loans were easily available to the ordinary Americans before the financial crisis emerged. This type of loan was given to those individuals and institutions that did not have positive credit worthiness. They were those whose loan applications were declined by many credit lending financial institutions. Furthermore, many under-developed states were transferring their savings into American banks and other financial institutions ((Shomali & Giblin, 2010). In the late 1990s and early 2000s, a considerable amount of savings were attracted by many American banks and other financial institutions. Since many of these countries were enjoying economic growth and development, they preferred to earn more lucrative returns by depositing their savings into American banks. This excessive liquidity in American banks further facilitated the financial institutions towards the risk taking behaviour. As a result, many banks, with the intention of earning more lucrative returns, started investing into what is known as innovative finance ((D’Arista and Griffith-Jones, 2008). Without fully contemplating the involved risks in these risky investments, many banks did not waste much time and started investing into the risky investments. Additionally, as the banks were filled with ample liquidity, they became greedy and careless; they started compromising on many of their regulatory requirements. It was the greed of lucrative returns; that attracted banks to accept the credit applications for sub-prime loans. Interestingly, they had a reason to do so as they were charging extra-ordinary interest rates over the sub-prime loans. Furthermore, banks deliberately compromised on the risk management policies. First, due diligence practices were poorly carried out, the public disclosure was considerably insufficient and off-balance sheets means were used for raising funds (The Interim Report of the Financial Stability Forum presented by Italian Central Bank Governor Mario Draghi at the G7 meeting in Tokyo, quoted by Felton, 2008). Also, credit rating agencies irresponsibly played their role. Evan Davis, who is the former BBC’s economic editor and presenter, highlighted in the documentary called The City Uncovered with Evan Davis: Banks and How to Break them (14 January, 2008), describes that credit rating agencies were selling the ratings of many companies; they were accepting bribes and were displaying positive credit ratings, encouraging individuals and institutions to take up risky investment securities (Shah, 2010). Explanations in European Union and in united States of America Technically speaking, macro and micro supervisory and regulatory models totally failed in U.S. and in EU as well. However, there were some differences which brought a different explanation for the causes of the financial crisis. First, the American mortgage lending was at the heart of this problem; besides very low US interest rate caused a widespread housing bubble (The High-level Group on Financial Supervision in EU, web). This EU group contended that the housing bubble was totally unregulated, mortgage lending and techniques of financing securitization were not sufficiently regulated; additionally, this EU Group was also of the opinion that in US government sponsored entities (GSEs) like Fannie Mae and Freddie Mac were not properly regulated and monitored. Additionally, these GSEs were under a political pressure to facilitate low income households for home ownership; this further fuelled to the fire of mortgage lending industry. Comparatively, European Member States were using a different housing finance models. These housing models and financing schemes increased and promoted moderately in some Member States; aggregately, this Group was of the opinion that mortgage lending in Member States was more responsible. This seems to be a reasonable comprehension from the Group. Majority would find it difficult to disagree with that the crux of the financial crisis got birth on the land of the United States of America. It was the chain effect that showed its presence on other countries where the financial crisis severely hit their economies. Regulatory corrective actions in EU and US Some regulatory corrections were considered by the Group. This Group contended that it is wrong to hold responsible the Basel 2 rules per se for contributing into the problem of financial crisis. In the EU, these Basel 2 rules became applicable on 1 January 2008 and they will be applicable in the US on 1 April 2010. The Group was of the opinion that in fact some of the latest improvements in the framework of Basel 2 would have helped reduce to some extent the occurrence of the crisis had they been fully implemented in the foregoing years. To substantiate the argument, the Group said that had the capital treatment for liquidity lines given to some special purpose vehicles been in application then they might have mitigated some of the difficulties (The High-level Group on Financial Supervision in EU, web). However, the Basel 2 framework is not error-free. It considerably underestimated the important risks. Such as the concept that the distribution of risks via securitisation took risk away from the banks miserably failed and became incorrect globally. The distribution of risks further aggravated and added the element of complexity in that process. Consequently, these mistakes brought the concept that too little capital being required. This must not be remaining the same. Additionally, the Basel 2 framework overestimated the bank’s ability to handle the risk did not hold much water after the occurrence of the global financial crisis. Recommendations: EU and US The EU has recommended strong regulatory and supervisory measures. With regard to the above mentioned background, the Group has recommended the following modifications in the Basel 2 framework. 1. Banks should hold more high quality capital as shown by the crisis. And, that capital must be more than the current minimum levels. Additionally, this holding must not be done in the times of stress rather it should be held in good times. The main purpose of holding this huge capital is to manage and cover unusual risks and to include the broader macro-prudential risks. Aggregately, the Group recommends that the fundamental goal should be to increase the minimum requirement. Furthermore, some other regulatory and supervisory measures are unavoidable at the micro and macro levels. European Systematic Risk Council (ESRC) must be established and be chaired by the ECB President. The main function of this Council is to pool and analyse financial stability information to understand macro-economic conditions. European System of Financial Supervision (ESFS) is proposed by the Group. The Group is of the opinion the existing regulatory committees have been insufficient to maintain financial stability in the EU and its Member States. Due to a number of inefficiencies which cannot be dealt within the existing legal framework; as a result, the Group has proposed the establishment of ESFS. Highly decentralised structure, the ESFS in coordination with other existing national supervisors, would be required to monitor and carry out day-to-day supervision. US regulators have also proposed some amendments and modifications. Three major areas are selected- financial firms, financial markets and credit rating agencies, consumers and investors. For them, a robust supervision and regulation have been recommended (Financial Regulatory Reform). First, all OTC derivatives and asset-backed securities must be brought into a coherent and coordinated regulated framework. Additionally, the Report of Financial Regulation Reform is of the opinion that further record keeping and reporting requirement on all OTC derivatives should be imposed. Also, the Report recommends that the Federal Reserve must enhance its authority over market infrastructure as this would diminish the potential for contagion among markets and different firms. Finally, the Report is of the view that a harmony between statutory and regulatory regimes for futures and securities must be there. Consumers and investors must be disallowed from the financial abuse. For that purpose, A Consumer Financial Protection Agency (CFPA) is recommended by the Report. The CFPA must be bestowed with the responsibilities such as reducing gaps in federal supervision and enforcement; improving and ensuring coordination among the states, promoting consistent regulation of similar products, besides setting higher and appropriate standards for financial intermediaries. For consumer protection, the Report proposes legislative, administrative and regulatory reforms with an intention to ensure fairness, simplicity, accountability, transparency and access in the market for financial products and services for consumers. Additionally, the Report is of the view that creating new authorities and resources for the Federal Trade Commission would protect consumers in a wide range of spectrum. Last, but not the least, the Report recommends new authorities for the Securities and Exchange Commission to protect investors, improve standards and disclosure requirements and ensure enforcement of these proposed recommendations. International context The global financial crisis must be dealt globally. International financial institutions and informal groups are, still, dealing with supervisory and regulatory issues separately despite risk transfers between parts of financial system(The High-level Group on Financial Supervision in EU, web). Additionally, there are no practical arrangements to manage the cross border financial crisis management globally. It is highly recommended to devise and implement a coherent, strengthened international financial regulatory and surveillance system that minimise the reoccurrence of such financial crisis in future. In their hunt for international regulatory and supervisory framework, the international leaders met at the G20 Summit in Washington on 15 November. With their consensus on an action plan promoting transparency, enhancing strong regulations, ensuring integrity in financial markets, and reinforcing international cooperation, G20 leaders have clearly marked their priorities for the months and years to come. Effectiveness of these international measures The international cooperation must be ensured; it must be practically there. Undoubtedly, the G20 leaders commitment was a commendable attempt towards the internationalization of the financial crisis; it was envisioned in the meeting that future must not be victimised at the cost of current political differences. However, so far the promised work has not been carried out the way it was promised in the G20 meeting. A strong resolve to implement these measures is still unable to show up practically. The political leaders did meet but without taking into the main market players and without their coordination, the resolve to ensure international regulatory and supervisory framework would remain in the pages. Conclusion The financial crisis considerably damaged the global economy. Bursting of the real estate bubble in the United States of America created the shockwaves of the financial crisis globally. Sub-prime loans, excessive liquidity, low interest rates, widespread compromises on risk management by banks and other financial institutions caused the emergence of the global financial crisis worst after the Great Depression of 1929, acknowledged by the International Monetary Fund (IMF), George Soros and Joseph Stiglitz (Tong and Wei, 2008; Jaffee, 2008). Furthermore, the crisis was so severe that it hit at the core of the global financial system (IMF, 2008). To control the effects of the financial crisis, the EU mostly focused on the micro and macro level by putting some strong and sound regulatory and supervisory measures. By proposing different councils at the macro level, the EU has ensured to monitor the impacts of the financial transactions on the entire financial system. Additionally, by recommending some additional regulatory councils at the micro level, the EU leaders want to monitor and supervise day-to-day activities. The US has come up with own plans to control the effects of the financial crisis. The CFPA is proposed to protect consumers and investors from the financial abuse; additionally, some strong measures for the Securities and Exchange Commission are also recommended in this regard as well. Furthermore, as the financial crisis damaged international economy and on the international scale, it has become necessary for the international leaders to coordinate their efforts and devise their future strategy and plans to regulate and supervise the international system. Within that context, some commitments were made between the leaders of G20. However, they have yet to achieve the much needed international cooperation and coordination towards regulating the international financial system. References 1. Iannuzzi, E & Berardi, M., 2010, Global financial crisis: causes and perspectives. Euro Med Journal of Business, 5(3), 279-297 2. Udell, GF, 2009, "Wall Street, Main Street, and a credit crunch: thoughts on the current financial crisis", Business Horizon, Vol. 52 pp.117-25. 3. Shomali, H & Giblin, G R 2010, “The Great Depression and the 2007-2009 Recession: The First Two Years Compared,” International Research Journal of Finance and Economics, Is. 59. 4. D'Arista, J, Griffith-Jones, S 2008, "Agenda and criteria for financial regulatory reform", Initiative for Policy Dialogue, Columbia University, NY,  5. Shah, A 2010, “Global Financial Crisis.” Global Issues, Updated: 11 December, [Accessed: 28, March, 2011] 6. Felton, A, 2008, ‘The first global financial crisis of the 21st century’, London: Centre For Economic Policy Research (CEPR). 7. The High Level Group on Financial Supervision in the EU, 2009, [Available at: http://ec.europa.eu/internal_market/finances/docs/de_larosiere_report_en.pdf ] [Accessed: 01 April, 2011] 8. Financial Regulation Reform, A New Foundation: Rebuilding Financial Supervision and Regulation, [Available at: http://www.treasury.gov/initiatives/wsr/Documents/FinalReport_web.pdf ] [Accessed: 01 April, 2011] 9. Jaffee, D.M. (2008), "The US subprime mortgage crisis: issues raised and lessons learned", The Commission on Growth and Development, Washington, DC, Working Paper No. 28, pp.1-36. 10. 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