Analysis of the Banking Crisis of 2007-2008 - Essay Example

?Introduction Every once in a while comes an economic or financial event that stops us in our tracks, puts a brake on the system and challenges present wisdom. The new millennium had brought along with it new hopes and aspirations. However, the banking crisis of 2007-2008 precipitated the deepest global recession since the 1930s and has led to calls for significantly tighter controls over banks’ activities. All across the globe, people have been hit by food inflation, rise in unemployment and the vagaries of weather which have disrupted growth plans and the consistency of daily life. When events like this occur, we automatically look back at the control systems that are supposed to alert us and in fact prevent such a fiasco from assuming alarming proportions. In this case, obviously something went wrong somewhere or the signs were ignored. Part I of the paper will critically assess whether or not this crisis has fundamentally undermined the corporate governance frameworks in both the UK and USA. Part II of the paper will assess how to change the current frameworks to lessen the likelihood of a recurrence in the future. PART I: The Banking Crisis of 2007-2008 and its Impact on World Economies It all started with an excess of lending in the mortgage sector of the USA. The economy was going well and life was good. It seemed that the good times were here to last and there was no letting up. In the UK things were largely happening in a similar vein. Lending on mortgage loans had assumed alarming proportions as had consumer credit; it was said that the UK economy in 2007-2008 was the most indebted in the world (UK House Building Market Report, July 2010). Bankers were even giving housing loans to consumers whose credit history was patchy- meaning that they had defaulted on loans in the past and were likely to default again- and pocketing fees and commissions in the process. This is called the sub-prime mortgage sector. And then it finally happened. Bankers who had previously considered even people with a bad credit history as good enough for taking a loan now began to cut back on lending in the interests of risk control and compliance. As the economy shrunk and credit dried up, bankers began to call on the sub-prime mortgages and the consumers were left with nowhere to turn to. Imagine their predicament as interest rates rose up and they had to give up their houses because they could not pay up the loan instalments. It was havoc and pandemonium in the housing sector. As the crisis deepened, the banks that had not provided adequately for bad debts in the real estate sector were adversely affected. Merrill Lynch and Lehman Brothers in the USA and Northern Rock in the UK were institutions that were brought down by the crisis; others like Royal Bank of Scotland were forced to sell off parts of their businesses, divest and re-organize themselves. For institutions like international banks, who have diversified their investment portfolios across the world in different continents to spread risk, it was inevitable that their holdings were impacted in some way or the other. AIG and Citibank in the USA, Deutsche Bank in Europe, Citigroup in the USA and Standard Chartered in the UK were all offered stimulus packages that have helped them recover rather than join the ranks of the bankrupt companies. To date in excess of 400 small and large banks have had to bite the dust. At the Heart of the Crisis At the heart of the banking crisis lies the root cause of it all. Actually it is never one factor but a combination of factors that interact or add on to the unfolding crisis and make it inevitable. Prior to the 1930s crash was the period of the Roaring Twenties, a time of unprecedented growth and stability. People had borrowed against everything they had and even resorted to margin trading to take advantage of the stock market boom. It seemed that the bull market would last forever. But by July 8, 1932 the DJIA had lost 88 percent of its value and closed at 41.22, its lowest point in the 20th century. By 1933 the depression had spread to all countries including Australia, France, Germany and the United Kingdom (Bernanke, 2004). Coming to the 2007-2008 crises, this time around the impetus was greed to earn more commissions and fees in a healthy economic climate, and that pre-empted the banking and real estate sector to allow loans to the sub-prime customers, who have had bad credit ratings and history of foreclosures in the past. Why did they lend to them if they knew they were a bad risk? For these people, it must have seemed like a boon that the banking sector was allowing them the privilege of a mortgage loan. Anyway interest rates were also not too high and there were even instances of people taking new mortgages at lower rates. It was an offer that seemed too good to forgo. This situation was allowed to continue so that sizeable amounts of fees and commissions were earned from the sub-prime borrowers. Then one day it all came apart when one bank after another decided to tighten their credit risk portfolio in the light of rising house prices and less liquidity, and called upon the sub-prime sector to pay up its outstandings or face foreclosure. One of the mistakes noted from the 1930s Depression Era was that the Federal Reserve did not step in to rescue failing businesses and by the time it did, it was too late. This had further exacerbated the crisis. This time around, the Government did make a plan to rescue key sectors of the economy and came to the aid of AIG, Citibank, General Motors and others. Even then it was criticised for its slow and lopsided response. The key to recovery is in stimulating consumer and business confidence to kickstart the economy again, but this will take some time. Unemployment has peaked at 10 percent in the USA and remained there for a long time. Too many lives have been affected through unemployment, loss of shelter, medical cover and other calamities for them to forget so easily and start anew. The Root of All Evil It is a sad but true fact that greed for wealth is what precipitated all the economic and financial crises that man has visited upon himself. This is as true of the 1930s Depression Era (De Long) as it is of the 2008 crisis. The point though is that if there indeed exists a system of checks and balances to monitor such events and in effect give a warning signal to the management and the companies they represent, why does it not go off? The sad truth is that apart from any whistleblower making it evident, management is often in the know and a party to what is happening because things are good and they want to take advantage of the present situation while it lasts. It will increase shareholder value as well as bring them bonuses and salary increments. This is the very reason why it has been emphasized that the function of corporate governance be given to knowledgeable people who are unrelated to the businesses they oversee or its stakeholders and have no personal interest in the business apart from seeing it operate ethically and according to the principles of good corporate citizenship. Our Economic and Political System In the civilized world of Western culture, we have always favoured a system of free enterprise, where each one is free to live the live he or she wants, provided that it does not injure or interfere with the rights and freedom of another. We follow the ideals of capitalism, where wealth is allowed to accumulate in the hands of the capitalists and they use the same wealth to create businesses and accumulate even more money. In the end they end up owing a sizeable part of the economy of a nation, called private enterprise. These owners of private enterprise are often seen creating their own lobbies and rights groups in order to induce Government to accede to their desires regarding policy decisions that would further favour their interests. On the political front, we prefer the rule of a Democratic Government which is elected by a majority of the people. Once elected- Republican or Democrat, Labour or Conservative- they think that they have the people’s mandate to run the nation till next election day (Bernanke, 2000). Merits and Demerits What we do not see or are blinded to are the evils of capitalism and private enterprise. We do not see that the capitalists or owners of large corporations control the strings of Government and have the real power to kickstart or stall the economy. According to a documentary by Annie Leonard called ‘The Story of Stuff’, 31 percent of the economy of the world is controlled by large corporations (Leonard, 2010). They have in effect more power than Presidents or Prime Ministers and can often dictate policy and influence decisions. One of the glaring merits of democracy is that it counts the votes of the people, but does not weigh them. In other words a peasant has the same weight in his vote as does a Leeds or Harvard graduate. This state of affairs has disillusioned many of us so much that we do not even care to vote any more. PART II: The Need for Checks and Balances The need for checks and balances is very necessary so that no one abuses the power and responsibility that he has while holding public office. We have adopted this system in the three arms of the Government- the Executive, the Legislature and the Judiciary. If any one branch is seen as superseding its authority, the other branches can hold it back. In the same way, it was hoped that corporate governance and the existence of a Corporate Governance Board/ team of experts elected or appointed to public and private corporations would do well to prevent unethical behaviour on the part of executives or employees and keep the interests of all stakeholders in mind while reviewing the proposed action plans of the organization for the coming year. Corporate Governance Corporate Governance has been defined by the OECD which regards it as ‘a set of relationships between a company’s board, its shareholders and other stakeholders. It provides the structure through which the objectives of the company are set, the means of attaining these and monitoring performance are determined’ (OECD, 1999). This definition captures the entities of all who are involved as well as the working relationships among them with respect to the functions and responsibilities of corporate governance. The Present Framework in the UK In the UK, efforts at framing a code for corporate governance started with the Cadbury Report, which was set up after corporate scandals of the 1980s. It recommended the establishment of an Audit Committee (for internal control), a Nomination Committee (to oversee Board appointments) and a Remunerative Committee (to recommend remunerations of directors). These initiatives were implemented in 1993 for all listed public limited companies. The Greenbury Committee was appointed in 1995 to consider whether remunerations to higher managements were justified. It suggested that Remuneration Committees be made up of wholly Non Executive Directors of the firm, who had been independently hired. This recommendation was also implemented in October 1995. Further work on corporate governance as recommended by the Smith, Turnbull and Higgs studies were consolidated into the Combined Code of Corporate Governance 2003 which was amended in 2006 and became the UK Code of Corporate Governance which every UK public listed company is required to comply with today. The Present Framework in the USA The USA has unfortunately been the scene of most of the corporate scandals and errors of the last decade. Enron, World.com and Madoff Investments are some recent examples. While the Sarbanes-Oxley Act 2002 did make some good recommendations regarding separation of ownership and control, and the disclosures relating to directors of corporations, few failures were revealed by these measures. In consequence, calamities like the sub-prime mortgage crisis continue to unfold on Wall Street. A positive step is the enactment of the Wall Street & Consumer Protection Act signed in July 2010 under which it is proposed to have a Consumer Financial Protection Agency to regulate items of consumer credit such as car loans, credit card loans and mortgages. Why the Systems Failed It is not hard to see in hindsight how and why the systems have failed in the past. Either the corporate governance team was inadequately qualified to monitor business activities, or was deliberately kept in the dark or feared loss of remuneration and benefits from serving the company. It is also hard work balancing the interests of all shareholders (Solomon, 2007). For example, management and workers interests may conflict- as may also the interests of creditors and shareholders. Sometimes the company is run by a domineering personage like Robert Maxwell (Ellis & Urquhart, 1991) or Enron’s Ken Lay who had cultivated friendships in politically powerful circles. Sometimes the actions of one person can bring down a bank e.g Nick Leeson and Barings; at other time it is a collusion of higher management e.g. Bank of Credit & Commerce International (Time Magazine, 1991; Wearing, 2005). Yet integrity and a sense of duty must supersede all these considerations, which admittedly is quite a tall order. The present thinking recommends the idea of non-executive directors, who are preferably retired directors of public or private corporations with a record of integrity and service. These directors should be appointed with the sole purpose of looking at the ethics of what the business is doing and the way it is doing it. Any suspicious activity or fraudulent practice or attempt to mislead must be delved into by the auditors and the board of corporate governance and the true facts revealed. There must be no mercy shown to the miscreants. Non executive directors could be rotated every three years or so (www.cimaglobal.com). Averting Another Crisis The question is how can we avert another crisis? The answers once again lie in following the principles of good corporate governance. No one individual should be allowed to have too much power and all key decisions must be approved by a majority of the Board of Directors. There must be an adequate system of internal control not only for audit purposes but for management purposes as well. Employee and management feedback to Human Resources or directly to the Corporate Governance Board should be encouraged while their confidentiality ensured. The names and addresses and email contacts of the members of the Corporate Governance Board should be known and accessible to all stakeholders of the corporation and published in the financial reports. Laws such as Sarbanes Oxley Act of 2002 and the UK Code of Corporate Governance should be implemented in true spirit without any qualms. The role of non-executive directors on the board and being entrusted with corporate governance has been commented on above. Hopefully the continuing emergence of wise and prudent controls and safety measures from our best social thinkers and intellectuals will help in reducing such crises in the future. References Bernanke, B. (2000). A Refresher Course for Central Bankers. Foreign Policy Magazine, 1 Sep 2000. Bernanke, B. (2004). Essays on the Great Depression. Princeton University Press. DeLong, B. Depressions and Panics, 1840–1933. Economics: American Economic History. University of California at Berkeley. Ellis, D. & Urquhart, L. (1991). Maxwell’s House of Shame, Time Magazine, 08 April 1991. Leonard, A. (2010). The Story of Stuff. Free Press. OECD, Retrieved May 20, 2011 from: http://www.oecd.org/topic/0,3699,en_2649_37439_1_1_1_1_37439,00.html Solomon, J. (2007). Corporate Governance and Accountability. Second Edition. John Wiley & Sons. Wearing, R.T. (2005). Cases in Corporate Governance. London: Sage Publications. Time Magazine (1991). The World’s Sleaziest Bank. Cover Story, 29 July 1991. The Role of the Non Executive Director: Making Corporate Governance Work. Accessed at http://www.cimaglobal.com/Documents/ImportedDocuments/NEDSmakingcorpgovwork_techguide_2003.pdf Read More