Causes of an Economic and Financial Crisis - Essay Example

?Running head: Banking Regulations Banking Regulations Insert Insert Grade Insert April 8, Outline Introduction Causes of an economic and financial crisis The developments in banking regulations Possibility of successes or failures Banking Regulations 1. Introduction Financial crises have been recently experienced in several countries leading to instability of the global economy. There have been various factors that have been responsible for the crises and the causal factors need to be identified before mechanisms are adopted that can manage the situations. A track record should be kept so that similar incidences are not replayed in a given economy. However, this has not always been the cases. Various financial crises have often been recurrent due to the poor response mechanisms by the local and at times the international regulatory agencies. Failures of various governments in managing trade liberalization. The governments in these cases have failed to properly introduce their national economy into the international capital market (Raghavan, 1998). An important point to note in the issue of the economic and financial crises is that they are similarly characterized in both the developed and the developing countries. The causal factors and the manifestation of the economic crises are more or less the same across all the economies in the world (Raghavan, 1998). There are also some lessons that can be learned from the global financial and economic crises and that can be used to provide an insight into the possible preventive and management mechanisms for future crises. One lesson is that it is not appropriate to make changes in the financial system of a given country when the country is already experiencing a crisis (Raghavan, 1998). It was also observed that ‘when currency turmoil is associated with financial difficulties, raising interest rates may simply worsen the situation by bringing about widespread corporate and bank insolvencies’ (Raghavan, 1998). Besides, it has also been noted that it is often a big loss to a given economy if the currency in the economy loses value in the international money market when it had international creditors (Raghavan, 1998). 2. Causes of an economic and financial crisis The proper management of financial crisis requires a thorough understanding of the possible causes of the crises and the features characteristic of such situations. A reduction in the average income caused by underemployment or unemployment increases the poverty level among a given population. This coupled with an increase in the cost of living like food prices and other human needs provides a proper avenue for an economic crisis (Raghavan, 1998). The situation then worsens and can only be redeemed by addressing unemployment issues, lowering interest rates, expanding liquidity and increasing public expenditure by the governments (Raghavan, 1998). 3. Developments in banking regulations The banking regulatory measures are aimed at strengthening the global capital in order to have a flexible banking industry. The regulatory developments aim at improving the ability of the banking industry to absorb stress that follows a given financial stress so that the overall effect is not felt on the economy. The efforts also aim at ensuring proper governance and developing techniques for risk management by the banking institutions. The regulations ensure that transparency and accountability are manifested by the banking institutions. They outline the appropriate procedures for market disclosures by the financial institutions to enable the investors build confidence in the banking institutions. The crises that have been witnessed gave out a picture of what the regulatory bodies have been in the recent past and that led to their failures in mitigating the crises. The characteristics of the crises showed that there were no proper techniques for prudential regulations by the regulatory bodies. Firstly, it was observed that the regulatory procedures were not sufficient enough in managing the emanating issues. There were no proper mechanisms for risk management by the banks (Europe Economics, 2010, p.19). It was also observed that banks were allowed to hold capital that was not enough for the operations. In effect, some banks were greatly over levered while others became illiquid (Europe Economics, 2010, p.19). It was also observed that the international regulatory agencies were also unable to provide mechanisms for financial coordination and control among the financial institutions (Europe Economics, 2010, p.19). Besides, there were less security provisions by the banking institutions. The bank depositors were not assured of their security against the probable risks and uncertainty (Europe Economics, 2010, p.19). It was also observed that the crises occurred due to very low resolution regimes. In order to correct the above situations, the respective corrective measures have to be taken by the banking institutions and the regulatory bodies. These are some of the appropriate regulatory measures and which have been adopted by financial regulatory authorities in many of the countries. Firstly, there is a need to increase the capital requirements by the banking institutions to solve the inadequacy of capital that has been experienced in some of the banks. The regulatory bodies should outline more strict provisions on leverage (Europe Economics, 2010, p.19). It is also necessary that there be provisions for liquidity standards and that the standards be set well above the standards that have been adopted in the past. Besides, the regulatory procedures should greatly focus on risk management by the banking institutions. There needs to be incentives in the baking institutions that allow for the stakeholders to take risks in the institutions (Europe Economics, 2010, p.19). The resolution regimes also need to be reviewed and extended to meet the requirements bank depositors. There is also a need to assure the depositors of protection against risks by developing an elaborate insurance system (Europe Economics, 2010, p.19). Much of the regulation in the banking industry has been performed by the central banks in the respective countries. Some countries have opted to designate the central banks as the overall regulator and yet others have established independent agencies to provide financial regulation and supervision functions (Walker, 2001, p.99). These regulatory moves are aimed at developing and promoting a banking and finance industry that can support long term economic goals and provide equal opportunities for the investors in the banking industries. There are also government departments and institutions that are involved in resolving a crisis depending on the nature of the crisis. There are a number of regulatory measures that have been or are yet to be adopted by banking institutions. One of the dimensions of the 2007 economic crisis witnessed in the US and other countries was a build-up of both corporate and household debt (Kilmister, 2008). It had emerged following the fact that bad dept had grown more than expected and managing the increasing amount of loan defaults was becoming a problem to governments. The effects of these were adverse. The increase in bad debts posed insolvency challenges to many banks (Kilmister, 2008). It also affected the trust between banks and no bank was will to lend out to another bank. There were also no investors willing to get into the stock markets. There were different reactions to this by various governments but all was a change in the policies towards bailing out of the banks. The US government opted to buy debts from the banks disregarding the possibility of the future occurrence of the same situation (Kilmister, 2008). The UK and other European countries adopted the model that had been used by Scandinavian countries in their financial crisis of the 1990s. It was a restructuring plan with the government buying shares from the banks to provide an opportunity fro a debate on the role of the government in controlling the banking system (Kilmister, 2008). As the main regulatory body for financial services, the kind of governance and the defined functions of the central banks are essential in realizing their required mandates. Therefore, much of the developments that have been carried out in response to the recent crises involve the revision of the legal framework that defines the roles of the central banks. The banks have the main objective of ensuring price stability (Akhtar et al, 2009, p.34). The central banks also have the role of supervising the other banks and supporting the payment systems (Akhtar et al, 2009, p.35). One regulatory measure that has been adopted is to ‘improve the quantity and quality of capital…by raising the quality, consistency and the transparency of capital base’ (Europe Economics, 2010, p.17). To provide for this accountability and transparency, there have been legal reforms that advocate for accountability and budgetary independence of the central banks (Akhtar et al, 2009, p.35). The banks have been given some legal independence and have generally been given the power to develop their principles on monetary policies. Despite the independence, there is also a need for cooperation between the central banks and the government. There have been rules and provisions that like the central banks to the respective finance ministries (Akhtar et al, 2009, p.36). These are, however, not effective and have been violated in some countries. The governance structure at the central banks is essential to its effective performance and has been another area of development. Laws have been enacted that provides for the appointment and dismissal of the governors and the members of the board in a manner that shows transparency. The laws define the ‘independence of the internal and external audits’ (Akhtar et al, 2009, p.38). There is also monetary policy committee that has the mandate of developing the monetary policies. There are legal provisions for the appointment of this committee. Policies regarding interest rates, liquidity and leverage ratio are then addressed by the committee. Introducing a harmonized leverage ratio is another regulatory approach that has been set to be developed. The central banks have to develop international systems (Walker, 2001, p.99). There have also been moves to establish ‘measures to promote the build-up of capital buffers in good times that can be drawn upon in the periods of stress’ (Europe Economics, 2010, p.17). This is aimed at providing a build-up buffer to improve capital availability. Other regulatory measures include strengthening Counterparty Risk coverage, addressing the resolution regimes, making transformations on the accounting processes and checking the taxes or stability fees (Europe Economics, 2010, p.17). 4. Possibility of successes or failures The success of the regulatory mechanisms that are adopted in an attempt to recover from the financial crisis may well depend on the type of crisis that was experienced. There are basically three forms of crises that can be faced by firms. These are liquidity crises, solvency crises due to the previous losses, and the future profitability crises (Europe Economics, 2010, p.22). Liquidity crisis occurs when a firm has no enough cash to settle due payments. Such a crisis can easily be solved through borrowing in the event that the firm has assets that are valued above the liabilities and the condition is set to stay for a long time (Europe Economics, 2010, p.22). A solvency crisis occurs if a firm has liabilities more than the total value of the firm’s assets. The situation follows the losses that have been experienced by the firm in the past and poses a threat of continued trade by the firm. Unlike the liquidity crisis, this form of crisis can not be managed by borrowing (Europe Economics, 2010, p.22). It is often risky and often not permitted for a firm to continue trading when under a solvency crisis. However, in the event that the firm is confident in the future profitability, the firm may continue trading with a hope that the future profitability will restore its solvency. It can also be solved through recapitalization- putting in new capital into the business. On the other hand, future profitability crisis occurs if it is anticipated that there will be future losses more than the profits or that the profits will not be enough to settle the future due payments (Europe Economics, 2010, p.23). This situation can neither be corrected by lending nor recapitalization. The situation requires a quick liquidation by the firm and an increase on the future profitability expectations. Recapitalization will be a loss to the firm as it only temporarily delays the time at which the firm becomes insolvent. The different forms of crises will influence the regulatory bodies involved in managing them and the appropriate supervisory procedures. Simple situations can be resolved by a single institution while complex circumstances require that more government agencies be involved. The central bank in a given country is sufficient enough to resolve a pure liquidity crisis (Europe Economics, 2010, p.23). The solvency crises emanating from past losses may require that the firms obtain new capital from other competing financial institutions. This then calls for the involvement of competition authorities. The situation can also call for the involvement of the finance ministries in the event that the taxpayers’ money is to be involved in the recapitalization (Europe Economics, 2010, p.23). Besides, the anticipation of the future profitability crisis may require that a whole industry be restructured. There would be need to revise the policies like those providing for the security of ordinary deposits. In such situations, it would be appropriate to involve different government departments and institutions. In particular, the competition authority and industrial policy authority are appropriate in resolving the anticipated future profitability crises (Europe Economics, 2010, p.23). It is therefore apparent that the success of the regulation and prudential supervision will be influenced by the form of the crises that have been experienced. Practically, the crises that are witnessed are a mixture of the different forms of crises and this call for mixture in the regulatory approach that is given for the cases (Europe Economics, 2010, p.23). Besides, the institutions involved and the subsequent success of the regulatory procedures involved will depend on the scope of a given crisis. There are those crises that affect one firm or a group of firms in a small entity. There are those that affect several firms within a country or a number of countries. There are those that are widely spread and experienced globally (Europe Economics, 2010, p.24). The latter will require the involvement of the local bodies and the international regulatory bodies like IMF. The most commonly experienced crisis is liquidity crisis. However, the crises are always associated. Once a liquidity crisis occurs it is likely that solvency crises will also be experienced. It is then followed by anticipation of future profitability failures and the likely failures of regulatory mechanisms (Europe Economics, 2010, p.24). The development of regulatory response mechanisms after previous crises were greatly hindered by the poor resolution regimes and the lack of adequate liquidity measures for the bank depositors in case some misfortune occurs (Europe Economics, 2010, p.24). In this view, a successful regulation mechanism is one that addresses ‘the resolution regimes, supervisory response regimes, and liquidity requirements’ of a banking institution (Europe Economics, 2010, p.25). There is however, a feeling that the regulations that are currently available are sufficient and that any moves by the regulatory bodies will negatively affect the banking institutions (Benoit, 2011). Most governments have responded to the economic and financial crisis and the subsequent recession by increasing their borrowing and prompting their central banks to lower their interest rates (Kilmister, 2008). However, both the approaches have had some problems and are not likely to succeed in certain cases. The cost of bank bail-outs will determine the extent to which a government can borrow. Besides, it is likely that if governments borrow excessively, then interest rates in the central banks are likely to rise and the value of the currency lowered leading to an extension of the crisis rather than a solution (Kilmister, 2008). On the other hand, lowering the interest rates is also not appropriate. The central banks have little control over long-term interest rates and the private banking institutions do not always abide by the policies and regulations provided by the central banks (Kilmister, 2008,). It is also necessary that the central banks of different countries have a communication mechanisms and this may not be easy (Walker, 2001, 154).In essence, the government policy provisions have little effect on resolving a crisis resulting from low income earnings by a given population unless the other issues like unemployment and poverty are alleviated. Reference List Akhtar, S. (2010). Effectiveness of Central Banks and Their Role in the Global Financial Crisis: Case of Selected Economies. (Online). Available from: http://www.adb.org/documents/studies/central-bank-effectiveness/central-bank-effectiveness.pdf [Accessed April 9, 2011]. Benoit, D., 2011. J.P. Morgan's Dimon Warns about New Capital Rules. Financial Times. (Online). Available from: http://online.wsj.com/article/SB10001424052748704409004576146113406423184.html [Accessed April 9, 2011]. Europe Economics. 2010. Comments on the Future of Banking Regulation A Research Report. (Online). Available from: http://www.europe-economics.com/publications/bc_rs_thefutureofbankingregulation.pdf [Accessed April 9, 2011]. Kilmister, A., 2008. World Economy: The Economic Crisis and its Effects. (Online). Available from: http://www.internationalviewpoint.org/spip.php?article1581[ Accessed April 9, 2011]. Walker, G., 2001. International banking regulation: law, policy, and practice. London: Kluwer Law International. Read More