The Basic Nature and Extent of the Economic Crisis - Dissertation Example

?Contents 2 1Introduction 3 2Discussion 5 2.1The basic nature and extent of the economic crisis 5 2.2The chief factors that led to the economic crisis 7 Lax financial policies 10 2.3Lack of financial supervision and regulation 14 3Conclusion 18 Bibliography 19 Abstract The economic crisis of 2007- 2008 is an archetypal study on the failure of the existing financial regulatory mechanisms that led to the collapse, and the rapid spread of the crisis globally. This crisis, which started within the banking sector, occurred mainly owing to the lackadaisical nature of the regulation on the money lending processes adopted by the various banks. In UK, this financial crisis resulted owing to many incidents (the causal factors) that had occurred simultaneously, all of which contributed to this disaster. The primary factors that led to this economic downturn were the failure of the FSA to appropriately monitor various financial transactions; the failure of the Tripartite arrangement for financial stability amongst Treasury, the infirmity of liquidity management within the Bank of England, a lack of commensurate provisions for deposit insurance, and a banking sector with exiguous regulations for insolvency. This article will examine the nature of this economic crisis with special focus on exploring the contention that the FSA was major factor in causing this market crash owing to its policy of non-intervention where it did not do enough to prevent the 2008 financial crisis. 1 Introduction The financial crisis in 2007-09, which is the worst economic downturn since the times of the Great Depression, initiated in the US sub-prime mortgage market, from where it spread across the globe at an unprecedented rate, affecting almost all the markets in the world (Mohan, 2010, 3). In early 2007, the US investment banks and the mortgage backers operating within the sub-prime mortgage markets started feeling the tremors when they faced problems from the defaulting debtors who were failing to repay their loan owing largely to the spiralling interest rates. Soon these financial institutions comprehended the extent of their debt and the overshooting of their limits (Cable, 2009). This ripple soon spread to Europe, and in 2007 in UK, the Northern Rock faced with market liquidity crash, and failing to find any private takers was finally nationalised by UK government (Ibid). In US, the Federal Reserve started lowering the loan interest rates in order to avoid large-scale financial defaulters in the market. Despite this, by 2008, there were a large number of cases of failed banks, starting with the insolvency of Bear Stearns, an investment bank. This was soon followed by large-scale bailouts of the mortgage backers by the US government, for well know financial institutions like, Freddie Mac and Fannie Mae (Gamble, 2009). Within one year, by early 2008, it was evident that the financial crisis was not limited to just the subprime mortgage markets, but had affected the entire financial system (ibid), and had been primarily caused due to the manner in which financial debts were converted into an intricate web of various securities, and then traded with other financial institutions (ibid). Thus, what had started as a small crisis within the housing mortgage market, transformed into a catastrophic banking disaster, seriously affecting primary the financial systems of US and Europe (both at domestic and international levels). Though the crises the global in nature, it was noticed that despite the Asian and LATAM emerging market economies (EMEs) suffering bad setbacks from the crisis, the basic financial system of these countries remained comparatively stability. The economic crises failed to affect any of fundamental financial institutions in these countries, thus making the economic downturn as being more of a North Atlantic financial crisis instead of a global one. A press report in 2007 stated that it was necessary "to draw up radical proposals to improve transparency in financial markets and to change the way credit rating agencies operate in an attempt to prevent any recurrence of the financial turmoil arising from the credit squeeze…[and] for tighter regulation of unregulated entities that generate loans and then pass on the risk to others” (Barber, EU plans market reforms to avert crisis, 2007). Here we find the mention of the issues of inadequate market regulation and a lack of transparency, which are generally counted as the basic reasons for failure to avert the economic disaster (Mohan, 2010). The financial crisis changed the perspectives within the field of financial market regulations and brought in the notions of more stringent measures for greater control by the government, and other financial regulatory bodies. As Gamble comments, ‘the argument that better regulation might have avoided or moderated the crisis has some force since there was nothing inevitable about the rush to deregulate” (2010, 7). Observations have revealed that countries like India and Canada had regulations that were more stringent for monitoring their financial systems, than UK, Ireland, and USA, and the two former countries were less affected by the financial crisis than the latter three countries (ibid). This article will study to find out as whether the financial regulatory bodies in UK (the FSA) did indeed fail in its supervisory role to avoid or minimise the effects of the economic downturn in the country. 2 Discussion 2.1 The basic nature and extent of the economic crisis The severity of the crisis could be realised when we find that the average annual GDP growth rate that was constant at 4.1 % between the years 2001 and 2008, fell sharply to a -0.6 % in 2009 (the aftermath of 2008 economic downturn) (Horton, Kumar and Mauro, 2009). In the initial period, there were some speculations amongst the mortgage bankers about the actual value of their equities represented in their books. Such speculations and subsequent studies revealed that “a gigantic paper mountain of debt had been erected on tiny capital bases and expectations of infinite growth in financial markets…[and] once these foundations were called into question, the entire edifice crumbled” (Bernhagen, 2010, 4). The catastrophe soon started with the bankruptcy and failure of the Lehman Brothers (US) in 2008, one of the most famous global investment banks, after support was denied from the US government. This led to a complete panic situation in the market, and forced the various State governments to step in, and support the financial institutions from going the Lehman way. This rapid intervention by the UK and US governments and other developed nations, using the processes of underwriting and nationalisation of many of the premier banks saved these institutions from the verge of bankruptcy and subsequent collapse (ibid). By late 2008, the crisis that began in the mortgage sector rapidly spread to the ‘real economy’ via inflations in the general price sector (primarily in the energy and food sectors), decreased liquidity values, and a contraction of the entire economy, as in UK. Countries like Ireland with an economy that was financially more exposed, rapidly felt the full blow of the crisis, and moved very fast into recession (Bernhagen, 2010). To avoid further spiralling into the downturn UK government “announced the use of ‘quantitative easing’, including setting interest rates to under 1 % to increase the money supply and counteract deflation. The rises in liquidity, asset relief funds, nationalizations, and other quasi-Keynesian responses [that] hoped to spark an early recovery…put unprecedented strains on public finances – in UK, more than in other developed capitalist countries” (Bernhagen, 2010, 4). The problems related to the economic crises that we discussed in the above section refers mainly to the industrialised (developed) nations, since the emerging markets or the developing nations did not face the major brunt of this crisis. A number of microeconomic and macroeconomic systemic failures that were occurring simultaneously created this crisis in the UK economy (and elsewhere). The general microeconomic failures, as regards the worldwide economic crises, were associated with the limits set for adequate Basel capital requirement; capricious securitisation within the financial sector; basic defects in the economic model followed by the rating agencies; the ‘procyclical’ aspects of the ‘marked-to-market’ ascendency (Adrian, & Shin, 2008). Besides these, other factors included were the existent system of disintermediation (that does not work in the real social context); and the widespread global de-regulation to facilitate economic competition, which helped in bringing about the crisis (Bernhagen, 2010). In UK, the situation was further exacerbated by the fallacious tripartite deal between Financial Services Authority (FSA), Bank of England, and the Treasury, for handling economic crises; a complete failure of the FSA to adequately supervise the financial transactions and dealings; and grave defects within the financial policies that were liquidity based and the discount window operations of the Bank of England (Buiter, 2007). The flaws in the Bank of England were due to miscomprehension of “the nature and determinants of market (ill)liquidity, [its] unique role in the provision of market liquidity…and of the conditions under which there is a trade-off between moral hazard…and the ex-post provision of liquidity to (a) markets and (b) specific individual institutions” (ibid, 1). The macroeconomic factors comprised of the fact that the two global leading banks the Federal Reserve and the European Central Bank both opted for creating excessive liquidity that was further bolstered by the fact that many developing nations and the countries that held the world oil and gas supplies decided to restrain their currency enhancement, versus US dollar rates. Another additional factor was the entry of many developing countries into the global market like China, India, and Brazil (that had high-saving economies), resulting in a redistribution of global wealth. In this context, we will closely examine the factors to ascertain various improper monetary transactions that took place right under FSA’s supervision, and reflecting its inadequacy in preventing these risk activities that finally led to the market crash of 2007-08. 2.2 The chief factors that led to the economic crisis Arbitrary securitisation within the investment banks: The term securitisation usually refers to the apportioning of related securities issued for the same transaction (with some additional attributes to make it more lucrative), against some underlying cash flows or assets. Here the higher ‘tranched’ part gets a priority, and allows it get a higher credit rating than the “average of the assets backing all the tranches together” (Buiter, 2007, 3), like the insurance offered by the financial institutions (‘monolines’) against default risk, especially prevalent in the US market. This process came into being during the 1970s, when Ginnie Mae (Government National Mortgage Association) and Fannie Mae (Federal National Mortgage Association) started offering securitisation for residential mortgages. There two forms of securitisation: the cash-flow securitisation that stared when the UK government permitted the formation of the ‘International Finance Facility’ aimed at securitisation of all liabilities for future developmental assistances; and asset securitisation refers to the sale of assets that tend to initiate income like car loans, or trade receivables, to a special purpose vehicle (SPV). This process became extremely popular with the private banks, where they used it to transform their ‘illiquid loans’ into liquid assets. The process thus, made non-marketable assets saleable in the market while the illiquid assets were transformed into liquid ones, and along with it came into existence a wider berth for risk trading, variegation, and hedging. During the last decade, there were unprecedented increase in the securitization of securities and various other associated subsidiaries (Yellen, 2009). This is evident when we find that within two years, between 2001 and 2003, the Residential Mortgage Backed Securities or RMBS increased its issuances by almost US $ 1.4 trillion, which was justified by stating that it works towards alleviating risks associated with the banking system. In April 2006, the IMF’s in its report also stated that this mode of credit securitisation would help to “mitigate and absorb shocks to the financial system” thus, resulting in “improved resilience [and] fewer bank failures and more consistent credit provision” (Global Financial Stability Report, Chapter II, 2006, 1). In reality, however what happened was exactly the opposite of the sentiments expressed in the IMF report. When securitization turns illiquid credits into liquid assets, it theoretically disseminates the risks while also alleviating the need for financial capital for the banks, and along with it, there is a lack of motivation to supervise the loan risks within various basal assets. With the securities, being seen in terms of liquid measures for short-term investments, they were soon resourced by liabilities that were extremely short-term in nature, (some were even overnight investments) and such risk activities by the various banks increased over the years without any intervention of the IMF or FSA (Mohan, 2010). A large section of this securitized loan assets were seen to be in leading banks and other financial institutions, thus, the risk instead of spreading out, became more concentrated. There were elevations in the levels of systemic risk and a large part of these operations took place in the opaque manner in unlisted securities, within the arena of the alternative investment market in LSE, and caused a great deal of swing in the market prices (ibid). It was thus a “complex chain of multiple relationships between multiple institutions” (Turner Review, 2009) which resulted in a greater risk of cascading failure, within the entire financial sector, if one operating system failed. Additionally there were more dangers arising from the point that the aspect of risks associated with liquid assets were not clearly understood, and the investors merely took for granted that the present form of liquid market would never cease to exist, giving rise to the presumption that securitization would involve less risk than the long-term illiquid loan assets (Mohan, 2010). All the opaque proceedings that took place under FSA, yet there were no action taken by the body to alert the institutions to the impending danger, owing to ‘light-touch’ non-intervening way of operating. “Thus, when problems arose in these markets and prices were not visible, valuation of the assets of banks and the shadow banking system became unobservable. Consequently, trust and confidence evaporated and markets froze” (ibid, 11). Lax financial policies Amongst the various factors that affected the economic downturn of the 2007-08, the role of lax financial policies in the developed nations (like UK and US) forms to be a major one. For the past few decades, this trend in capital flow has been seen where first there are lax monetary policies within the economies of the developed countries, usually subsequently followed by a tightening of the policies that again led to reverse capital flows (Mohan, 2010). It was observed in all the past instances in the last three decades, where there had been excess liquidity in the market, it were the developing economies that faced the financial crises (Committee on Global Financial System 2009). However, this time it was the developed nations, which form a part of the North Atlantic economy, and which faced the brunt of the 2007-08 market crash. When there are lax financial policies and poor interest rates that are continuing for a long period, there is a tendency to naturally search for “yields leading to outward capital flows in search of higher yield” (ibid, 6). Something similar occurred during this economic recession (2008), where the financial policies being lax for some years in countries like UK and other industrialised nations. Furthermore, with the outward flowing of the capital that went in search of higher yields, there was a large production of liquidity assets, which led to a surge in financial diversification within these nations, for obtaining internal higher yields. This paved way for many of the financial irregularities that were frequently observed during this time (and to which the FSA or IMF failed to show any reaction and intervene timely to warn and stop the ‘illegal’ processes) resulting in the 2008 global financial crash causing heavy losses to the developed nations’ economies. As the situation became more complex, the financial institutions that were more intent on controlling the Consumer price index or CPI, or the core inflation rate of the country, and without any forewarnings from the behalf of the FSA or IMF, the banks felt safe, as there were no visible disturbances or increase within the CPI or basic inflation rates. They remained unreactive to the sudden surge in the asset prices (like increase in real estate prices), and the sudden increase in the commodity cost prices that were supply actuated (ibid). Thus, even though the signs of danger were clearly present, no heed was taken, finally leading to the major economic crisis. Creation of a surfeit advantage in the market, owing to reiterating economic crises: Within the financial sector, the history of banking and economic crashes has co-existed for a long time, with each supplementing the other (Reinhart and Rogoff, 2009). At any point of time, the liquid asset markets are prone to be susceptible to the small variations in the market mood, and may result in significant deviations from the realistic balanced prices. Here it must be noted that the fluctuations in credit markets tend to show greater consequences than the fluctuations equity values, unless the latter has investments from loaned resources at a great leverage (Mohan, 2010). Almost all economic crises have one particular feature in common, which is the creation of a surplus advantage (leverage) within the financial system, which is invariably followed by the breakdown of the financial bubble created from such leverage (Kindleberger and Aliber, 2005). Here, it is particularly noteworthy that such high leverages (an almost sure-shot sign of impending financial disaster) were accumulating for a quite some time, prior to the recent 2008 global economic crises, yet the regulating and the supervisory bodies like IMF or FSA failed to ring the warning bell. The excess advantage managed to accumulate over some years even though there was a consensus that had evolved through the Basel process, on the necessity for creating a suitable capital level required in the banks in all developed and developing nations (Mohan, 2010). Furthermore, there was a highly developed form of ‘financial risk management’ created within majority of the large financial institutions, during the time of the unprecedented and abnormal fast growth in the global economy (both in extent and in the intricacy of the financial systems). This resulted in certain negative points. “First, because of the perceived increase in sophistication in the measurement of risk, high quality risk capital in large banks could be as low as 2 % of assets, even while complying with the Basel capital adequacy requirements. Second, large financial institutions could maintain lower high quality capital because of the assumption that they had better risk management capacity than smaller less sophisticated institutions” (ibid, 9), which led to the downfall. Additionally majority of the developed economies like that of UK and US showed rising preferences for financial deregulation within their operating financial systems, leading to growing intricacies within the operations of the existing financial institutions. Soon there were financial groups that began to bring all the different financial operations under a single roof, and soon activities like proprietary trading, brokering, insurance, banking, asset management, all were performed by the same financial invitation, under one roof. It resulted in scanty depreciation and incorrect comprehension of the level of the rising risks, both internally within the financial institutions and externally within the national financial systems (ibid). The system of the emerging shadow banking operations The complex situation within financial markets during the 2007-08 period were further exacerbated by the gradual rise of the shadow banking system that was not regulated, and removed assets from the balance sheets of the financial institutions hence alleviating the capital requirements of the banks. Greater focus on the capital sufficiency in banks however created a financial system that was poorly capitalized, and it was the intricate nature and scale of the various transactions that took place within the intra-financial sector, that surged in the last free years. This is evident when we see that the emergence of the global credit derivatives grew to around US $60 trillion in 2007 (from being nil in 2001). The commerce in oil futures grew to around 1000 million barrels in 2007 from 300 million barrels in 2005, which was actually 10 times more than the oil actually produced (Turner, 2010). Thus, we find that it is very clear that the economy was actually serving its own needs, rather than serving the actual economic needs of a nation. As the financial sector showed high growth rate and high profits, there was not much work done towards the betterment of the various non-financial sectors, which was the main purpose of its activities. The levels of compensation within the financial systems surged drawing in talent from various other sectors of the society. Soon the liability of the financial institutions moved to such heights or levels that they crossed the GDP of many of the economies of the major developed countries. In UK, it was seen that the debt within the financial sector surged a 40 % of the GDP value (1987) to a 200 % GDP value in 2007 (Financial Services Authority, 2009). However, using securitisation of credits and removing the risks from the balance sheets sort of backfired and the risks came back within the realms of the banking operations, so instead of minimising the risk value of the intricate securitization processes and its derivatives, it only worked towards to elevating the risks. It was also becoming increasingly tedious to locate the exact nature and location of the various risks involved. Thus, from the above section, the various inefficacies within the financial systems prior to the economic crises of the 2007-08 clearly shows the growing trend towards greater risk taking within grey zones where there no clear regulations. The various regulatory and supervisory bodies like FSA and the IMF did not pay much attention to the on-going irregularities practiced rampantly by the various financial institutions, owing primarily to their policies of non-intervention and light touch. 2.3 Lack of financial supervision and regulation After the 2007-08 economic fiasco, much of the discussion now pertains to the nature of the existing and future financial supervision regulation and supervision. This is reflected in almost all the major reports, official and non-official, that explored this global economic crises, the largest since the Great Depression (Commission on Growth and Development, 2010; de Larosiere Report, 2009; G-20, 2009; United Kingdom, 2009; Warwick Commission, 2009). A common theme within all the reports reflect the recognition of the fact that the adequate regulation and supervision by the various bodies like the FSA or IMF within the economies of the developed nations were far relaxed (than necessary) in the past few years. Apart from this, there was also basic misunderstanding of the various processes used in the in appropriate financial regulation. It was assumed by most of the experts that that the regulation of the aspects of micro prudential and the supervision each separate financial institutions would keep the system stable, and it was not taken into account the negative effects arising from the various negative externalities. The Turner Review (2009) proposed certain rectifications in this regards, which are: “At the core of these assumptions has been the theory of efficient and rational markets. Five propositions with implications for regulatory approach have followed: (i) Market prices are good indicators of rationally evaluated economic value. (ii) The development of securitized credit, since based on the creation of new and more liquid markets, has improved both allocative efficiency and financial stability. (iii) The risk characteristics of financial markets can be inferred from mathematical analysis, delivering robust quantitative measures of trading risk. (iv) Market discipline can be used as an effective tool in constraining harmful risk taking. (v) Financial innovation can be assumed to be beneficial since market competition would winnow out any innovations which did not deliver value added” (Turner report, 2009, 30). From a study of the nature of the 200708 economic crises, there are certain points that one must focus on (as regards the UK economy) to avoid repeating the same errors. It was very clear that the tripartite arrangement was a complete failure, and the chief problem in this deal was that the information on the banks was located within the FSA, which is different from the agency having the monetary resources (liquid finances) to assist a bankrupt bank for a short period (as in the Bank of England case). As Buiter observes in this paper, “this happened when the Bank lost banking sector supervision and regulatory responsibility on being made operationally independent for monetary policy by Gordon Brown in 1997 (Buiter, 2007, 18). Thus is very clear that a separate body for storing information and a separate body for providing resources fail to work during times of emergency. The FSA failed in its supervisory role of predicting the bankruptcy of the Northern Rock, and failed to detect the risk associated with the economic model followed by Northern Rock’ for its funds allocation (ibid). Thus, the much publicized ‘light touch’ model of the FSA regulation (based on socio-economic principles) turned out to be a complete failure. As regards this FSA malfunctioning we find that Hector Sants, Chief Executive, FSA says that the failure arose mainly owing to the fact that the “‘old-style’ FSA rarely intervened until there was clear evidence that something had gone wrong.  It was a retrospective form of regulation.  Intervention needed to be based on observable historical facts. The old approach was never going to stop firms making mistakes, as that was not its intention...The old FSA’s reactive philosophy focused on ensuring firms had the appropriate systems and controls.  Judgements were rarely made on the consequences of management actions” (UK Financial Regulation: After the Crisis, 2010). Here it clearly stands out that the problems within the basic operating principles of the FSA at the time of the crisis were flawed and thus it did not allow it take any proactive part in diverting the economic crises. In this speech various other defects in the FSA operation at the time of crises were also highlighted, which were: “Traditionally FSA’s approach to conduct was, as with prudential, essentially reactive.  Too often, it focused on high-level systems and controls analysis merely reacting to crystallised risk and consumer detriment.  It also focused, as has been the approach across Europe, on disclosure, sales processes and suitability.  Both elements thus avoiding product and price regulation” (ibid). These forms of an approach were invariably associated with certain problems. The most important problem was the inability to locate and the failure to avert the impending risk from actually materialising, thus causing large-scale damages to the consumer and the domestic market. Levying fines and or publishing business reviews on certain risky situations did not act as a warning, nor did they act as a deterrent for the erring financial institutions, thus, proving the inefficacy of FSA as a supervisory body. It was late in identifying the factors that led to the crash and also failed to serve the necessary warning to the institutions that had taken part in the massive irregularities within the UK financial systems that later proved to be harmful for the consumer and national economy of the country.  Here Hector Sants admits, “Our Treating Customers Fairly (TCF) initiative, a key element of our retail agenda from 2004/05 onwards, did acknowledge that it is preferable to prevent substantial failures occurring.  However, its implementation essentially relied upon the ‘old-style’ supervisory approach that focused on senior management equipping themselves with the right systems and controls.  This therefore remained a reactive approach…[and] not yet delivered substantial on-the-ground benefits to consumers” (ibid). From a study of the various available data, it stands out very clearly that the FSA did indeed fail in its supervisory role to avoid or minimise the effects of the economic downturn in UK. This was primarily owing to its policy of non-intervention, and ‘light touch’ regulatory operating principles that did not allow it to do enough to prevent the 2008 financial crisis. 3 Conclusion From the above discourse, it is very evident that the examination of the conditions that triggered the global financial crisis has set about a new line of thought on issues pertaining to financial policies and financial regulation. Prior to the crisis, it was seen that the framed governmental policies and the systems for financial regulation under FSA, had become rather theoretical and too much formula oriented, thus too easily foreseeable for ‘real’ market operations. The existing policies and regulatory frameworks that primarily aimed at controlling high inflation rates, fell short of protecting the market from the disastrous economic situation, thus bringing forth the necessity of integrating financial policies and the activities of the financial regulatory bodies like FSA, more closely. From the economic crises, it was also revealed that the prior to the crisis “the FSA rarely intervened until it was clearly evident that something had gone wrong. Intervention needed to be based on evidence that risks had crystalized” (Pain, 2010). This ‘light touch’ by the FSA did not stop the financial institutions from making mistakes, since it did not function through intervention. This non-intervention made the FSA liable to take the blame for failing to avert the risk, even though the then prevalent socio-economic theories and notions had worked to create the FSA norms. The financial world is prone to herd like mentality, risk activities, and moral perils that require persistent regulations with stronger interventions from the supervising body, to keep financial disasters at bay. Despite the various precautionary norms and supervision sometimes situation may arise as such that cannot be viewed correctly under these two aspects, then it becomes essential for the concerned authorities and the financial regulators (under FSA) to use their own expert judgements to find a route out from any future financial risk situation. However, it must be mentioned that simply monitoring and regulation by the UK government and the FSA will not work, and there must be in place proper measures for enforcement of obtrusive and pro-active form of supervision, where administration (government) must competently modulate, and the overseer (the FSA) must adequately supervise to anticipate any financial crisis, beforehand. 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