Reforms in the International Finance System - Essay Example

Reforms in the International Finance System Introduction The financial crisis or great recession as it is called in some quarters is probably the worst financial catastrophe after the Great Depression in the 1930s. The global financial crises typically led to the subsiding of many financial institutions all around the world, crumpling of stock and financial markets globally and bailouts of financial institutions by governments. The real estate market was also affected significantly, often resulting in evictions and foreclosures. Companies all around the world initiated downsizing mechanisms to stay afloat, which led to massive unemployment as millions of people lost their jobs globally. It, therefore, goes without saying that consumer wealth declined. It is estimated that declines in consumer wealth led to loss of millions of US dollars. This led to an acute global financial recession in 2008. Economies of individual countries, as well as that of the global economy, plummeted during the financial recession, as a result, declines in international trade and credit crunches in major financial institutions globally. This paper will examine the global financial recession of 2008, describing its causes, effects and reform proposals such as removing some virtual assets, lowering speculation in financial markets and creating a special financial institution to boost companies. The financial crisis took a major toll on the global financial position it is, therefore, imperative to institute reforms to deter its reoccurrence. The Start of the Financial Crisis The global financial crisis did not occur over night; rather it was a series of occurrences that led to the progression of the crisis, which impacted the entire world. The US National Bureau of Economic Research asserts that the financial crisis began in early to mid 2007. The most notable start of the financial crisis was the marketing and sale of US mortgage-backed securities that had risks, which proved difficult to assess. This marketing took place on a global basis that saw risks being spread out to all areas of the globe. In addition, a comprehensive credit boom exemplified the international speculative bubble witnessed in industries such as the real estate and equities industries of the global economy (IMF, p. 23). This further enhanced the risky practice in terms of financial institutions’ lending capacities. Drastic increases in global food and oil prices also served to enhance the precarious financial status of the world. However, the financial crisis actually began following the surfacing of sub-prime loan losses in 2007. This uncovered risky loans and the over-valued asset prices. As loan losses increased, as well as the collapse of Lehman Brothers, a global panic broke out in the inter-financial institution loans market. When share, as well as housing prices, eventually declined, a majority of financial and investment institutions in the US incurred massive losses, with some even facing bankruptcy. This ultimately led to major public, fiscal assistance to the tumbling institutions. The global financial crisis led to a sudden decline in international trade, massive unemployment and collapse of global prices of essential commodities. In summation, the situations that led up to the financial crisis include the boom in demand for financial instruments, excessive rise in asset prices, all of which were compounded by lack of sufficient regulation. The financial crisis subsided in late 2008, but the global economy has experienced several aftershocks. Reason behind the Financial Crisis The reason behind the global financial crisis is a complex combination of liquidity and valuation issues in the global banking sector in the year 2008. In the US, in year 2007, the global economy experienced a boost following the emergence of a real estate bubble in residential markets. The real estate bubble refers to a scenario where real estate is sold at highly inflated values. The 2007 real estate bubble was characterized by speedy increases in the prices of real property up to levels that became unsustainable thus resulting in major declines. The bursting of this real estate bubble as property valuations rapidly rose, and fell is a practical cause of the global financial crisis. This is because as the prices of real property value in the US fell; the prices of securities tied to these real properties also fell thus damaging financial institutions all over the world. Banks’ solvency became unstable as crash downs in credit availability resulted in lower investor confidence, and this had major, negative effects on the global stock markets as securities traded in these markets incurred massive losses in 2008, as well as early 2009 (IMF, p. 15). As a result, of these detrimental effects on the worldwide economies, different governments and monetary institutions such as central banks responded to the financial woes through monetary policies and financial stimulus strategies that involved the integration of bailouts in government policies (Currie, Nathan, Greely and Courvalin, p. 46). While some speculate that the financial crisis may have been a natural calamity, the accepted logic is that the global recession was as a result of intricate financial products and high risk taking tendencies in the real property sector. With regard to the complex financial products, it is imperative to note that financial institutions may have suffered greatly as a result of having hidden conflicts of interest with regard to their support of the real property bubble, failure of regulators to establish, implement and enforce viable measures to tackle financial problems before they got out of hand. However, credit rating agencies, as well as the market itself are also to blame for the financial crisis or its magnitude. For instance, the US Securities and Exchange Commission issued a statement to the US Congress citing it worries that anti-competitive practices conducted by credit rating agencies, as well as the latter’s conflicts of interest with regard to determining credit worthiness, could have exemplified the financial crisis of 2008. The markets such as Wall Street are also to blame for the financial crisis as they thrived on the excesses of the real property bubble without considering the implications of such actions. Investors, as well as credit rating organizations, did not correctly set a price on the risks concerned with mortgage-related financial products. The governments too did not amend their regulatory practices to accommodate the financial markets of the 21st Century. Before the financial crisis, the Glass-Steagall Act of 1933 was in force. The act, to all intents and purposes, got rid of the disconnection that formerly existed between depository banks and Wall Street investment banks (Currie, Nathan, Greely and Courvalin, p. 98). However, following the financial crisis, regulatory solutions, as well as market-based solutions have been debated or implemented. The following section examines three key reform proposals that are effective in reducing the occurrence and extension of the financial crisis. Remove Some of the Virtual Assets  Virtual assets essentially refer to non-physical objects that are sold or bought for use in the online communities. Virtual assets are considerable sources of growth and funds. Investment in virtual assets is growing rapidly in members of OECD (Organization for Economic Co-operation and Development). Moreover, in some instances, investments in virtual assets exceed investments in traditional asstes such as real property, equipment and machinery (IMF, p. 59). Increased global competition, advances in ICT, the growing essence of the global services sector and formulation of new business models are all factors have augment the importance of virtual assets to individuals, corporations and national economies as a whole. The global recession gave new focus on the effects of accumulation of virtual assets on growth of economies. Concerns are rife that the financial crisis may have undermined financing of investments in virtual assets. While most entities acknowledge that virtual assets are key in the development of emerging economies as they facilitate value-added activities such as important technologies that improve production and manufacture, it is paramount to note that the high quantity of virtual assets in the market could also be detrimental to growth as high numbers of virtual assets in the markets enhances financial crisis. Virtual assets, which are also referred to as intellectual assets, intellectual capital or knowledge assets, primarily focus on software, research and development within companies, as well as key personnel. However, the capacity of virtual assets is quite large as it encompasses a number of classifications. For instance, some of the most common types of virtual assets are the computerized information such as databases and software; innovative property that include scientific and non-scientific research and development. These include designs, trademarks and copyrights; and economic competencies such as human resource capital that is tailored to suit the firm’s needs, different aspects of advertising and marketing, networks that link people and institutions and organizational knowledge that aims at improving organizations’ efficiency (Gorton and Rouwenhorst, p. 219). As earlier cited, in many countries all over the world, investment in virtual assets shows faster growth than investment in tangible assets. For example, in the UK, investment in virtual assets has more than doubled between the year 1970 and 2010. In addition, in the US, recent ratio studies show that investors have invested between $800 billion and $1 trillion in virtual assets in different markets. The stock of virtual assets (intangible assets) in the US market is currently as high as $ 5 trillion. In most countries, the ratio of market value of assets to the actual value of assets has grown exponentially over the last few decades. As a result, of the increased demand for virtual assets on the global front, a considerable quantity of exports is directly tied to investments in software such as product design. While the essence of virtual assets is immense, the quantity of these assets within global markets is detrimental to curbing the financial crisis and reducing the chances of its resurgence. High numbers of virtual assets distort capital markets as these resources may not be accounted for in the company, as well as country assets. This, in turn, influences the financial position of the company or country. Pricing virtual assets is a relatively complex process compared to pricing tangible assets. This means that credit rating agencies may have insufficient information regarding organizations, which could, in turn, have detrimental effects on the organizations’ credit rating. Credit rating plays a vital role in financial institutions as it offers a benchmark to determine credit worthiness. In order to enhance financial sustainability by deterring the occurrence or resurgence of financial crisis, policy makers should remove some of the virtual assets traded at capital markets. Virtual assets such as design and copyright can be scrapped from the list of virtual assets tradable in markets. This is bound to allow for simpler allocation of investment resources in markets as more persons invest in traditional tangible assets (Gorton and Rouwenhorst, p. 225). Removing some virtual assets could also mean that companies, and ultimately countries improve their employment rates as functions previously conducted by machines that are conducted by softwares will become phased out. This means that unemployment rates will plunge globally, and customer wealth will improve. As noted earlier, a substantial cause of the global financial crisis was lowered customer wealth as a result of massive unemployment. Therefore, reforms that uphold the removal of some virtual assets are warranted in order to save global employment opportunities. Some viable alternatives to virtual assets include machines that require human energy for operation. Another reason to endorse removal of a number of virtual assets is because companies engage in fraudulent financial reporting with regard to the value of their virtual assets. This means that most organizations understate the value of their virtual assets to escape paying hefty taxes. Reforms should also be established to mandate companies to include virtual assets in their final financial statements, which are submitted to the tax agencies for proper taxation. Such a measure is bound to reduce the purchase and investment in virtual assets, thereby enhancing investment in tangible assets and, in turn, enhancing financial viability of the company or country. Virtual assets encompass a higher degree of risk compared to tangible assets. This signifies that investors of virtual assets could suffer massive losses thus affecting not only their individual economies, but the entire nation’s, as well (Gorton and Rouwenhorst, p. 209). In addition, firms that exclusively use virtual assets encounter limitations with regard to potential investors. This is because most investors are attracted to companies that own massive amount of tangible assets rather than intangible ones. For instance, an investor is attracted to a company that owns large amounts of tangible assets such as machinery, real estate and equipment rather than one that owns highly prices virtual assts such as product designs. This is detrimental as investors are a key source of finance for companies, as well as countries. Therefore, if companies’ virtual assets repel investors, the entire nation suffers, and this could result in another financial crisis. In order to ensure the removal of some virtual assets in the market, the government should establish thorough supervision of financial and capital markets, especially by putting a cap on the quantity of virtual assets being traded in these markets. Reduce Speculation in Finance Market (Actual Procedures and Definite Actions)  Speculation refers to the action of assuming risk with the hope of gaining, while at the same time acknowledging the likelihood of loss. Speculation entails higher risks as it does not guarantee safety of the investment together with the return of the principal invested amount. Speculation also refers to the act of providing funds to facilitate the purchase of assets, debts and equities but in a module that is not thoroughly thought through. This translates to high risks as margins of safety of loss of the initial investment are high. However, speculation is not entirely negative as it sometimes brings high returns on investment, but the greatest issue is the amount of risk involved in speculation. For example, a person or company that enters into positions in a futuristic market rather than entering positions in a current market is considered to be speculating. Such practices are done to diminish the likelihood of suffering financial loss due to adverse shifts in prices. Another appropriate definition for speculation is the act of purchasing or selling futures instruments as temporary alternatives for cash-based transactions that are bound to take place at a later day. Speculation can take place through two distinct practices. These are: first, one can take on a log cash market position, which entails one’s ownership of the cash commodity in question or, secondly, short cash market position that entails one intention to purchase the cash commodity at a future date (Brunetti, Cand Buyuksahin, p. 124). According to the Commodity Futures Trading Commission, a speculator is an entity that is not cautious, but rather engages in trade with the aim of realizing profits as a result of successfully participating in price movements. Speculators, therefore, refer to entities that do not trade with the sole purpose of evading risk. Governments, as well as international trade governing bodies such institute measures aimed at reducing speculative behavior in financial markets in order to reduce the occurrence of unnecessarily risky situations such as the ones witnessed during the global financial crisis. Prices and price instability of most of the essential commodities are crucial matters to countries and their economies. For instance, perhaps one of the most essential commodities that are most volatile is energy. Energy prices, with regard to oil and other fuel prices is of substantial importance to most economies globally. These prices are also a significant determinant of household budgets in developing, as well as developed counties. In addition, the prices of essential food products like corn and wheat are essential to budgets in countries and the global economies. The prices of all these commodities is critical not only to direct and indirect consumers of these products, but also those who choose to invest in these commodities through, for instance, investing in oil exploration or alternatives to oil or planting more of a certain commodity. These decisions are often based on speculative tendencies as investors make decisions relative to prevailing and anticipated prices. An interesting question, therefore, emerges seeking to discover what drives the prices of commodities and whether or not price volatility of certain items is excessive. This issue is of major concern to policy makers, businesses, financial markets and non-governmental organizations. Observers of financial markets assert that there are two theories that affect the prices of essential commodities, and which promotes speculative behavior. Firstly, economic factors are bound to influence the prices of key commodities. These factors include market factors such as demand and supply, which have a proportional impact on prices. The second factors are purely financial, especially financial factors of futuristic markets. Future financial factors are independent of physical trades currently taking place and which distort prices in unnatural ways. Within the scope of speculation, there are different types of entities that participate in the risky affair and who have distinctive objectives for speculation, as well as different time scales for their speculative tendencies. For example, collective investment plans and index funds seek to replicate the progress of commodities market and tend to maintain long positions for long time lines, while some participants of managed money ventures only hold their positions for a few minutes. There is another set of speculators who participate in illegal manipulation of markets through hording of commodities, which aims at pushing up the prices of commodities. Index funds, as well as other financial schemes, have been growing over the last few decades. It is apparent that these major financial flows have significant impacts on future prices as long-only commodity futures commodities have grown to nearly $375 billion currently. The decisions by investors to invest in speculative markets affect prices as it is known to drive prices. Investors in long-only commodity futures typically invest in diversified portfolios in a rather non-active manner instead of basing such investment on short term commodity price movements (Brunetti, Cand Buyuksahin, p. 163). In most instances, index funds and other investor pools typically invest their clients’ funds in more than twenty different futures commodities. It is clear that these speculative activities have negative effects on the global financial standing as futures investments abnormally increase the prices of commodities in the global market. For example, if many speculative investors invest in futures oil, the price of this essential commodity is bound to rise hence impacting the rest of the world. Because rapid increases in essential commodity prices are detrimental to the global financial standing, it is paramount that speculative behavior in financial markets is kept minimal. This can only be done by governments and international trade organizations establishing measures and policies to limit the quantity of speculative purchases in financial markets to deter the occurrence of another global financial crisis. Before the incident of the financial crisis in 2008, real commodity prices rose dramatically, and fell precipitously in 2009 before resuming their increase to levels that are almost equitable to those of the pre-financial crisis era (IMF, p. 96). Such dramatic movements in the prices of essential commodities accelerates financial crisis, as was the case in 2008. Avoiding a repeat of such occurrences requires joint action from governments all over the world. This can only be done through the establishment of robust supervision of financial firms, index funds management firms and other investor pool institutions. A new global financial services oversight commission can be established to ensure speculative behavior with regard to essential commodities is kept minimal. This is paramount in identifying emerging risks and finding ways of dealing with the risks through inter-government cooperation. Create a Special Finance Institution to Support Companies Instead of Assisting Banks  It is apparent that the banking sector, as well as other financial institutions, suffered major losses in the 2008 global financial crisis. The governments of many nations globally implemented bailout plans to rescue these banks and restore their liquidity and asset bases. While this move is a positive one as it gives banks and other lending institutions a chance to offer financial instruments to companies and other clients, it would be an even better move to establish a special financial institution to offer direct assistance to companies rather than offering such assistance to banking institutions. This proposed special institution would act as a reservoir for companies’ liquidity and always maintain companies’ wellbeing in terms of protecting their assets and ensuring they do not suffer exploitation from banking institutions that offer financial instruments at excessively high rates. This special institution would be mandated wit supervising all firms’ activities to identify firms and industries that pose a threat to the overall financial stability (Withers, p. 73). If such a firm had been in place before the global financial crisis, real property institutions would not have incurred such profound losses that, in turn, affected the entire economy. A special institution set up to support companies would also help in the identification of emerging systemic risks that could adversely affect an industry or the entire economy. This firm would subsequently bring inter-company cooperation to ensure sustenance of economies. In addition, such a firm could work in cooperation with principal financial regulator in individual countries, as well as international monetary agencies. This will be done to ensure all companies abide by financial regulations to deter unwarranted and excessive speculation, which could damage the recovering global economy. Furthermore, such an institution is paramount in the recovery of economies as it will ensure stronger standards with regard to capital, as well as other prudential standards for all companies and even greater standards for large multinational companies that influence the economies of more than one country. The maintenance of such high company standards entails preventing companies from trading excessively in virtual assets and reducing the overall quantity of virtual assets held by companies. In doing this, the special protective institution will ensure that work force employment rates are at par with companies’ production. This will also protect consumer wealth ratios and, in turn, promote the wellbeing of companies as consumer purchasing power will be heightened. The establishment of a special protective institution for companies will also maintain all-inclusive supervision of financial markets through the improvement of securitized markets that ensure market transparency and transparent credit rating of companies (Shirley, p.116). This protection in terms of supervising financial markets will mean that companies will be protected from exploitation from financial market brokerage firms that benefit at the expense of companies by pushing for investment in highly risky ventures. Such a special protective institution will also offer advice to companies in terms of the latter’s investment portfolios. Advising against private polling of capital, hedge funds, and other pools could save companies against massive losses. The special institution could also have a special branch to protect consumers from financial abuse by financial institutions. This protects companies as consumers will be able to retain their wealth, which is vital to the survival of companies all over the world. The special institution could work in coordination with federal agencies to oversee regulation of over-the-counter derivatives traded by companies, oversee the payment, clearing and defrayal systems involved in company procurement process. Companies would, therefore, enjoy a level platform to conduct business in, while still enjoying the protection offered by this special institution. Therefore, because such a special institution will have all information regarding companies in different sectors of the economy, the institution is a viable tool to assist governments to manage financial crises within their boundaries, as well as find ways of preventing the occurrence of other forms of crises. The institution could provide information to the government to allow for enactment of fresh regulations that govern the financial markets, as well as financial institutions. This means that global standards of operations will be significantly improved through enhanced capital frameworks, supervision of international firms, enhancement of management tools to counter financial crisis and improvement of global oversight on financial markets. Conclusion The global financial crisis took a major toll on the global economy as real gross domestic product (GDP) fell to unprecedented lows that had only been witnessed in the mid 20th Century. The financial crisis resulted in the loss of more than $10 trillion in real value of global companies (IMF, p. 48). Different countries have since established a number of strategic measures aimed at deterring the resurgence of such financial crisis in future, while at the same time mending the effects of the 2008 crisis. Mass protection strategies have arisen in response to the economic crisis. Different governments’ major bailouts of financial institutions are perhaps the most notable strategies employed by government to mitigate the impacts of the 2008 global financial crisis. While it is clear that the financial crisis emerged as a result of boom in prices of essential commodities and risky loans, it is also probable that political turmoil in some of the global producers of oil and other fuels could have further compounded the financial problem. This paper looked at three probable financial reforms that are bound to bring needed change in the global financial condition. These measures are the reduction of speculative practices in financial markets by establishing definite actions and actual procedures to implement this proposal. In addition, this paper proposed the creation of a special finance institution that will support companies rather than the traditional institutions that assist banks. Lastly, the paper proposed the removal of some virtual assets to counter excessive tradition in intangible assets. Because of the massive losses that took place globally as a result of the global financial crisis, it is vital for governments, as well as the international community, establishes reforms to deter the resurgence of the crisis. Works Cited Brunetti, Cand Buyuksahin, B. Is Speculation Destabilizing? London: McGraw Hill Publishers, 2010. Web. Currie, J., Nathan, A., Greely, D. and Courvalin, D. “Commodity Prices and Price volatility: Old Answers to New Questions”, Goldman Sachs Economics, Commodities and Strategy Research: Global Economic Paper No. 207. 2010. Web. Gorton,G and Rouwenhorst, K. G. “Facts and Fantasises about Commodity Futures”, Financial Analysis Journal, 121(2): 145-263, 2006. Web. International Monetary Fund (IMF). World Economic Outlook: Financial stress, Downturns, and Recoveries. New York: International Monetary Fund, 2008. Web. Shirley, M, M. Institutions and Development: Advances in Institution Analysis. Cheltenham: Edward Elgar. 2008. Web. Withers, H. International Finance: Discover How to Benefit from Capital, Banking and Investment on a Global Stage. Web. < http://www.danielwatrous.com/wp-content/uploads/2010/04/International-Finance-Hartley-Withers-WordVersion.pdf> Read More