Principles of Banking and Finance - Essay Example

?Q The 2007 credit crisis has been attributed to myriad forces: firstly, one of the forces behind the crisis was perverse incentives (Evans13); there are so many instances where incentives played a major role in the making of the crisis. For instance, the sub-prime mortgage sales agents offered low initial repayments in order to attract more clients and be able to earn more incentives; the banks on the other hand were only interested in generating as many mortgages as possible and were not careful to assess likelihood of repayment. Apart from that, the investment banks that took the initial mortgage backed securities ended up creating highly collateralized debt obligations and generated huge profits from fees (Morgan). The second major driving force behind the crisis was the US interest rate policy, which kept interest rates very low for a very long period (Evans 15); the sudden forceful growth of mortgage lending can be attributed to the low interest rates. The attractive mortgage lending was based on a faulty premise that the house prices would continue rising, thus over-lending by the banks, in total disregard of the likelihood of repayment. When the false bubble in the mortgage lending finally burst, the financial crisis began taking its toll, many loans were unrecovered by the banks and the banks become bankrupt. The third force behind the credit crisis was global imbalances; the developing Asian exporting countries had large current account surpluses, a situation that has been defined as “global savings glut”. This situation led to an inevitable influx of capital into the US thus leading to the bubble in share prices in the late 1990s, and the bubble in house prices accordingly; however, the US current account deficits kept going up from the 1990s due to offsetting inflows of capital to the US. In addition, another influential force that was behind the credit crisis was deregulation policies, which had left the exchange rates to be influenced by foreign exchange markets (Evans17); deregulation of the financial sector in response to neo-liberal government policies led to the expansion of the US’s financial sector. In line with the expansions were the emergence of new and riskier financial instruments and accumulated credit; this is what led to the stock market bubble and the housing bubble accordingly. Finally, the credit crisis can be attributed to excess capital in terms of huge sums of capital that had been stashed in the US and Europe at the time (Evans19); this led to stagnation in household incomes, thus constrained purchasing power of the population. This condition led to increased borrowing in households so as to sustain consumption and a built up of debt securities; extensive borrowing to finance consumption spending in turn led to a rise in asset value, but when the rise could not be sustained any further, the growth of consumption stopped suddenly and recession began. Q2 It has been proven beyond any reasonable doubt that indeed, the US government treated some financial institutions differently during the credit crisis. For instance, when the Wall Street Investment bank Lehman Brothers crumpled in response to the crisis, there was a dramatic fall in the global economy; this was a great blow to the financial sector and many people lost faith in the banking system. However, exactly one month after the bank had collapsed and caused a global outcry, the US congress passed a bank bailout scheme that was labeled Troubled Asset Relief Program (TARP) (Fareed). The Troubled Asset Relief Program entailed taking billions of taxpayer money and using it to bail out financial institutions from the deep pits of the credit crisis; ironically, the same financial institutions that were now being bailed out by TARP had caused the credit crisis in question. Questions have been raised with respect to the way the US government reacted at the onset of the credit crisis; one of the most serious questions that arose is with regards to whether the Lehman Brothers could be saved or not. Thus exactly, why did the US government ignore the distress calls from the Lehman brothers? This questions whose answer may not be readily available; and eventually, all attempts to justify this action only seem to lend credence to the idea that probably they were not “too big to fail”. In this regard, it is true to say that the US government treated some financial institutions differently- the Lehman Brothers were left to fail where as other financial institutions that threatened to fail were urgently rescued, ironically, by the same US government that could not rescue the Lehman Brothers. It was not appropriate for the US government to treat some financial institutions differently because then it was passing the wrong message, which meant that they were not “too big to fail”. The US government’s intervention by bailing out financial institutions during the crisis may not have been very appropriate on moral considerations, but it was certainly unavoidable at the time. The truth of the matter is that banks themselves had been reckless before, thus exposing the entire global system to the credit crisis that emerged thereafter; this automatically rules out any justifiable reason towards bailout. It has also been argued that US government, similar to the way other financial institutions were later bailed out and rescued, could have averted the Lehman Brothers predicament; however, it is also obvious that the incidence was a great lesson to the US government because it prompted action that mitigated the problem and stabilized the global economy (Fareed). Given that the odds of the situation were technically too big to be ignored, I think it was appropriate for the government to intervene and bailout financial institutions that were going under after Lehman Brothers. Q3 The “Too Big to Fail” doctrine has two possible interpretations; the first one refers to the universally acknowledged myth that big firms are unlikely to fail because they are relatively big in size, unlike smaller companies. This doctrine is based on the premises that a large corporate is typically more diversified, enjoys economies of scale, enjoys a large market share and low cost of capital. In this respect, this doctrine posits that large firms are more likely to operate efficiently in the end, thus, rising to highly competitive positions within the global markets, where risks of exposure to adverse market conditions is minimized. “Too big to fail” in this context merely refers to the idea that the strategic position of large firms guarantees them survival even on a backdrop of severe economic realities in the market. The second interpretation has been derived to refer to firms that are considered too big to be allowed by the government to fail and therefore must be bailed out (Moosa). Therefore, “Too big to fail” in this context refers to the pervasive idea that some financial institutions are very influential in the global financial system, and as such, their failure can be very disastrous to the economic stability. The global credit crisis has made it clear that the “Too Big to Fail” doctrine is a pseudonym for taking large sums of taxpayer’s money from the treasury to bailout financial institutions from mistakes of their own making. This “Too Big to Fail” doctrine has been a hot subject for debate and it has received too much criticism, especially in the credit crisis period, even amid the increasing number of bank failures in the recent past. The US government embarked on a bailout spree of what it termed “too big to fail” financial institutions, and this decision to bailout financial institutions from a crisis they helped to create has been very controversial. This “Too Big to Fail” doctrine can result to a number of problems such as the challenge for determining the kinds of firms that are to be considered “Too Big Fail” and the ones that are “Not Too Big to Fail. This could be the reason why Lehman Brothers were allowed to fail by the US government when probably they could be saved as well, just like other financial institutions that were later bailed out. Furthermore, the “Too Big to Fail” doctrine leads to parasitic operations that could potentially cripple the financial base and financial infrastructure of financial resources in the global economy (Moosa). In addition to these challenges, the “Too Big to Fail” doctrine has also been subject to a number of other confusing and cynical notions such as “too big to survive”, “so big that it has to fail” and “too big to succeed”. In this respect, the “too big to fail” notion must be done away with and the US government should consider alternative ways and mechanisms of bailing out financial institutions that is unbiased. Q4 Bailing out financial institutions could potentially lead to a “moral hazard” because the bailout program encourages institutions to take much more risks knowing that they are “too big to fail”. The moral hazard can directly be attributed to a total lack of market discipline due to the lack of firm regulation mechanisms that works with large financial institutions; large financial institutions are more likely to misbehave by taking high-risk operations in search for greater returns on investments. The financial institutions are motivated to act recklessly because they are fully aware that they will not be obliged to pay for their mistakes; in this respect, a bailout scheme works as a subsidy for risky behavior on the part of the financial institution (Weiner). For instance, prior to the credit crisis, financial institutions had made very high-risk decisions that culminated to the infamous subprime mortgage debacle; however, when Wall Street started crumpling, the government intervened with its bailout program known as TARP. The criterion for bailout was greatly flawed as some financial institutions like Lehman Brothers, which were considered not “too big to fail”, were allowed to fail while others were bailed out, thus causing a moral hazard. The moral hazard is heightened further when some financial institutions such as the Bank of America and City group, having been the biggest beneficiaries of the bailout program, registered supernormal quarterly profits (Morgan). In this respect, these financial institutions are benefitting from a problem they helped to manufacture, thus creating a moral hazard; in this respect, it is not surprising that many financial institutions are willing to take high risks because they stand to gain from their own mistakes. This is very baffling and morally unacceptable, especially because such actions advertently portray the skewed principles operating in the financial institutions sector. It is not fair that banks should be allowed to walk away from their own mistakes; instead, they should take corporate responsibility for their reckless actions. This will create reforms in the financial sector by instilling discipline and all industry players will have a level field; large banks will desist from high risks that put the entire industry in danger. Concerns have also been raised over credibility of the credit rating agencies (Lawder); given that they are paid from fees raised from issuers of securities they rate, they are more likely to give falsified details, thus leading to a moral hazard. In view of all the above, the “too good to fail” doctrine could potentially lead to a moral hazard, and alternative remedial measures should be taken to restore sanity in the financial sector. Q5 The collapse of Lehman brothers is perhaps one of the worst-case scenarios in the global finance systems, and the unprecedented incidence has attracted a considerable amount of attention in the recent past. Collapse of the Lehman Brothers instigated a major crisis in the global economy’s stability and there was panic over sustainability of financial institutions all over the world; the situation was to worsen later with the slump in stock markets and dried up credit (Baker). In my own perspective, I do not think the US government should have allowed the Lehman Brothers to fail because then it only resulted to far worse situations that could have been averted. However, it has been contested for many years that the US government, prior to congress’s decision to pass the TARP program, was not in a position to intervene. For instance, Bernanke, the Federal Reserve Chairman insists that bailing out Lehman would have resulted to billions of dollars in losses for taxpayers (Puzzanghera). This belated confession also goes ahead to reveal that it was practically impossible to bail out Lehman brothers because it would have been illegal; this is especially because Lehman Brothers lacked collateral needed to back aid. At the time of the crisis, it would have been illegal to intervene by bailout because prior to bailout legislation, Fed was not allowed to lend money without any reasonable assurance of the likelihood of repayment (Clark). In this respect, Fed posits that any attempt to bailout the firm would not only be unsuccessful, but would also have resulted to large losses of taxpayer money. This argument is rendered baseless by the fact that the overall impact of Lehman Brother’s failure was potentially greater and worth the risk of bailout; furthermore, the main reason why the US government was hesitant to intervene was because it did not want to raise alarm that the situation was dire. The US government should have acted more bravely by acknowledging to its citizenry that the financial sector was in a mess and taking remedial actions through bailout. Despite the myriad technical and legislative challenges facing the implementation of bailout programs, financial institutions are indeed “too big to fail”, because they maintain global economic stability. However, there is need for a comprehensive financial regulation reform so as to curb indiscreet behavior by financial institutions (Park); this regulatory reform proposal will strengthen the financial industry by keeping the large financial institutions in check. Secondly, there should be a separate reserve fund for the “too big to fail” firms to create economic disincentives for companies that put others at risk through reckless behavior (Park). Works Cited Evans, Trevor. “Five explanations for the international financial crisis”.Ipe-berlin.org. 2010.Web. 26th Feb Fareed, Zacharia. “Wall Street bailout a heroic move”.Edition.cnn.com. 2010.Web. 26th Feb. 2013. Moosa, Imad. “The Myth of ‘Too Big to Fail”.Journal of Banking Regulation (2010) 11, 319–333. Park, JeeYeon. “'Too Big to Fail' Doctrine Must End: FDIC's Bair”. Cnbc.com. 2009.Web. 26th Feb. 2013. Lawder, David. “U.S. bailout program increased moral hazard: watchdog”. Reuters.com. 2009.Web. 26th Feb. 2013. Morgan, Gwyn. “Bailouts and the nasty consequences of 'moral hazard’”.Theglobeandmail.com. 2012.Web. 26th Feb. 2013. Weiner, Eric. “Subprime Bailout: Good Idea or 'Moral Hazard?'”. Npr.org. 2007.Web. 26th Feb. 2013. Baker, Dean. “Getting Lehman wrong a second time”. Guardian.co.uk. 2009.Web. 26th Feb. 2013. Clark, Andrew. “Lehman Brothers rescue would have been unlawful, insists Bernanke”. Guardian.co.uk. 2010.Web. 26th Feb. 2013. Puzzanghera, Jim. “Bernanke says Fed had to let Lehman fail”. Latimes.com. 2010.Web. 26th Feb. 2013. Read More