Too Big to Fail Doctrine in the Context of Principles of Banking and Finance - Assignment Example

Q The 2007 credit crisis has been attributed to myriad forces: firstly, one of the forces behind the crisis was perverse incentives (Evans 13); 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 base 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 (Evans 17); 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 (Evans 19); 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 credit crisis in question had been caused by the same financial institutions that were now being bailed out by TARP. 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 the Lehman Brothers predicament could have been averted by the same US government the way other financial institutions were later bailed out and rescued; 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. 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). 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. 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. 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”. 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 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; therefore, it should not be a surprise that many financial institutions are willing to take high risks because they stand to gain from their own mistakes. 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 have rate, they are more likely to give falsified details, thus leading to a moral hazard. 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). There have been various views from various corners of the planet concerning the matter, with a main focus on whether the US government was justified to allow Lehman Brothers to go under. In view of all the odds against logic in the credit crisis situation, I am tempted to think that the US government was obliged to bailout Lehman Brothers when they were going under. 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 other words, Lehman could not raise enough capital that could warrant an intervention through bailout and this unprecedented situation meant that the firm could not be saved. 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. In view of the above discussion, I would want to think that the unpopular decision by the US government to allow Lehman Brothers to fail might have been atrocious, but it was both justified and justifiable. Despite the myriad technical and legislative challenges facing the implementation of bailout programs, financial institutions are indeed “too big to fail”; this is because financial institutions play a major role in maintaining 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. In addition to regulatory reforms, there is need to create a separate reserve fund for the “too big to fail” firms so as to create economic disincentives for companies that put others at risk through reckless behavior (Park). Under this scheme, all large companies including financial institutions will be obligated to contribute more towards the fund, and this will prompt the “too big to fail” firms from putting others at risk. 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: FDICs 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