Pre-Crisis Risk Factors - Essay Example

Finance and Accounting ars scribendi (A journal for understanding the of the business administration professions Introduction The sovereign debt crisis in euro area is continuously happening and it is becoming difficult to solve this problem. The crisis took a major figure in the year 2010 when the return on the govt. debt of Greek had risen but the international market could not rely on the sustainability of the financial system of the company. Thus rate of borrowing became suddenly high for other countries like Ireland and Portugal as they are suffering from fiscal deficit. Then all the three countries were bound to seek support from the international monetary fund and from the EU because they have lost the support from other private investors (Higgins, No Date). Although the current financial crisis has affected the whole world economy but it has specially caused trouble to euro zone. The monetary union is, no doubt subjected to deviated true stuns through the external competition and exchange. With the failure to alter trade rates, these weights are constrained into the work business sector and unemployment. This has headed a few nations over past years to attempt to mitigate weights with financial slippage. The ensuing obligation has been exacerbated by the money related emergency and retreat, and this thus is helping underlying monetary shakiness – Europes most serious issue. . The financial system has experienced an enormous change since the late 1990s, through deregulation and advancement. Derivatives had risen from 2-1/2 times world GDP in 1998 to a truly stunning 12-times GDP on the eve of the emergency, while essential securities remained extensively stable at around 2-times GDP over this period. These unique patterns are demonstrative of the development of ‘capital markets banking’ and the re-hypothecation (rehashed re-utilization) of the same guarantee that increases the risk of counterparty through the system of banking. Europe blends, universal and capital markets keeping money and this is communicating with the sovereign emergency in an unsafe manner. The nations with vast capital markets banks are intensely laid open to the sovereign obligation of bigger EU nations like Spain and Italy, and these securities‟ sharp value changes influences security values and accurate imprint to-market misfortunes. Any worry about dissolvability instantly changes into a liquidity emergency. Securities managing, prime broking and over-the-counter (OTC) subsidiaries are dependent upon edge records and the necessity for quality security, calls for which are occasionally activate by noteworthy value shifts. The point when banks cant meet guarantee calls, liquidity emergencies develop and banks are not given the time to recapitalize through income. Little and medium-measured endeavor (SME) financing relies on upon banks, and leveraging as an outcome of these weights strengthens descending weight on the economy (Wignall, 2012). Pre crisis risk factors During the year 2000, debt for the euro area was not seen as growing problem because during the past decade, USA and euro area almost had the same debt dynamic system in their countries. The gross public debt ratio to GDP was 60% in USA in 1995 and it was 70% in the countries that have formed euro area later. In case of both euro area and in USA, the debt to GDP ratio had declined during the late 1990 but it again increased by the year 2007. It ahs been seen that the debt to GDP ratios were increasing more rapidly for the united states than for the euro zone. However, it has been that variation in debt level was different for different countries in the euro area. The above figure shows that the change in public debt ratios for the seven main countries in the euro area during the period of 1982-2011. These countries were specially selected as because France, Italy, Germany and Spain are the largest member in the world economy, while Greece, Portugal and Ireland were severely affected by the fiscal crisis. Along with this, Spain and Italy were also considered as the most vulnerable countries during the time of financial crisis as they have the most fluctuating debt histories in the past decade (Lane, 2012). The sovereign debt crisis and the vulnerable banking system:- Banking Regulation and two forms of baking risk The main reason for the financial crisis is under-pricing of risk. Banking system can always detect if there is any chance for excessive risk in the market by two basic ways, the first way is if there is very leverage and second is if the dealing of high risk products increase when the leverage is stable. There are few banks who are allowed to use their own derivatives and internal strategies to reverse the risk features of assets on which the capital weighting is calculated. But according to the Basel rule, other banks cannot control two forms of risks at the same time (Wignall, 2012). The outburst of derivatives and the counter party risk The above figure shows the assets and securities which are important to increase the investment and growth of securities, bank assets and equities in order to contribute in the world GDP. The theoretical value of derivatives has grown from 2.5 times to 12 times of the world GDP in 2008 during the global financial crisis. Although derivatives do not increase the real time investments but it carries all the factors that act as a catalyst of bankruptcy situation in debt instruments. The banks gave justification for this huge amount of derivatives by stating that those were essential to control the risk and to improve the productivity and creativity in the economy. But the justification went wrong with biggest financial crisis in the post war decade (Wignall, 2012). The interactions between sovereign and bank crisis The interaction between the sovereign credit default swap spread and bank CDS can be seen in the above figure. It explains the average weight of the CDS spreads for European banks and European sovereigns. It can be seen that the both bank CDS and Sovereign CDS are moving in correlated way which shows the impact of financial volatility on the banks and the interaction between market and sovereign risks. Some break in correlation can be seen due to the tightening of ECB policies during 2011. The Balance of payment crisis in the Euro Area The euro area and its periphery countries have relied on the foreign borrowing to increase the wealth of their countries. They have done it after they have joined the monetary union because membership in monetary union has lowered the cost of borrowing. Thus these countries took that advantage and increase their spending on foreign goods. Along with this, global recession in 2008 have shown that excess amount of leverage and debt can have negative impact on the balance of payment of a country which can leads to situation of financial crisis. Similarly in the year 2010, when Greek was having excess sovereign debt then investors were also concerned about the credibility of other euro countries (Higgins, No Date). Policies for solving the financial and debt crisis in Europe There are several proposed policies that can be used to recover from the situation of financial and debt crisis in Europe. The policies are as follows- Fiscal Consolidation- It includes strict rules for borrowings and fiscal deficit for future. Govt. of euro area countries should allow the issue of Eurobonds. It will help to reduce the excess debt level and will improve the credibility of euro zone countries. Role of ECB- It includes LTRO operations to reduce the collateral needs and requirements. It will also increase the number of lenders for IMF. It will help the bank to increase funds for short term lending and liquid cash to meet urgent crisis. It also supports the method of interbank lending process which will help to reduce the failure of bank. Role of ESM or EFSF- It encourages the lending and borrowings from govt. it includes buying of securities in lesser price from the secondary market and it enhances the way to invest in banks which is also known as recapitalization. It will help to recapitalize the banks which are going through liquidity crisis. Structural Policy needs- The countries in euro zone need a structural growth policy to improve the condition of labor market and product market. It states that the leverage ratio should be fixed as 5% as it will help to transparent the accounting policies for the hidden losses that can occur in a company. It also needs to separate the activities of investment banking and retail banking for ensuring the transparency in banking operations. This process will help to reduce the consolidation cost of fiscal system and it will improve the competitiveness in the labor market (Wignall, 2012). Conclusion From the above study it can be seen that there were large imbalances in the savings system in euro zone countries during the years of recession and debt crisis. The crisis was mainly hiked as the private investors had lost their confidence about the credibility and sustainability of euro area countries. Thus they were not willing to invest in those countries. It leads decrease in the selling of govt. debt and increase in the rate of interest for those countries. As a result, those euro area countries were bound to go for reduced borrowings from private foreign investors and the borrowed capital encouraged the higher consumption and spending with negligible cost which has led to problems in adjusting the loss of foreign cheap currencies in domestic market. Although the euro zone countries have recovered from their previous state during the sovereign debt crisis, but still now long way to go before earning sufficient growth in the international market. Thus the countries need to adjust the productivity gains by lowering the wages and slower growth in the investment spending and domestic consumption. References Wignall, A. (2012). Solving the Financial and Sovereign Debt Crisis in Europe. Retrieved from : http://www1.oecd.org/finance/public-debt/49481502.pdf. Higgins, M. et al. (No Date). Saving Imbalances and the Euro Area Sovereign Debt Crisis. Retrieved from: http://www.newyorkfed.org/research/current_issues/ci17-5.pdf. Lane, P. (2012). The European Sovereign Debt Crisis†. Retrieved from: http://pubs.aeaweb.org/doi/pdfplus/10.1257/jep.26.3.49. Higgins, M. et al. (No Date). The Balance of Payments Crisis in the Euro Area Periphery. Retrieved from: http://www.ny.frb.org/research/current_issues/ci20-2.pdf. Read More