Causes and Effects of the Global Financial Crisis - Coursework Example

Causes and Effects of the Global Financial Crisis History often repeats itself, and in some respects this is true of the current financial crisis. The specific catalyst of the crisis was a housing boom, financed mainly through credit extended by banks, which ended suddenly and destabilized the financial system, a similar change of events as crises in Japan and Sweden during the 1990s. (Savic, 2008) The difference now, of course, is in the world-wide scope of the crisis and the underlying flaws in the financial system that allowed it to collapse so comprehensively this time. The structure of the financial system, at least as it was before the crisis began, is sometimes called the New Financial Architecture (NFA). What the term NFA refers to is the unprecedented integration of normally highly-regulated financial firms such as banks and mortgage lenders with the comparatively lightly-regulated financial markets. (Crotty, 2008) One of the characteristics of this arrangement is a behavior known as regulatory arbitrage, wherein a large portion of the financial business normally handled by regulated banking institutions is shifted to less-regulated non-bank entities such as brokers, hedge funds, money market fund managers, and the like. (Roubini, 2008: 3) That ability to evade most of the controls on the banking system combined with good economic conditions from 2003 to 2007, which featured low interest rates, a relatively low rate of defaults on loans, high profits for companies, and rising stock prices. (Crotty, 2008) Obviously, this was a recipe for disaster. The concept of ‘risk’ in loans and other financial transactions all but disappeared, thanks in large part to the development of mortgage-backed securities, the product of an idea called “originate and distribute”. (Roubini, 2008: 2) Under the optimistic theory of the NFA, not just the loan itself was distributed but also the risk associated with it. Diluting the risk, along with the natural, self-correcting mechanism of efficient capital markets would virtually eliminate the risk, or so the theory went. (Crotty, 2008) What happened as a result was that the size of the financial markets relative to the overall economy grew dramatically. Debt in the US credit markets was three-and-a-half times the GDP in 2007, and the paper value of financial assets was ten times greater than the GDP. The financial sector generated 40% of the total corporate profits in the US in 2006. (Crotty, 2008: 10) The real basis of this phenomenal growth was the high level of risk that became acceptable. The “originate and distribute” model of mortgage-backed securities removed the incentive for the originators of loans to prudently assess the credit-worthiness of the people they were signing to mortgages (Roubini, 2008: 2); after all, once the mortgage was bundled into a security and sold to someone else, the bank would be paid, and the repayment or default of the loan would become that someone else’s problem, not the bank’s. To make matters worse, compensation for managers and executives in the credit industry became increasingly based on incentives to generate more business in the highly-competitive market, encouraging even greater risk-taking. (Crotty, 2008: 4) Once the effects of defaults on mortgage loans began to be felt in the financial markets, the pricing of mortgage-backed securities began to show fatal flaws. Securities had been priced on a “mark-to-market” basis, which is another way of saying that they were priced not based on what they were really worth, but on what someone was willing to pay for them. This fed the “bubble” by inflating prices above their fundamental value – which in the case of mortgages should be the value of the property for which the loan was made in the first place – and allowing investors to borrow and leverage more. When the bubble burst, “mark-to-market” meant that the bottom dropped out of security prices, in most cases driving them below their fundamental value. (Roubini, 2008: 6) There are also disturbing moral aspects to this crisis. Crotty (2008: 10) points out that the World Bank identified 117 systemic banking crises worldwide between the late 1970s and early 2000s, and in every case the banking systems were rescued by adjustments in central banks’ monetary policies and through bailouts that should not have been necessary if the theory of the NFA was accurate. In other words, according to Crotty, gains were private but losses were socialized; investors as a result became accustomed to the notion that if they failed there was a safety net, and the financial markets continued to grow beyond all reason. In addition, the financial world was riddled with pure corruption. Daniel Kaufmann, a former director of governance for the World Bank, gives several clear examples (Kaufmann, Forbes, 27 January 2009): Millions of dollars spent by failed mortgage giants Freddie Mac and Fannie Mae to lobby Congress for looser regulations, most significantly lower capital reserve requirements for these companies. AIG’s quiet placing of its derivatives unit in loosely-regulated London, where it could obscure its accounts and take on enormous credit risks thanks to lax oversight. Several large mortgage lenders such as Countrywide Financial reorganizing their operations so as to fall under the less-restrictive Office of Thrift Supervision rather than be subject to the stronger regulations applied to the banking industry. An April 2004 meeting where, in less than an hour, several large investment banks convinced the SEC to relax regulations to allow them to take on larger amounts of debt. And finally, the enormous fraud of Bernard Madoff, for which regulation and oversight was in place to prevent, but was not applied. Kaufmann implies that Madoff’s influence as a former member of SEC’s advisory board helped to keep his activities from being challenged even when the SEC knew about them. Failures in Financial Regulation The biggest failure in regulation of the financial system was the repeal of the Glass-Steagall Act in 1999, which ended the separation of investment and commercial banking activities. The Glass-Steagall Act was intended to prevent the use of bank deposits in financial speculation in the markets, which was part of what caused the Great Depression. (Crotty, 2008: 5) This was a part of the NFA concept, which had its roots in the deregulation of the Reagan era in the US. Beginning in the 1980s, innovation in financial industries successfully avoided and weakened regulatory controls, and with no strong political movement in favor of financial regulation – in fact, most of the regulatory agencies were controlled by strong believers, like Alan Greenspan, in the free-market ideology of self-regulation and market discipline – those controls were progressively reduced. (Crotty, 2008: 6, 9, and Roubini, 2008: 5) Britain’s Finance Minister Gordon Brown blames part of the crisis on the separation of prudential supervision – monitoring the solvency and liquidity of financial firms – from the supervision of business conduct, another side-effect of the repeal of Glass-Steagall. (Brown, 2009) What he seems to be describing is the situation created by the combining of various financial businesses into large conglomerates – the ones that are supposedly “too big to fail” – and the rapid innovation of complex financial products. Big, complicated companies with many complicated products defy the expertise of outside regulators to effectively monitor and control their business activities and financial health. Because of this, and because the regulators are disciples of the free-market ideology anyway, these firms are allowed to evaluate their own risk and determine their own safe levels of capitalization. As an example, the securitization of loans takes the loans off bank balance sheets, lowering risk to banks and freeing capital for banks to make more loans. (Crotty, 2008: 8-9) To the regulators in charge of monitoring business conduct, there doesn’t seem to be anything wrong with doing this, particularly since the law (Glass-Steagall) which once prevented this kind of activity no longer applies. And to the regulators in charge of prudential supervision there doesn’t seem to be any problem, since the free-market concept ensures that the new securities will be priced and distributed efficiently. (Ibid.) Clearly, however, theory and reality have diverged. A very big reason for this is also one of the easiest to understand: the utter failure to regulate the system of compensation for executives and managers in the financial system. Incentive-based compensation and bonuses based on profits creates a moral hazard by encouraging traders, managers, and executives to take huge risks, since they are not likely to be paid at all if they do not. The goal changes, then, from maximizing the value of the company’s shares to maximizing profits. (Roubini, 2008: 1) In short, the compensation system does not reward savvy financial management, it rewards gambling. The effect on the world economy has been painfully obvious. Suggested Solutions to Regulatory Flaws Some of the best solutions to the shortcomings in financial regulation are actually old ideas, beginning with a fundamental shift in the theoretical basis of regulation. The theory of efficient capital markets and the concept of the NFA have been firmly proven false. Milton Keynes was right and Ayn Rand was wrong, and financial regulation should be approached from this point of view. (Crotty, 2008: 56) Limits on business and portfolio growth are another reasonable concept to apply to financial industry regulation. Organizations that expand too rapidly outgrow their ability to manage themselves, and stretch information and control systems too far. Applying growth limits would ensure that businesses are able to consolidate and effectively control their operations before expanding further. (Vittas, 1992: 37) Limiting portfolio growth or requiring progressively higher levels of capitalization for growing portfolios would simply ensure that institutions would have enough money to continue to operate effectively through economic downturns. (Vittas, 1992: 36-37, and Jiwei, 2009) Requiring banks and lenders to manage most or all of the borrower risk that they accept would encourage sounder lending practices. One way in which this could be done is to require lenders and investment banks to hold a portion of the securities that they generate by bundling mortgages. (Roubini, 2008: 2) Because the banks would no longer be able to “pass the buck”, or at least not all of it, they would most likely be more discerning in their loan decisions. In addition, detaching compensation from short-term profits by placing limits on incentives or requiring that a proportion of them be made in the form of stocks would also encourage better management. (Roubini, 2008: 1) And finally, close international cooperation to establish a broad set of basic regulatory principles will help to stem the “avoidance by innovation” and close many of the loopholes made possible by conflicting national regulations. Instead of trying to develop a uniform set of regulations – apparently one of the objectives of the recent G20 summit – world leaders ought to aim instead to develop flexible, general objectives that each country could adapt to its particular needs. (Oatley, 2009 : 39) Possible components of such an agreement could include minimum standards for capitalization and foreign reserve holdings (Jiwei, 2009) and adoption of unified prudential and business conduct oversight structures. (Brown, 2009) Allowing flexibility while operating on a common set of ground rules would ensure that global financial markets still have room to grow, evolve, and be competitive, yet prevent them from taking advantage of gaps in regulation in different countries like AIG did in England. Most significantly, an economic crisis in one country would be less likely to be as damaging to the rest of the world. Whether these measures will be adopted remains to be seen; perhaps better solutions will be discovered. Whatever the outcome, the need for fundamental changes is clear, and most distressingly, has been for a long time. Works Cited Brown, Gordon. (2009) ‘Why we need tougher regulation of our financial system’. Telegraph.co.uk, 15 March 2009. [Internet] Available from: [Accessed 5 April 2009] Crotty, James. (2008) ‘Structural Causes of the Global Financial Crisis: A Critical Assessment of the “New Financial Architecture”’. Political Economy Research Institute, U. of Massachusetts – Amherst. Working Paper Series 180, September 2008. [Internet] Available from: [Accessed 5 April 2009] Jiwei, Lou. (2009) ‘Sovereign wealth funds can help stabilize global financial system’. China Daily, 1 April 2009. [Internet] Available from: [Accessed 5 April 2009] Kaufmann, Daniel. (2009) ‘Corruption and the Global Financial Crisis’. Forbes, 27 January 2009. [Internet] Available from: [Accessed 5 April 2009] Oatley, Thomas. (2000) ‘The Dilemmas of International Financial Regulation’. Regulation, 23(4): 36-39. [Internet] Available from the Cato Institute: [Accessed 5 April 2009] Roubini, Nouriel. (2008) ‘Ten Fundamental Issues in Reforming Financial Regulation and Supervision in a World of Financial Innovation and Globalization’. RGE Monitor, 31 March 2008. [Internet] Available from: [Accessed 5 April 2009] Savic, Ivan. (2008) ‘Containing the Global Financial Crisis’. In: Kirton, John (Ed.). (2008) The G20 Leaders Summit on Financial Markets and the World Economy. Toronto: University of Toronto. [Internet] Available from: [Accessed 5 April 2009] Vittas, Dimitri. (1992) ‘Policy Issues in Financial Regulation’. World Bank, Policy Research Working Paper WPS 910, May 1992. [Internet] Available from the IDEAS database: [Accessed 5 April 2009] Read More