Role of State and Central Banks in Financial Crisis - Essay Example

?The financial crisis and the lender of last resort. What is the role of the and central banks? Introduction The world economy has witnessed a series of crisis especially in global financial markets. Financial crisis and economic downturns are found most of the time to be positively related to the activities of the central bank. Such a connection dates back to the time of Great Depression in 19301. Similar is the case of global meltdown of 2008-09. These are supposed to be the price paid for central banks’ improper actions and banking sector’s engagement in speculative activities. The state every time after undergoing a crisis had to interfere in the monetary policies adopted by central banks and frame suitable policies for recovery. This has continued to be a regular phenomenon. Even for the current scenario the state as well as central banks have very carefully made certain changes in existing laws and imposed certain new legal restrictions to deal with the economic conditions post crisis. Appropriate monetary and fiscal policies have become a necessity right from the emergence of crisis. They are framed as per the needs of the respective countries. Governmental policies play an active part in setting up an effective regulatory framework that control all segments of financial services2. The concepts of economic Law and monetary law at the international levels have been merged together for establishing rules for regulating financial services globally. With this at the backdrop the paper intends to give a detailed description on the role of central banks and state during financial crisis and how reforms undertaken have brought about a change in the situations post crisis. World economy has suffered from a series of crisis dating back to the days of World War II which left the economy into a miserable state. The great depression of 1929 proceeding World War II deserves mention in the list of economic disasters. The financial crisis at the end of 1998 in the West hampered the normal functioning of many liberalized markets and private sectors3. The most recent has been the global financial meltdown in 2008-09 which led to vast unemployment and demand cuts. It was found that some features of monetary policies could be blamed for such a crisis. The defects of the prevailing macroeconomic framework had been realized immediately after the crisis. It needed a reconstruction for recovering from crisis. Monetary policies under pre crisis situation State had given central banks much freedom so as to frame monetary policies for the country. It was believed that the central banks should be allowed to frame monetary policies independently so as to maintain a stable price system in the economy and minimize the chances for high inflation. For giving this independence to the central banks modifications were made in the policies during 1990. But such a freedom proved costly to the state as it was utilized elsewhere like short term demand management. Besides the ‘flexible inflation targeting’ policy adopted by central banking system ignored the problem of instability in inflation. Established with the purpose of reducing output volatility, the inflation policy initiated instability by limiting information about inflation output gap. Errors were detected in gap measurements and this diverted the economy from the right track. The issue of liquidity and money were also ignored and this favored the climate for economic downturns. The inefficiency of the adopted theoretical models was revealed during crisis.4 The models did not have practical implications. While looking upon the stability of one period it did not consider important factors that also contributed towards stabilization. It neglected a wider picture of the assumed period. Fitting models only on the basis of empirical data could not be considered enough. It was equally necessary to look upon the causes of instability and capture those factors in the model5. The 2008-09 financial crises has taught a lesson to many risk loving investors who were lured by the low interest rate regime adopted by the banks at that time. At the same time it also indicated the urgency for lawful regulations of international financial markets. A report published by US has blamed the lack of such legal rules in the market for the failure of Lehmann brothers in September 2009. There used to be a significant difference in repo rate of US and UK which paved the way for mal practices. This has proved the need for lawful regulations globally. The countries have also learnt a lesson from bankruptcy during the crisis. So with the emergence of transitional banking greater amount of stress has been laid on financial law for imposing legal restrictions. 6 . The policies framed by central banks had serious constraints as they failed to identify and predict such a financial crisis that brought with it lots of sufferings for the world economy. It was found that the countries suffering from debt and security issues were more vulnerable to the financial crisis. The asymmetries existing in global capital markets could not be sustained. The banking sector was troubled with the structural issues. The banking system underestimated the powers of such a crisis which led to liquidity freeze and closedown of credit market transactions. Clearly the ‘credit crunch’ of 2007 in United States and other European nations was a result of this underestimation. Clearly the central banks did nothing to restrain the interest rates although the interest rates were increasing. Sensing crisis situation central banks did not even ask the financial institutions to change their models for business.7. The central banks however also made active contributions to the financial crisis. Credit crunch of 2007 as a result of mortgage defaults and fall in house prices. The Central banks made errors in determining asset prices. Asset trading had declined in quantity during that time. Other financial institutions were unable to provide loans. There were shortages as well as restrictions upon supply of credit. The securities associated with risky mortgages and these assets were purchased by banks as well as international investors. All this culminated into credit crunch with a decline of the value of banking capital. It soon shaped up into a global phenomenon. With innovations in resale and packaging of assets in global financial markets the issue became a complex one8. The permission given to banks to use CDS in 1996 engaged the banks more in speculative activities9. All such instances necessitated state intervention in the matters of output and inflation gap. The excessive freedom of central banks and the lessons learnt from financial crisis had forced the fiscal authorities to take control over the banking regulations and monetary policies and frame effective policies for recovery. The minimal role of fiscal policies and government became a totally unacceptable fact after experiencing the crisis. Role of the State prior to and during financial crisis The global economic meltdown was putting pressures on the government for active participation in the economic matters. Large market failures have prompted the fiscal authorities to put in efforts to bring about economic welfare. It became urgent for the state to active take part in regulating global financial markets. Efficient allocation of resources was important. Previously fiscal authorities hardly did anything for increased risks mitigation in financial markets and this led to the crisis. Years ago Keynesian economics had suggested fiscal policies in markets for the stabilization purposes and this became evident after crisis. Prior to crisis governmental policies have mainly been directed towards social causes like reducing inequality in income. But with emergence of international markets protection against underlying risks was deemed equally important. Government had also made active contribution in providing essential public goods. Prior to crisis most of the countries have seen governmental actions only towards higher government spending and taxation10. Fiscal authorities mostly in rich nations have actively participated in regulatory norms. They have imposed legal restrictions and adopted various regulatory models for international finance regulation. Some nations like United Kingdom have adopted unified financial regulators for regulating international financial markets. There can be partially unified financial regulators or fully unified regulators. Local conditions of countries and the objectives underlying such regulations have played a key role in structuring of unified regulators. In UK structuring has mostly been on financial matrices. It has considered segregation of sectors and the concerned departments catering to the need of the sectors. Such a regulator does not permit overlapping of various financial services. FSA is fully unified regulator in UK. It does the task of supervision for almost all kinds of business activities. As per reforms for institutes financial supervision has been totally hand over to unified regulatory agencies. Other conditions for imposing unified regulation have been skilled human capital and sufficient financial resources. UK being a rich country could afford all this11. The feelings of corporate social responsibility and business ethics need to be injected for achieving sustainable development and for proper functioning of global financial markets. Governments in different countries have established different guidelines and legal restrictions on corporate as part of its public policies. This has been done to instill within them a sense of responsibility for environment and society. Such legal guidelines and restrictions have been very successful in preventing illegal activities in financial markets such as dumping. Such legal aspects have achieved success in regulating financial markets especially in the areas of foreign direct investment and international trade12. The concept of International Financial Architecture came into being at the end Britten Woods Monetary System. In due course of time it has been replaced by global financial markets. With the emergence of such global markets regulation has become a compulsory activity. Legal rules were established for the banking sector especially in matters of capital requirements13. Regulation of financial markets became very important for giving protection to investors and for giving them sufficient confidence for investing in the markets. The regulatory framework without prevalence of legal guidelines has often been under criticisms. In absence of law in the markets there is no transparency in transactions. Insider dealing and money laundering become frequent cases under such circumstances. Hence legal restrictions are essential to ensure markets are fair and there is less black marketing. For such reasons fiscal authorities stepped forward to impose various legal restrictions and passing laws for maintenance of stability and regulations in global financial markets14. Laws and fiscal policies in United Kingdom before crisis A case study of the legal framework behind the budgetary process of United Kingdom has shown that the country does not follow a written constitution on legal aspects of governance. Only some laws have been passed by the parliament for the purpose of constructing budget and some related financial activities. Such laws have been highlighted in a tabulated format below15: Table 1: Laws passed in United Kingdom Source: The Legal Framework for Budget Systems, 2004 Lack of financial law is clearly reflected in the budgetary process of United Kingdom. There has hardly been any mention of the finance department in the laws enforced for budget making process. Political activities have mainly coincided with this process. The country’s system comprises of an extra legal body. The lower houses hardly have any role in the annual budget. In recent times executive agencies have been appointed for making budgetary process more efficient. Such reforms have been brought about post crisis16. United Kingdom adopting fully unified regulation can provide a good illustration. UK had moved with a fully unified regulatory framework. Infrastructure and other conditions have favored imposition of such regulation. UK has owned an international financial centre unlike other countries. The financial services offered domestically have also been on the superior side. The unified regulatory agencies of the country have been concerned with all the prudential regulations as well as the disciplinary actions for businesses. The reforms undertaken for providing accurate information by the authorities of UK Financial Services have also helped to impose such regulations. The task of banking supervision was taken over by this authority after the Bank of England Act passed in 1998. A written permission has been granted to the authority for such powers by the Financial Services and Markets Act in the year 200017. The financial crisis was like an epidemic that brought about loads of sufferings for all the nations worldwide. However post crisis the countries are implementing legal strategies and framing effective policies to overcome this. The figure below highlights those countries who have recovered quite fast compared to other countries18. Figure 1: Line chart showing countries recovering fast from crisis Source: Doing Business 2010, 2011 The line chart above shows although UK has recovered quite fast, but the rate has been low compared to other Asian and European countries. This obviously raises questions on the success of the regulatory framework that UK has adopted. But at the same time it can also be said that UK suffered a lot more than other European countries due to the crisis. The intensity of crisis was comparatively less in Asia. So it is natural that UK would take a little more time for recovery. Reforms undertaken by state post crisis In the wake of crisis the government spending for most countries increased tremendously. Bankruptcies and closedowns were frequent cases under financial crisis and banking sector was left in a miserable and disastrous state and did not posess any ability to provide further loans. They had mostly stopped functioning. Under such circumstances governments of respective had to lend huge sum of money to the banking sector. These were the planned packages for bailout and recovery from crisis. The increases in government expenditure for different countries during the 2008-09 financial crises have been demonstrated in the figure below19: Figure 2: Column chart showing government expenditure of countries prior to and during crisis Source: Aizenman & Jinjarak, 2010 The annual percentages of government expenditure for UK, US and other European Nations have been presented under the situations prior to crisis and even during the crisis scenario. Clearly for most countries a hike in expenditures is visible. This increase contains the ‘bailout’ amount that has been extended for recovery from financial crisis. Study of the rich countries during crisis reveals that they had to pay financial packages for bailing out the economy from crisis. This could also be regarded as the price paid for under regulations and lawlessness in financial markets. The amount offered as financial packages by different countries during the years of financial crisis i.e. 2008-09 is shown below diagrammatically20: Figure 3: Column chart showing financial assistance by different countries during financial crisis Source: Nanto, 2009 The data depicts the state of financial assistance in UK, US and other European countries. Clearly the biggest amount offered as package was by US ($787 billion). UK offered the lowest amount ($29.6 billion) as financial bailout package to save the economy from crisis. A possible reason could be cited as adoption of effective regulations and regulatory models by UK that helped it to overcome crisis situation by paying the minimum amount. Financial crisis have produced debts and involved costs for recovery which could not be thought of in the normal range of statistics. US government is spending huge for recovery from the financial crisis and in the next year its deficits from such spending and borrowings could amount to 12.5% of the country’s GDP. The country has computed the bank bailouts to cost as far as $13 trillion21. Key role had been played by the state for preventing as well as resolving global financial crisis. However, implementing fiscal policies in an open economy tends to have certain other effects, especially when the economy is facing global meltdown. Under flexible exchange rate regime fiscal policies produce positive spillover effects over the economy. Money supply increases in an economy and this in turn raises demand for imports. The state should undertake fiscal reforms in a manner so as not to crowd out the private sectors22. Post crisis the state had put in loads of effort so as accurate information is available in the markets and hence bring in efficiency. Asymmetric information previously had been a major reason for crisis such as The Enron crisis in 2001 and the recent subprime crisis of 2007. During that period US government failed to provide accurate investment to investors. In such cases Reference price information reflecting the actual value of assets and the inflation rate would have been a good option. In this era of globalization and from the experience of crisis governments in respective countries are thinking about effective policies that can capital markets23. The US government has undertaken various legal procedures such as signing agreements and enforcement of various laws for regulating international finance. The Import administration department under International Trade Administration has enforced various anti dumping laws and other duty laws. This has saved the US economy from various harmful imports that were traded through unfair means. This department has issued a manual containing restrictions for dumping. The unit of Market Access and Compliance under Trade Administration has signed up various bilateral and multilateral trade agreements for US with countries like Russia, Afghanistan, Africa, China and Japan. In the financial sector some centralized banks like Banks of International Settlements, Institute of International Bankers have regulated the financial sector globally through certain legal rules and regulations. Financial institutions like International Monetary Fund have also imposed certain legal restrictions on exchange rates and special drawing rates to maintain a stable currency system24. In an attempt to regulate financial services, EU in their 2006 session of report had suggested inclusion of financial instruments measures in Article 4 in the draft level 2 Directive of their legal rules. Such an inclusion was expected to bring down risks in financial markets to a considerable extent for investors. Such a law has been passed keeping in mind the growing impact of markets on financial services and the market structure of member states. The recent issue of Green paper on regulation of financial Services has proved the importance of the legal framework for consolidation of financial services 25 By giving soft or hard protections to financial markets the government is now acting as its regulator. Inequalities are being removed from markets so as to provide a fair market to all players. However US government has recently been criticized of triggering inequality into the economy post crisis. People have come out in the streets showing protests for such a phenomenon. In this disastrous state of economy post financial crisis engrossed with employments and job cuts S&P CEOs’ salary averaged $10.5 million. 50 private fund managers are getting an average salary of $588 million26. With the recently held crisis and active governmental support the creation of a new regulatory framework for global financial markets is being talked about. Such a framework is concerned with the establishment of a new financial law that will include both hard and soft law instruments for regulation. Soft law refers to those financial existing laws that made quick adjustments in accordance with the ongoing economic and political changes during 20th century. This was a result of sheer pressure. Hard laws are those that changes only with political consensus and hence leaves a space for improvement. They refer mainly to the norms and regulations. The new financial law thought of should be a combination of these two types of laws. However international responses and commitments are very much necessary for such establishments. Then only a global agreement could be reached for financial regulation27. ‘Assessed Work Rules’ in the School of Law Guide 2009/10 The working rules that have been mentioned in the 2009-10 edition of the School of Law provide a manual of legal norms for the foreign workers. Under Section C of this guide the law states that if the individual working has a family background holding diplomatic status, he is allowed to work even without having a work permit. However he has to carry a ‘no objection letter’ that will be issued by the protocol department of DFAIT. Such workers will be closely monitored by the division concerned with external affairs of the country. The other categories of workers who are exempted from the rule of work permit include individuals who are military personnel and have received permissions of moving out from their respective countries. They are those people who are designated in Canada under the Visiting Forces Act. These army men may also come abroad in order to attend any educational institute or undergo any training as instructed by their respective countries. These men are also allowed to move around in foreign countries without carrying a passport. This is as per specified in the R52 Act. The individuals accredited as foreign representatives by the Department of Foreign Affairs and International Trade (DFAIT) is also allowed to work abroad without a work permit. These dignitaries are also allowed to carry their personal servants and they are also given the similar working facilities28. Temporary foreign workers, once they hold permanent positions in context of work, are required to show off their work permit in order to continue there. The work places may include theatres, dance groups, orchestras etc. These people are also required to carry their LMOs. This category includes people mostly from entertainment business. Participants in global wrestling events may also be allowed to come to Canada under the R186 (g) Act. In case of diplomats who are aged above 16 years, they are required to carry an identity card. Civil servants of particular countries as well as some high ranked police officials are included in this group of diplomats. The countries might consist of those having diplomatic relations with Canada. Members of United Nations or any of its agencies are also accredited as diplomats29. Central Bank Reforms post crisis Reforms in regulations for mitigating risks have been enforced by Financial Services Act of the year 2000. Such a regulation was chiefly aimed at efficient allocation of resources in order to eliminate risks. Under this regulation resources have been allocated in a prioritized manner. Even the riskiest issues have been handled effectively. Such a regulation is an attempt to remove misperceptions about risk which had been the main reason for downturns in Royal Bank of Scotland in 2008.30 The Federal Reserve post crisis has made reductions in discount lending rate. It has been modified to 3.25%. It has placed restrictions on easy credit by charging a wide range of collateral securities for granting loans. For the banking sectors National Currency Act has been revised which now seeks to maintain uniformity in national currency. The Federal Reserve Act of 1913 has been amended and the Bank Mergers Act has been prohibited31. This is an attempt to reduce speculative activities for banks and reduce possibilities of risk expansion. Laws and regulations are being thought of and they are undergoing several reforms after the recent financial crisis. After experiencing sharp bankruptcy during crisis all across the globe, the US bankruptcy law has been reformed. Effective procedures and laws have led to speedy recovery. With modifications in reforms many firms could survive facing tough situations. In 2008 Uruguay enforced a new bankruptcy law. This helped the management to file within 30 days after discovering insolvency within the system. During 2008-09 reforms have been made in existing laws of licensing policies in most countries like Russia. In recent years countries such as Bulgaria, Chile, United States and United Kingdom have passed new laws for maintaining qualification standards. Some laws have also been revised to allow the trustees to sell quickly their distressed assets32. The Base II framework has undergone a revision by the Central Bank Governors and Supervisory heads. The new framework tends to include more protection for banks through ‘capital conservation buffer requirements’. The risk coverage has been extended. The framework intends to banking sector resistant towards liquidity shocks33. Conclusion The recent financial crisis of 2008-09 was like an epidemic and brought unprecedented sufferings worldwide. The victim countries have realized their defects in monetary policies and banking regulations. Excessive freedom given to banks and their engagement in speculative activities had led to such a crisis. Losing out capital from the banking sector caused the credit crunch of 2007. Such instances have necessitated active governmental participation and effective fiscal policies for dealing with the financial crisis. Although the fiscal authorities have made some recovery from the crisis, it is only half way and still much needs to be done. As part of policy implications the paper suggests to bring more transparency in the economic system to reduce illegal and speculative activities. Fiscal policies also need to reduce inequality and not create some. References: 1. Aizenman, J & Jinjarak, Y. (2010). 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