International Trade and Finance Law: The Global Financial Crisis 2007/2008 - Essay Example

? THE GLOBAL FINANCIAL CRISIS (2007/2008) Inserts His/Her Inserts Inserts Introduction During the 2007/2008 period, the world experienced a financial crisis that rivaled the great depression experienced in the late 1920’s. According to Turner, the total cost of the crisis undoubtedly exceeds trillions using any of the major currencies1. The crisis resulted in the collapses of businesses, major bank bailouts, very poor performance of stock markets worldwide and collapse of housing markets. The crisis also played an important part in the decrease of consumer wealth and poor economic activity ultimately leading to the global economic recession experienced between 2008 and 2012. Various causes of the 2008 economic crisis have been identified. These causes have been assigned weights by various economists in order to offer a comprehensive understanding of the event. According to a report presented to the U.S. senate on the financial crisis, the main causes were identified as poor regulatory systems, failure of rating agencies and high risk products among other cumulative effects2. By considering the financial crisis, we find that various questions need to be answered. First, what reasons resulted in the vulnerability of banks to problems in the credit market? What roles does the effectiveness of current international and national regulatory frameworks play on this vulnerability and finally, what changes are needed in the regulatory framework to prevented any future occurrence of a global financial crisis. Looking at the situation preceding and following the financial crisis, we conclude that the main cause of the financial crisis included poor implementation with regards to corporate governance and risk management, poor design of regulatory frameworks and weaknesses in risk assessment and reporting. Basically, the answer focuses on systematic risks and the inability of current regulation frameworks to prevent these risks. Systematic risk refers to the probability of a given event to serious impair the broader economy. History of the Financial Crisis In order to understand how systematic risks affected the financial crisis, it is important to review the history of the financial crisis and its evolution. The main trigger of the financial crisis was the collapse of the U.S. housing bubble that begun in the late 1990s and peaked in 20073. According to Bullard (2009), the rapid demand for housing and the resulting increase in prices can be attributed to rare low interest rates, fast income growth, improvements in the mortgage market and large capital influx. During the housing bubble, there was a rapid increase in the offering of nonprime mortgage loans especially those with unusual terms. According to research, there was a 40% increase of nonprime mortgage loans between the year 2001 and 20064. Most of these loans were given to consumers with poor credit histories, marginal down payments and other deficiencies precluding them from prime loans5. The rise in subprime lending was accompanied by a fast increase in the percentage of subprime loans that lenders sold to banks. Firms such as Fannie Mae and Freddie Mac played a crucial part in the development of lending, which they funded through selling of bonds in the capital markets. Ultimately, Government Sponsored Enterprises that were tasked with policing mortgage originators and maintaining underwriting standards were forced to relax these standards in order to compete with private banks6. When the bubble burst and there was a sharp fall in house prices, most borrowers realized that their loans exceeded what their houses were worth. This resulted in the inability of most borrowers to refinance their mortgages ultimately creating the motivation for defaults. Due to this, loan defaults and foreclosures increase sharply as can be seen in Figure 1 Fig 1: The U.S. Housing Bubble7 The failure of the mortgage market was also accompanied by the explosion and subsequent collapse of shadow banking. Competition that arose from shadow banking forced local banks to lower their standards and devise riskier loans. Entities in the shadow system became vital to credit markets reinforcing the economy; however they were not enforced by similar regulatory systems8. These entities were also susceptible due to mismatch in loan maturity in which short term loans were borrowed to secure risky long term fixed assets. This resulted in a situation whereby disturbances in the credit market exposed these entities to fast deleveraging and selling assets at lower prices. The collapse of the shadow banking system led to the decline in funds that could be borrowed thus consumers and businesses could not get themselves out of the credit crunch that was happening. Systematic Risks Systematic risks describe the susceptibility to events that impact overall outcomes such as the broader economy, market earnings or total income such as the problems of one bank leading to the subsequent problems in other banks and ultimately impacts on the overall economy9. Systematic risks are more important in financial systems that nonfinancial systems mainly due to interconnections between financial firms, leverage and the penchant of companies to finance their fixed assets with short term loans10. First of all, interconnectedness leads to vulnerability to systematic risks whereby investment banks and big commercial firms trade and lend with each other through over the counter transactions, settlement systems, deposit markets and interbank lending11. The risk that one party involved in a financial operation will default is a key concern for major financial firms. Due to the existing complex structures and fast rates of financial transactions of these firms, it is difficult to completely monitor all the counterparties involved in the day to day running of the firm12. The fast decline of strong banks has the potential to expose other businesses to major losses. Secondly, systemic risks have a large impact on financial systems due to leverage whereby financial firms and banks fund a large portion of their assets through issuing loans rather than selling equity. When the housing boom was at its peak, hedge funds, banks and other financial firms invested deeply in mortgage-based securities by financing their assets by taking large loans from debt markets. According to research, investment banks were heavily affected with debt to equity ratios of about 25 to 1. Commercial banks on the other hand had leverage ratios of 12 to 1 due to the restraints on capital requirements13. High leverage resulted in high return rates during stable economies however it also exposed firms to high failure risk when the markets failed. Firms such as Freddie Mac and Frannie Mae encountered financial difficulties mainly due to their risky leverage. Finally, systematic risks are particularly important to financial firms due to the reliance of these firms to use short term loans in financing long term assets. The nature of financial means that they are not only highly leveraged but their also exists an intrinsic disparity in the maturities of their assets and liabilities leading to vulnerabilities to liquidity and interest rate shocks14. Many financial institution finance long term fixed assets using short term loans. This exposes the banks to the risk of bankruptcy if depositors heavily withdraw their funds or creditors decline to purchase commercial papers from security firms15. Regulatory Frameworks Globalization and international trade has necessitated the need for various guidelines and regulatory frameworks to be developed in order to ensure that different countries are able to conduct trade and other dealings in an amicable manner. The 2008 financial crisis however revealed that the current international and national regulatory systems aimed at preventing systemic risks and excessive risk taking have big weaknesses. Many reports have been produced highlighting causes and possible responses to the crisis. In this section we look at the relevant international and national policies that relate to risk management and how they failed plus possible amendments and solutions. One of the policies that contributed to the financial crisis is the international capital framework. Many economists hold that the existing capital minima established by the Basel II system is too low. Before the financial crisis, banks in the United Kingdom and elsewhere were able to maintain capital well above the 8% Basel minimum16. However, most companies depleted their capital levels thereby requiring government help or infusion of more capital. The existing policy also resulted in a deficit of high quality capital to cushion losses permitting banks to operate. It is evident that financial institutions also held low capital levels against risks, mainly due to weaknesses in model-based approaches to market risks17. Over-reliance to economic capital models exposes many financial institutions to the inability to identify and rank risk especially systematic risks. This may be due to using less conservative choices for given variables or from changing levels of correlation across asset portfolios. The institution of a high capital minimum value provides various advantages such as; providing an acceptable degree of protection for creditors, reduces the risk of extensive risk taking, cushioning banks during times of financial difficulties18. Another weakness noted is that their existed certain activities that resulted in the reduction of regulation standards. This led to excessive leverage and the weakening in capital standards as time goes by19. The original Basel Accord gave banks the ability to re-package essential assets thus decreasing capital requirements while retaining substantial risk. This necessitated banks to look for high leverage thus setting themselves up for major losses in case of poor market performance20. Over time banks began taking high risks businesses minus an equivalent rise in capital required. Changes proposed include ensuring that supervisory bodies have a full understanding of unregulated activities within regulated groups. National bodies should also be imbued with reserved powers allowing them to introduce innovative activities into the regulatory arena21. The lack of minimum standards for liquidity funding also contributed to the financial crisis. Due to financial intermediation, the balance sheets of financial institutions are usually more liquid on liabilities than assets22. This leads to banks being more vulnerable to investor confidence or the loss of counterparty irrespective of their solvency position. The lack of minimum standards has allowed the widespread use of asset pledging to provide more funding liquidity without recognizing the disadvantages of obstructing an enormous share of the institution’s assets23. It is therefore necessary to set up a core funding ratio that would act as a deterrent of extreme credit supply, as it would curbing the ability of banks to grow fast through the use of unsustainable sources. Poor supervisory frameworks and approaches have also been cited as a cause for the 2008 crisis.24 Complications encountered by groups such as AIG showed how corporate structures working in several jurisdictions face various risks and issues. Poor regulatory approaches involved include; the employment of unregulated bodies for capital-intensive products, the presence of high numbers of legal entities employees as tax optimization or support business for the groups, and the centralization of large amounts of liquidity at parent companies in order to meet financial needs at the sub-companies distributed elsewhere without breaking set regulatory standards25. These practices make it hard for regulators in areas outside the parent’s company jurisdiction to understand business lines, legal entities and the true solvency position of the firm. In order to deal with this problem, an argument has been made that only a global regulator can help with matters of information sharing cooperation and coordination amongst regulators of multinational institutions26. However, the ultimate responsibility of information collection and sharing remains a national responsibility. Finally, the lack of a comprehensive system for improving the resilience of individual firms to market shocks has been cited as one of the weaknesses in current regulatory frameworks. Financial institutions are forced to undertake high risk businesses in order to survive in times of difficulties thus leaving them vulnerable to bankruptcy and major failures that may rebound through the market27. Conclusion While most regulatory frameworks have evolved over time to deal with various financial difficulties, rapid growth that began in the 1990’s created a situation where the regulation were unable to effectively cover all possible risks involved in international and national trade. In order to deal with systematic risks and excessive risk taking by institutions several changes have been proposed as the current system have been shown to be lacking. First, an increase in the existing capital minima is required; next, establishing a core funding ratio that would set the minimum standards for liquidity funding; third, establishing a global regulatory body to improve information sharing; and finally ensuring that both national and international regulatory bodies are able to quickly implement changes as they are required. It is quite evident that the existing international and national regulatory frameworks have various weaknesses in preventing systematic risk and excessive risk-taking by financial institutions. However, there are changes that can be made, to ensure that a better framework is laid to prevent future financial crisis to occur. Bibliography Bullard J, Neely C, and Wheelock D, ‘Systemic Risk and the Financial Crisis: A Primer’ (2009) 5 Federal Reserve Bank of St. Louis Review 403 DiMartino D and Duca J, ‘The Rise and Fall of Subprime Mortgages’ (2007) 2(11) Federal Reserve Bank of Dallas Economic Letter accessed 6 November 2013 Elosegui P, ‘Aggregate Risk, Credit Rationing, and Capital Accumulation’ (2003) 43 Quarterly Journal of Economics and Finance 668 Fried J, Who Really Drove the Economy into the Ditch (Algora Publishing 2012) FSH, ‘A Regulatory Response to the Global Banking Crisis’ (2009) FSA Hanson S, Anil K, and Stein J, ‘A Macroprudential Approach to Financial Regulation’ (2011) 25 Journal of Economic Perspectives 3 Herdegen M, Principles of International Economic Law (OUP, 2013) Huang X, Hao Z and Haibin Z, ‘A Framework for Assessing the Systemic Risk of Major Financial Institutions’ (2009) 33 Journal of Banking and Finance 2036 Jorion P, ‘Risk Management Lessons from the Credit Crisis’ (2009) 15 European Financial Management 923 Lastra R, ‘Systemic Risk, SIFIs and Financial Stability’ (2011) Capital Markets Law Journal 43 Malz A, ‘Risk Neutral Systemic Risk Indicators’, (2013) FRB 51 Poole W, ‘Reputation and the Non-Prime Mortgage Market’ (2009) 5 St. Louis Association of Real Estate Professionals 20 Ricks M, ‘Shadow Banking and Financial Regulation’ (2010) Columbia Law and Economics Working Paper No. 370 Accessed 5 November 2013. Schinasi G, Craig S, Drees B and Kramer C, ‘Modern Banking and OTC Derivatives Markets: The Transformation of Global Finance and Its Implications for Systemic Risk’ (2001) 203 IMF Sengupta R and Emmons W, ‘What is Subprime Lending’, (2007)13 FBRSL Stein J, ‘Securitization, Shadow Banking, and Financial Fragility’ (2010) 139 Daedalus 41 Taylor J, Getting Off Track: How Government Actions and Intervention Caused, Prolonged, and Worsened the Financial Crisis (Hoover Institution Press 2009) Trebilcock M and Howse R, The Regulation of International Trade (4th Edn Routledge, 2013) Read More