Theory of Financial Institutions and Policy - Assignment Example

?Introduction to Agency Theory: This is phenomena mostly observed in s in which management and ownership are separate. This sort of mechanism is found mostly in a corporation, where the management of the organization is delegated to the managers of the organization (Berger and Patti, 2006). These managers are hired by the owners who hold stocks of the company and are part of the board of directors. The real conflict arises when managers start pursuing their own private interests rather than devoting their energies towards the protection and promotion of board members interest (BITLER, MOSKOWITZ, and VISSING-JORGENSEN, 2005). Means by which managers can accomplish their malign interest is through compensation plan, perks, bonuses, travelling on corporate expenditure and scamming against the corporation. Introduction to Balance Sheet Approach: In order to check the quality of earnings two approaches are predominantly used, one of these approaches in balance-sheet approach. The aim of this approach is to assess the true magnitude of accruals because it is these accruals which lead to manipulative earnings (Aghion, Bacchetta, and Banerjee, 2004). Thus it is of utmost importance to locate them and rectify the manipulative action to see the true picture of the organization. As a general rule the higher the total accruals are as compared to percentage of assets, the greater the likelihood that earnings quality is low. Remember that accruals can be either a reflection of earnings manipulation or just normal accounting estimations based on future business expectations. It is difficult to determine which one is driving the accruals, but there is evidence that the size of accruals can be used as a rough measure for earnings manipulation (Mulder, Perrelli, and Rocha, 2012). Following are the series of formulas that are used to find the real values of accruals (Pasiouras, 2008): 1. Total Net Accruals = Accrual Earnings - Cash Earnings But the balance sheet doesn't directly tell us what accrual earnings were in the period, so further calculations are required to retrieve this information.  2. End Equity = Start Equity + Accrual Earnings - Cash Dividends - Stock Repurchases + Equity Issuances 3. Accrual Earnings = ? Owners' Equity + Cash Dividends + Stock Repurchases - Equity Issuance = ? Owners' Equity + Net Cash Distributions to Equity 4. Accrual Earnings = ? Assets – ? Liabilities + Net Cash Distributions to Equity 5. Cash Earnings = ? Cash + Cash Dividends + Stock Repurchases - Equity Issuance = ? Cash + Net Cash Distributions to Equity 6. Total Net Accruals = Accrual Earnings - Cash Earnings = [? Assets – ? Liabilities + Net Cash Dist. to Equity] - [? Cash + Net Cash Dist. to Equity] 7. Total Net Accruals = ? Assets- ? Liabilities – ? Cash Reasons for the World Recession: Suppressing Demand of the World Market, leading to declining industrial growth and output, which further results in a negative mood spreading amongst the investors and a negative posture taken up by the overall economy (Torna and DeYoung, 2012). In the United States a housing bubble was being propelled by speculative behaviour. This speculative behaviour was fuelling the U.S economy. Federal Reserve’s irresponsible action to lower the interest rates encouraged a large inflow of foreign funds. This availability led to the creation of easy credit for borrowers, who started taking hefty home loans. As the demand for home loans soared this created an artificial demand in the housing market and an artificial price hike in the housing market. Since there was ample amount of money available in the economy the mortgage lenders started lending at an exponential rate and simultaneously lowered their lending standards. Such conditions helped individuals with poor credit history and those who made the NINJA category (No Income, No Job, No Assets), receive hefty amount of loan from the loan agencies for whatever purpose they see fit (Broeck and Guscina, 2011). Since the property market was on a role and was flushed with money, leading to soaring property value, homeowners started using this increased value to acquire a second finance (refinance at a lower interest rate). This time the money was used to fuel consumer spending rather than investing on productive capabilities. Another imaginative financial product stormed the market. This was known as Adjustable Rate Mortgage. This financial product allowed the borrower to make repayments at a lower rate first and gradually this rate would increase. This feature attracted lots of borrowers, who later went on to make defaults on the repayment schedule (Hetzel, 2012). Since the housing market was seeing a huge surge in demand, home builders started maintaining an inventory of new homes. But when the recession finally came this inventory became insolvent and played a role in declining of the home prices. After the falling of the housing prices in the US, refinancing became difficult. Home owners, who wanted to seek out a second mortgage, could not lay their hands on one. Finding themselves unable to refinance they start to default, banks started a procedure known as “foreclosure”. This procedure made the home owners vacate their homes. How to avoid Recession: In order to avoid a recession several policy actions are required, mostly from the government side. Hopefully these policies will help in avoiding a recession. Amongst several things that can be done to avoid a recession is (Gourinchas and Kose, 2011): The government and monetary authorities should try to influence and increase aggregate demand. This would entail increasing consumer spending, investment and exports. But these measures should be tailored to affect the causes of recession. These measures should have both short-term and long –term affects. Many proponents believe that it is easy to overturn the affects of a recession if it is restricted to just a single country. But in a global recession it becomes difficult to predict which policy measures would work and which won’t. Since most of this depends on how individual economies adapt to the independent policies (Obstfeld, 2011). Policies to avoid a Recession 1. Cutting Interest Rates.   This policy measure is aimed to increase to aggregate demand by encouraging people to spend rather than save. Moreover lower interest rates leads to reduced mortgage payments and simultaneously increasing consumers’ disposable income. When firms see consumers’ willingness to spend, they in effect also start to spend in order to enhance their productive capabilities (Romero, 2011). 2. Along with cutting the base rates, the Central Bank can buy government bonds and mortgage securities of different banks. This action would help in lowering the interest rates and increase consumption in the economy (BLANCHARD, DELL’ARICCIA, and MAURO, 2010). These policies however failed to accomplish their desired objectives in the United Kingdom. Although the interest rates were lowered to 0.5%, it did not help UK to avoid a shattering recession. The reasons identified for this failure were: Bank did not lend and maintained a policy that lead to a credit crunch. Simultaneously consumers also lost their confidence in the economy and constrained their consumption. A phenomenon known as the liquidity trap was seen. People fear another recession in 2011, this will result in the world plunging into a double dip recession and since interest rates are already low this policy will fail to achieve the desired objectives. 3. Prevent Home Foreclosure: This action by the bank is an action of last resort, it does not prevent bank losses and neither does it help in increasing consumer spending. However, a government can try to freeze mortgage rates to help prevent this action (Weisbrot, Ray, Johnston, Cordero, and Montecino, 2009).  4. Expansionary Fiscal Policy:  This policy can be used in order to encourage the consumers to spend more as decreasing taxes results in increasing the disposable income. But this action would make the government to borrow more funds from the central bank, and therefore would lead to higher inflation. This may not be applicable when government bond yield is increasing e.g. European Union members like Greece, Ireland and Italy. These countries are engulfed in an environment that has little scope for expansionary fiscal policy. Moreover, there is no assurance that tax cuts will restore consumers confidence in the economy and that they will start spending again. The government itself could under take capital intensive project to increase government spending on capital investment projects. This will inject money into the economy. Some economists consider this to be more effective than tax cuts (Kolb, 2010). 5. Devaluation: this policy action is aimed to increase aggregate demand through increasing exports. A fall in the value of the dollar makes exporting items cheaper and importing items more expensive. But in a global recession demand for export items may stagnate no matter what policy action is undertaken. This policy action may also lead other countries to devalue their currency and fight for export market, thereby converting an economic measure into a competitive advantage for the export industry. However, this action is self proclaiming. 6. Higher Inflation Target: Artificial inflation is nurtured to achieve growth targets 7. Portfolio diversification finds its true utility at the time of Recession. A shrewd investor will always keep his portfolio diversified and would not keep all his eggs in one basket. This measure will ensure that different phases of economic cycle do not disrupt the productive capabilities of a portfolio (Romero, 2011). Very specific measures that needs to be taken: Fiscal Policy: Fiscal policy is the classical response of Keynesian economics. In recession, the aim is to boost Aggregate demand through cutting tax and increasing government spending. This injection into the economy can boost demand and stimulate the economy. To be effective expansionary fiscal policy requires (Weisbrot, Ray, Johnston, Cordero, and Montecino, 2009): Low government borrowing. If you already have very high levels of government borrowing. It becomes difficult to finance further expansionary fiscal policy. Responsiveness of consumers. Cutting taxes may not always boost consumer spending, if people prefer to save the money. For instance high debt levels encourage many US consumers to save their tax cut. Possibility of crowding out. Higher government spending leads to lower private sector spending. Fiscal policy may not be able to avoid all recessions, but in some circumstances can help to minimize the severity of a recession. The worst thing is for a government to try and balance its budget in a recession. Monetary Policy: Cutting interest rates should make borrowing cheaper and stimulate demand. However, lower interest rates don't always work (Romero, 2011). If confidence is very low, people may not want to borrow, even if borrowing is cheaper. For example Japan had 0% interest rates in the 1990s, but, failed to stimulate the economy (Romero, 2011). Monetary policy can be constrained by inflationary pressures in times of cost push inflation (Romero, 2011). Even though the US government and the Federal Reserve have tried hard to prevent the repercussions of the recession, but the underlying problem is so deep and so out of order that all policy actions are receiving a negative consequence. The government in this recession has kept aside moral hazard and has gone out of its way to save the institutions involved. Many experts believe that this assurance that the government will come to save the institutions is allowing the institutions to undertake risky investments. Credit crunch and bursting of the bubble is making the financial environment even more difficult to predict (Garicano and Lastra, 2010). The government and regulatory authorities can be more effective by being more nimble in their policy actions to curtail a speculative bubble germinating in the economy. Because if this is allowed to go on, than it would be too late and whatever policies would then be taken would be reactive rather than counteractive. It is therefore important to synchronize long term economic plans with the desired growth rate and avoid the creation of any sort of speculative bubble (Goodhart, CAE, 2009). The fundamental problem One of the problems that can quickly spread in an economy is that of liquidity. This problem arises out of the different institutions comprising the economy. When this happen a within industry contagion effect results. In an economy of interconnected institutions systemic risk always exist and this risk threatens the existence of the entire system. This risk comes about when the system experiences a contraction of capital sources. When there is not enough liquidity available in the system the economic sectors start to contract and thereby, taking down the real economy with them (Ellingsen and Vlachos, 2011). Another problem that is very vivid over here is the importance placed on undertaking undue risk. Incentives for risk-taking are given to individuals in financial institutions. The underlying reason found for this sort of behaviour is the assurance that the government would come to the help of these institution. These institutions believe that due to their enormous size and the role which they play in the economy no matter what actions they undertake the government will save them from bankruptcy. This in turn subjects lenders and depositors to the problem of “moral hazard” (Hens and Rieger, 2010). In order to avoid the repercussions of moral hazard and protect lenders from this sort of behaviour it is important that regulatory authority have in place those regulations which curtail such actions. These regulations should prevent excessive risk taking by the institutions. The government should also avoid any rescue package or bailout plans for these institutes. The government should make it clear to these institutes that in case of excessive risk taking they would also have to face the probable bankruptcy (Cornett, McNutt, Strahan, and Tehranian, 2011). Measures taken by the U.S Government: Narrow banking and the Volcker rule Through the “Volcker rule” President Obama has restricted banks from owning, investing, or sponsoring a hedge fund, private equity funds, and proprietary trading operations. This policy action has been adopted by the opposition parties of the United Kingdom (White House, Office of the Press Secretary, 2010). One of the drawbacks of the proposal is that it will be highly difficult and complicated to implement the proposal, as it has been always difficult to differentiate the hedging activities from the speculation (Arnold and Ewijk, 2011). Making bankruptcy credible Another rule that must be enacted is the prevention of saving institutes through taxpayers’ money. In this rules enactment a clause that keep the activities of institutes under surveillance should be added. No loan or help should be passed on to institutes that become insolvent due to their risk taking behaviour. In such case company should undergo bankruptcy procedures (BONGAERTS, DE JONG, and DRIESSEN, 2011). To use bankruptcy as a tool to disciplining managerial behaviour with regards to excessive risk taking, two changes need to be made (Sadka, 2010): The government should prevent financial institutions to attain a size that makes it very important for the economy. The government should keep a check on financial institutions size, complexity and interconnectivity. In order to achieve this objective the government should tax an institute according to its size. The size over here means its asset base and balance sheet. The diversity and complexity of activities of a bank should be critically evaluated to establish a banks systemic risk score. If investors and other stake holders are comfortable with this risk score than they can continue to support the banks activities at their own risk. No tax payers’ money will be used to save them in case a problem arises which threatens the functioning of this institute. Those institutes that are linked with many other institutes and there falling apart will bring down other institutes as well than more prudent regulations for these institutions should be enforced. The regulators should keep them under constant surveillance. Some institutes due to their complex business activities threatens the entire system and are a reason for systemic risk. There activities should be keep under constant check and never should they be allow full autonomy. After identifying the institutions that pose a probable systemic risk to the entire economy, regulator should tailor specific regulations to constrain their actions. Credible bankruptcy should be made credible and no institution should be allowed to grow too big, too complex or too central (Acharya and Pedersen, 2005). New regulations, better regulators Bankruptcy should be made credible, in case an institute in highly indebted. This measure according to many experts will lead to the creation of an efficient, less risky and fragile financial system. Moreover the role of regulators and stringent regulations cannot be under emphasized. These should involve three main steps (Blanchard, 2009): Along with making bankruptcy more credible there should also be efforts made towards greater transparency. Thus a centralized banking system should be developed that allows a manager to access the risk exposure of any individual institution in the system. This measure would have allowed investors and supervisors to understand better the evolution of derivative markets (Hart and Zingales, 2009). Higher liquidity and solvency requirements should be enforced to keep institutions solvent enough to meet there accruing expenditures. Thus most of the reforms undertaken are addressing this area of financial solvency. In this concern institutes will have to meet certain capital requirements, for instance contingent capital which is actually a type of debt that would be transformed into equity automatically when certain economic indicators turn bad. Although these proposals carry weight but since they are unable to generate capital, they are inadequate to resolve a crisis. The crisis of liquidity came up because financial institutes kept on undertaking short-term financing of long-term liabilities (Kashyap, 2010). Worldwide systemic supervisors should be placed who should access individual bank and its performance. Supervisors should be given powers and autonomy to impose rules and regulations and also penalties where needed. Central banks should be used as a measure of last resort, however it should be made imperative upon banks to keep a track of the worth of their possessions: asset quantities and prices, so that they could shape an effective monetary policy. Other than this strong emphasis should be placed on corporate governance and compensation packages of high profile individuals (Shin, 2009). Many experts support the idea of having in place policies that improve corporate governance and prevent senior managers and CEOs from consuming too much capital that in real belongs to the shareholders. All the bonuses and remunerations should be given after shareholders consent and no individual should be allowed to indulge in risk taking behaviour with shareholders consent. In case if the shareholders allow excessive risk taking than they should also be prepared for bankruptcy in case the risk doesn’t payoff. No money of the taxpayers should be used to service any corporate debt or corporate risk. Government should not lead institutes to believe that they would receive any help from the government in case they fail. All measures should be taken to curtail moral hazards from the institutes. Moreover, stern tax reforms should be in place to prevent disparity of income and allowing organization to grow too big. In this regard generalized tax policy should be discarded and targeted taxes scheme should be adopted. This should be coupled with tax policies that are aimed at increasing the tax base and drawing tax money from the rich (French et al, 2010). Conclusions The most concerning issue in the financial system is the existence of the air of assurance among the financial institutions that no matter what they do they would always be saved by the government. These institutions are allowed to become so big that there failure will have deep and serious repercussions for the economy. These institutions believe that they can undertake activities that lead to moral hazard just because the government will bail them out. This attitude encourages excessive risk-taking behaviour. List of References Acharya, V., and Pedersen, L. 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