Bank Risk Taking Strategies before the Crisis - Essay Example

?Bank risk taking strategies before the crisis Short term interest rates This strategy was applied to minimize the chances of bank s withdrawing their deposits. This serves to ensure that the bank liquidity and capital base is maintained high. With the high capital base, the bank dilutes the regulations that govern lending to their customers and thus making loans more accessible. This makes the bank extend loans to even those loan applicants who have not been servicing their loans as required, granting them huge amounts and even extending their duration of loan repayment (Calomiris and Mason, 2004). The rise in the lending capacity of the bank serves to increase its risk taking propensity and eventually makes the assets with no risk unattractive. Monetary policy A lower monetary policy increases the bank’s risk taking. When the monetary policy is low, it impacts on the loan industry’s ability to lend and give mortgage. It also impacts on the consumer and the business loan interests. These insufficient considerations to protect the losses that could be incurred through loan defaulters, just served to increase the inappropriate usage by the loan borrowers. This created a need to put into place the measures that reduced the misuse of these funds. Therefore, a well laid down strategy integrating the mode of pay and the borrower’s loan thresh hold and ability to service it had to be established (Jaffee, 2010). This measure was meant to eliminate the motivation that encouraged the borrowers to take higher risks of unplanned for huge sum borrowing. Executive compensation arrangements is an arrangement that enabled the executive to get huge cash amounts of equity based and bonus compensation before the long-term consequences of decisions are realized. This motivated the executive to only pay attention to the short-term outcomes and fail to focus on the long-term adverse effects this had on the shareholders. This therefore called for the implementation of adequate legislation that would minimize the chances of the executive undertaking activities that exposed the banks to higher and excessive levels of risk taking. There has been found to have a need to instill into the banks management a good system of eliminating these risks. Secondly, internal Investment is another strategy that was applied by most of these banks. There was a high tendency of the executives of these banks to invest heavily on the shares of the banks they headed. Consequently, this tendency made them disregard the possibility of falling into the crisis. They only perceived the upward trend of investing more and more to increase their share holding in their companies. According to Calomiris and Mason (2004), it is against this background, that a need to regulate the executive pay was realized. This move is to ensure that the executives’ financial capacity is strongly linked to the shareholders interest. This being he case, the executive is hindered from possessing the great ability of investing highly into the organization they are heading. This ensures a reduced executive’s ambition, and consequently instills a sense of vigilance and supervision of lending activities by their banks. Bank performance Inflow of foreign currency Banks total assets in millions AGRI BANK 39866.5 47007.4 52264.0 63285.8 66143.3 AMEGY 9351.94 10359.2 11836.1 12354 11089.3 ALLIANCE 9490.5 10601.1 9368.8 8503.5 172313.0 Years 2005 2006 2007 2008 2009 There was an influx of foreign currency from other continents. It is this influx of these foreign currencies that resulted to relaxation of the lending terms by the banks. This served to enable business community to invest in the housing market. Later, the value of the houses greatly declined and consequently there were greater losses incurred by those who had invested in homes. These loses in turn enhanced the high rate of defaults in loan repayments, which in to a large extent minimized the financial stability of the banks. The banks instability affected the overall performance of the economy by slowing it down to relatively low growth rates. Consequently, the banks operation capacity was reduced as the banks tried to recover the amounts they had lent. This made the banks claim more homes from the borrowers who had defaulted in their repayment. It is this receivership of houses by the banks that lowered the prices to low levels (Kolb, 2011). Decreased value of stock market Most of the stocks in the US Stock Exchange market declined in value by a remarkable margin. With the decline in the value of stocks, the ability of the consumer to spend declined. This diminished the economic growth rate since that spending by the consumers is one of the drivers of economic prosperity. During this period, the consumers did not save a lot. They consumed most of their incomes and even borrowed more. This resulted to a decrease in the deposits that were made to the banks during the period. The financial reserves held by the banks were depleted further (Valdez and Molyneux, 2010). Source: Financial Crisis Inquiry Commission-Press Release-January 27, 2011 Internal Investment This is another strategy that was applied by most of these banks. There was a high tendency of the executives of these banks to invest heavily on the shares of the banks they headed. Consequently, this tendency made them disregard the possibility of falling into the crisis. They only perceived the upward trend of investing more and more to increase their share holding in their companies. It is against this background, that a need to regulate the executive pay was realized. This move is to ensure that the executives financial capacity is strongly linked to the shareholders interest. This being he case, the executive is hindered from possessing the great ability of investing highly into the organization they are heading. This ensures a reduced executive’s ambition, and consequently instills a sense of vigilance and supervision of lending activities by their banks (Jaffee 2010). The theory of too big to fail This theory became an important area of study during the crisis. The theory as termed mean that some of organizations which are well established and share a lot together cannot just be allowed to fall by the government. This theory was coined by those people who believed that these organizations should be highly supported by the government each time there is financial crisis so as to prevent major economic downfall of the country. It has since attracted attention to many and even become an area of study. The theory is seen as favoring major financial institutions such as big banks. This theory enjoys a lot of support although it is not unanimously acceptable by all countries. According to Calomiris and Mason (2004), the government exercises the theory in three major ways; it may dispose off assets and compensate the shareholders who are eligible for compensation, it may also encourage another organization to takeover the properties or the resources of another firm. The government my also provide loans to these institutions to assist them to overcome heavy financial crisis. These theories however are not universally believed to work especially the third one which made big banks to enjoy market survival and also had effects in their units of capital. Financial institution also faced a lot of difficulty in choosing the best suitable method to use among the three options that the theory advocated. The on going financial crisis thus made the government to pass the resolution to protect its banks from experiencing a hit and passing this crisis to other sectors which could halt the economy (Valdez and Molyneux, 2010). This theory however faced critics from some who believed that it would lead to unstable and inequitable economic climate and it led to solid and concrete decisions by the governing party during this crisis. Deposits were also safer with larger banks than the small banks, and even to certain extent attract much interest on the money that the customers had stored in the banks, people ended up entrusting their funds with larger institution than smaller ones. Due to this destabilization crisis resulted and rarely could this theory accomplish what it was meant to or even support the strategies that were set before the crisis (Kolb, 2011). The theory made these financial institutions much bigger and led to a lot of crisis than it was meant to prevent. It can therefore be said that despite its formulation to prevent extreme effects on the economic crisis it led to more crisis. An attempt to enlist the method will be an attempt to support further crisis. It can therefore be said that it did not back up the strategies that were enacted to prevent the economic crises 2004 to 2010. The government of US thus opted to not only by increasing the net worthy and taxation but also break them to much less units and subsequent subjecting these units to further payments of duties. This could bring about balanced economy and equitability when it comes to risking resources for profits by financial institutions. Reference list Calomiris, CW and Mason, JR 2004, Credit Card Securitization and Regulatory Arbitrage, Journal of Financial Services Research, vol. 26, no. 1, 5–27. Jaffee. DM 2010, The Role of the GSEs and Housing Policy in the Financial Crisis, Haas School of Business, University of California, Berkeley. Kolb, RW 2011, The financial crisis of our time, University Press, New York. Valdez, S and Molyneux, P 2010, An Introduction to Global Financial Markets, Palgrave Macmillan: New York. Read More