Banking Crisis - Research Paper Example

? Banking Crisis Introduction The Federal Reserve sets the nation’s monetary policy to promote the objectives of maximum employment, stable prices, and moderate long-term interest rates. (Federal Reserve System 15). In a country’s economy the factors like inflation, interest rates and employment are interdependent. Economic indicators based on actual data or leading indicators are used by the Federal Reserve in firming up its monetary policies. In order to achieve its objectives, Federal Reserve controls money supply directly in the economy through supply of Federal Reserve balances and indirectly by controlling the interest rates. It is important to ensure close co-ordination between the Federal Reserve and the Government, because monetary policies should be complementary to fiscal policies for achieving the country’s objective of sustainable and long term economic growth. Evolution of Central Banking The concept of Central Bank evolved in the second half of the 19th century. The banking institutions started with commercial purposes or government banks have transformed into central banks in most of the countries. Bank of England model has been adopted by several countries. Central banks became the lender of the last resort and started issuing notes. In the aftermath of the great depression the independence of the central bank has been curtailed in US. However, gold standard and laissez faire brought back independence to central bank to ensure monetary stability. The US Federal Reserve came into existence in 1913 through passing of The Federal Reserve Act. Panic in 1907 in banking circles gave rise to demands for reforms in banking sector and the National Monetary Commission was set up for this purpose. In mid 1990’s “in the wake of Russian default, the Fed lowered short term interest rates to minimize the consequences of international financial conditions for the US economy and to ameliorate those conditions abroad.” (Neely 35) Many world countries have agreed to adopt gold standard system in Bretton Woods Conference in 1914 which envisaged economic discipline among the nations. The role of central bank has increased substantially since stability of the currency is an important factor in international finance. But, gold standard has failed due to devaluation of currencies by several countries to protect their national economies. The International Monetary Fund created in Bretton Woods in 1944 with the aim of preserving global monetary order introduced fixed exchange rates of the currencies in relation to US Dollar or gold. This system has also failed due to various practical difficulties. Introduction of fluctuating exchange rates later coupled with internal economic factors has increased the clout of central banks further and most of the countries started adopting fluctuating exchange rate system based on demand and supply. Paul Krugman stated “Under the "floating" exchange rates we have had since 1973, exchange rates are determined by people buying and selling currencies in the foreign-exchange markets. The instability of floating rates has surprised and disappointed many economists and businessmen, who had not expected them to create so much uncertainty.” From the simple bartering system, the monetary order has undergone changes over years in tune with the dynamic economic environment, technological developments and introduction of exotic derivative products in banking and financial services sector. In determining the value of money in modern economy, the fiscal measures of governments and the monetary control measures of the central bank play very crucial roles. David Kupelian stated “Despite the varied theories espoused by many establishment economists, it was none other than the Federal Reserve that caused the Great Depression and the horrific suffering, deprivation and dislocation America and the world experienced in its wake. At least, that’s the clearly stated view of current Fed Chairman Ben Bernanke.” The globalization phenomenon gaining momentum during the recent years underlines the need for strengthening global monetary system with the cooperation of the central banks with the International Monetary Fund so that weaknesses noticed in specific areas based on emerging global signals could be addressed effectively by central banks to overcome economic imbalances internationally. Role of Federal Reserve and Monetary Policy Due to phenomenal increase in cross border commercial transactions consequent upon globalization drive initiated by various countries of the world, the role of central bank has undergone changes significantly in the recent years. Keeping inflation under control and regulating economic growth cannot be achieved ignoring global developments. Increase in money supply during economic slowdown increases money supply. This will result in decrease in interest rates which propels demand in economy. Maintaining stability in exchange rate is an important responsibility under the changed scenario as it is closely linked to the domestic price stability also. For maintaining desired parity levels of the currency, the central bank of a country needs to exercise its monetary authority with various policy initiatives undertaken for stability and monitor the movements of exchange rate of the country’s currency. Central bank’s intervention may take the form of open market purchase or sale of currencies to maintain stability or to achieve desired parity of its currency in relation to foreign currencies. Efficiency in monetary control operations hinges on flexibility available in the system and the other international developments such as rise in crude oil prices and emerging war like situations. European Central Bank stated “As regards the ECB, in the face of financial crisis, monetary policy was eased significantly through conventional means in late 2008 and early 2009, with key interest rates being reduced significantly” (10). Various control measures adopted by Federal Reserve includes ‘Reserve Ratio’ required to be maintained by the banks in accordance with the instructions issued by it from time to time and ‘Contractual Clearing Balances’ which aims to safe-guard the system from unexpected pressures like huge debits at the close of the business day. The banks also need to maintain excess reserve balances with the Reserve Bank for additional protection as may be required by the Fed to avoid risks. Purchase and sale of securities through repurchase agreements is carried out by the Federal Reserve for regulating money supply. The banks can borrow from the Federal Reserve through its discount window. The banks can avail the facility of autonomous factors which increases the money supply when the economy is in booming phase. Open market operations through Federal Bank’s discount window aims at controlling the Federal Fund Rate. For instance, the measures adopted by the Federal Reserve like increasing interest rates at the time of inflation have impact on consumption, consequently industrial production and employment. Regulating interest rate is a balancing strategy adopted by the Federal Reserve with or without increasing money supply after carefully weighing consequences after taking into account the interplay of various factors for regulating growth. Therefore, at the time of overheating in economy, the Federal Bank may resort to increase interest rates for regulating growth. Injecting liquidity into the system through money supply has its impacts on financial markets. Jagdish Handa observed “Many central banks, especially in financially developed economies, nowadays choose to use the interest rate, rather than the money supply, as the primary monetary policy instrument, while leaving the money supply endogenous to the economy” (429). In an economic slowdown, if the situation remains unchecked the negative multiplier effect could lead to recession in the economy. Therefore, the role of Federal Reserve through its monetary policies is considered very important for stability in the system and sustainable economic growth in the country. Banking Crisis and the Factors Leading to the Crisis Actually, BNP Paribas precipitated the issue for the first time while halting redemptions temporarily in August 2007 due to its inability to value subprime mortgage debts which caused cessation of interbank lending. Appendix I list out the top 25 companies benefited from bailout package announced by the American government. The financial system collapsed in vicious circle on account of suspicion and lack of confidence. The issue of hold on interbank lending overshadowed credit risk. Though the external factors responsible for crisis is not under the control of banks, complacency and unpreparedness on their part cannot be ignored. Bonuses and stock options to executives in financial services and banking sector have encouraged them to neglect ‘caution’ in their greed to amass wealth. Excess leverage, exotic financial products and cross holdings in the system have accentuated the problems further which culminated into financial crisis. The central bank and governments have failed to foresee the impending disaster and take timely corrective measures. Knowledge@Wharton states “regulatory efforts to encourage competition between Fannie Mae and Freddie Mac were misguided because they intensified the pressure on entities that were not completely free-market vehicles. Leaders either did not understand or were unable to balance the goals of a "public-private hybrid". The crisis has been evolving into the system over period of time and gone unnoticed or remained unchecked due to inefficiency and poor risk management which caused meltdown internationally in banking and financial services sector. There are several interlinked factors which led to financial crisis globally. For example, in the European context, the most affected countries have been Greece, Portugal, Italy and Spain. The current account balances of these countries have been deteriorating over years without any meaningful intervention by these governments to stem the tide. Competitiveness of these countries in global markets has been eroded significantly as reflected in increasing trade imbalances. The efficacy of the austerity measures proposed in improving the balance of payments position in these countries is debatable since the rescue packages announced cannot reverse the inflationary pressures. The central bank becomes helpless in such situations since interest rate as a tool of monetary control cannot be wielded effectively. Therefore, a combination of effective fiscal and monetary measures is necessary to overcome the difficult times with the help of other developed countries. Equal Opportunity Menace Various countries around the world are vulnerable to banking crises and uncertainties in banking sector have increased phenomenally over years and the developed countries are not exceptions. Carmen M. Reinhart and Kennet S. Rogoff found “that systemic banking crises are typically preceded by asset price bubbles, large capital inflows and credit booms in rich and poor countries alike” (Abstract). They also stated “the average length of time spent in a state of sovereign default is far above the average amount of time spent in a financial crisis. A country can circumvent its external creditors for an extended period. It is far more costly to leave a domestic banking crisis hanging, due to the crippling effects on trade and investment.” (10). It is also observed that the stock of government debt increases by 86% in the subsequent three years after the crisis. The fiscal repercussions of banking crises are considered more serious than the cost of bailouts. Mark Pittman (2008) stated that “Without the government money, Goldman, Merrill Lynch & Co., Morgan Stanley, Deutsche Bank AG and other firms could have become some of the biggest creditors in a bankruptcy filing by AIG, the world's largest insurer, because of its billions in losses on subprime bonds and corporate debt.” At the same time there have been glaring examples of fancy compensation to company executives. Nelson D. Schwartz stated “James M. Cracchiolo, the C.E.O. of Ameriprise Financial, received an options package worth $9.1 million in 2009, nearly identical to the value of his options award in 2008. But instead of giving him options on 656,535 shares as it did in 2008, the board gave him options on more than a million shares last year.”  Therefore, a question arises whether the bailout packages, as it is popularly called, which resulted in increased debt in the subsequent years are justified. The only alternative available to revival measures are inaction, which is in no way justified. The circumstances obtained in particular cases may differ, and consequently the revival measures undertaken. However, taking corrective action ensures vigilance on the part of the machinery. Also, the loopholes in the system are identified in this process for taking corrective action. Frederic Mishkin observes that “As in many previous crises, the current crisis has had three precipitating factors: 1) mismanagement of financial innovation, 2) an asset price bubble that burst, and 3) deterioration of financial institution balance sheets” (5). There were huge write downs on account of mortgage backed securities, exotic derivative products and other structured credit products which undermined the efficacy of risk management policies adopted by the banks and financial institutions. Federal Bank’s liquidity injection policy has helped soft landing and prevented the system’s collapse which has been considered necessary to revive confidence on economy and to limit the negative impacts. Mishkin argues “The fallacy that monetary policy is ineffective during financial crises may promote policy inaction in the face of a severe contractionary shock … aggressive monetary policy easing can make adverse feedback loops less likely” (11). Effectiveness of Monetary Policies and Deflation Ben Bernanke told in November 2002 that “having said that deflation in the United States is highly unlikely, I would be imprudent to rule out the possibility altogether. Accordingly, I want to turn to a further exploration of the causes of deflation, its economic effects, and the policy instruments that can be deployed against it”. In his remarks, the word ‘deflation’ was referred to in 83 places! This is just to stress on the crippling effect of deflation in an economy. Deflation is a vicious circle which feeds on itself. Revival of economy from deflation is a very arduous and prolonged process with negative multiplier effect set into the economic system. It will be very difficult neither to predict the bottom or bottoming out stage in deflation. Under negative multiplier effect if the government reduces spending, many of the government employees lose their jobs resulting in fall of national income. With unemployment inching upward, the unemployed people spend less. This leads to less demand with consequential effects on economy. This is called as malign deflation. Stephen Cecchetti stated “the Federal Reserve faced the danger of a sharp contraction in credit and bank lending in a way that threatened a deep recession or worse” (51). In a situation like this the central bank has to ensure and guarantee liquidity in the system to maintain the flow of business since payments and transfers are the life line for conducting businesses. Stefano Ugolini argued “that one of the preconditions for the central bank to be able to implement lending of last resort is its establishment at the centre of the payments system: when that is the case, a contraction of interbank lending typically translates into an expansion of central bank deposits – which allows central banks to lend more during crises” (26). Federal bank came to rescue of the banks by providing short term lending facility. Series of measures like Term Securities Lending Facility initiated by Federal Reserve were useful in reviving confidence in the banking system. “Given the very real and immediate dangers posed by the ?nancial crisis that began in August 2007, it is difficult to fault the Federal Reserve for its creative and aggressive responses” (Cecchetti 74). Seeking external debts through bonds for reviving domestic economy is fraught with dangers, if it is not properly planned since the borrowings are risky due to fluctuations in foreign exchange. This could also affect sovereign rating of the borrowing country negatively which will in turn increase the cost of borrowing. Greece is a case in point and the country is passing through a very difficult phase in its history. European Union came to rescue simply to avoid deeper world economic crisis. Inflation coupled with stagnation in economy or ‘stagflation’ as it is called needs to be tacked with multipronged strategies. The role of central bank in such case is very challenging as there are several issues such as inflation, unemployment, lack of liquidity and instability in exchange rate vying with each other for attention. Recession may be followed by double-dip recession and triple dip recession as well and revival will be very slow and protracted. Monetary Policies and Fiscal Policies While monetary policy of the Federal Reserve is related to regulating supply of money and the interest rates to achieve stability and economic growth, fiscal policy determines the tax rates and the government’s spending. Also, while monetary policies are free from political influence political ideologies dominates fiscal policies of the government. Tax rates and government spending will have impact on liquidity in the system. Therefore, close coordination between Fed and the government is very important in achieving the economic objectives of the nation, since working for cross purposes would defeat the efficacy of governance at all levels in the country. Public spending and reduction in tax rates during recession is considered essential for revival of economy. But, these measures will take time to yield results. Coordinated regulations through proper adjustments in monetary policies will increase efficacy of fiscal policies. Reforms in Central Banking Cecchetti (2007) stated, “…we have seen recently, financial markets and institutions can malfunction on a moment’s notice. To prevent this, governments regulate and supervise financial institutions and markets. And best practice dictates that financial stability is one of the primary objectives of the central bank.” However, in the history of Federal Bank, the government has intervened in its functions on many occasions only to reconsider their decisions and restore the independence of the institution subsequently. Central bank’s independence is important for its effective function. However, defending economic field and introducing reforms are essential for sustainable economic growth, though an altogether an entirely new field is not advisable since the current system could be improved with new policy initiatives. Under the direct control of the government, the institution’s style of function will change in tune with the ruling party’s economic agenda. Long term objectives of price and exchange rate stability can be better achieved by a politically insulated institution. Fed under government can lead to unrestricted treasury financing of large budget deficits. Frederic Mishkin and Stanley Eakins argue that “The argument supporting Federal Reserve independence is that the principal-agent problem is worse for politicians than for the Fed because politicians have fewer incentives to act in the public interest” (165). Reforms in economic field in general should encourage savings by the people since money saved is meant for future consumption that can act as a buffer in hard times. Debt culture in the country should be discouraged as it affects individuals and corporations alike. Borrowings at all levels prevent flexibility in monetary policies relating to liquidity. Redesigning of economic field is essential to restrict deficit spending to a reasonable limit. Economic slowdown, decreasing tax revenues and costly bailouts have increased deficit woes. Cut in non plan expenditure by the government is very important to improve fiscal discipline. Fed should equip itself with modern tools for monitoring risk management in banking and financial sector to avoid scams on larger scale. Conclusion The republicans are in favor of fiscal responsibility and against deficit spending. They are conservative in taxation as well. But, Democrats accused that the Republicans had turned their “back on the middle class Americans” (2012 Democratic National Platform). The macroeconomic policies of the political parties are bound to influence inflation, employment and long term growth, consequently, the monetary policies pursued by Fed either directly or indirectly. Therefore, achievement of the objectives of the monetary policies of the Federal Reserve is to a larger extent dependent on fiscal policies of the government. The fiscal policies of the government and monetary policies of the Federal bank need to be complementary to each other for achieving the objective of economic growth. References 2012 Democratic National Platform. “Moving America Forward.” Web. 18 Novembter 2013. Bernanke, Ben S. Deflation: “Making Sure "It" Doesn't Happen Here The Federal Reserve.” 2002. Carmen, M. Reinhart and Kennet, S. Rogoff. “Banking Crises: An Equal opportunity menace.” National Bureau of Economic Research. Working Paper 14587. 2008. Web. 17 November 2013. Cecchetti, Stephen.  “Subprime Series, part 3: Why central banks should be financial supervisors.” VoxEU.org. 30 November 2007. Web. 17 November 2013. Cecchetti, Stephen. “Crisis and Responses: The Federal Reserve in the Early Stages of The Financial Crisis.” Journal of Economic Perspectives—Volume 23, Number 1—Winter 2009—Pages 51–75. Einhorn, David. “Liquor before Beer…In the Clear”, Value Investing Congress, Greenlight Capital . 19 October 2009. Scribd. Web 18 November 2013. European Central Bank. “The Greater Financial Crisis.” 20-21 May 2010. Web. 18 November 2013 Federal Reserve System. “Monetary Policy and the Economy.” 2011. Web. 18 November 2013. Handa, Jagdish. Monetary Economics, 2nd Edition. Routledge. 2009 New York. Knowledge@Wharton. “Eyes on the Wrong Prize: Leadership Lapses That Fueled Wall Street's Fall.” 17 September 2008. Wharton School of the University of Pennsylvania. Web. 18 November 2013. 1http://knowledge.wharton.upenn.edu/article.cfm?articleid=2048 Krugman, Paul. “Exchange Rates, Library of Economics Liberty.” 2012. Web. 17 November 2013. Kupelian, David. “BERNANKE: FEDERAL RESERVE CAUSED GREAT DEPRESSION.” WND. 2008. 19 March 2008. Web. 18 November 2013. Marks, A. and Scherer, R. “U.S. savings rate falls to zero.” Christian Science Monitor. 3 August 2005. Mishkin, Frederic S. “IS MONETARY POLICY EFFECTIVE DURING FINANCIAL CRISES?” NATIONAL BUREAU OF ECONOMIC RESEARCH. Working Paper 14678. 2009. Web 18 November 2013. Mishkin, Frederic, S. and Stanley Eakins, Stanley, G. Financial Markets and Institutions. Pearson Education. Sixth Edition. 2011.New Delhi. Neely, Christopher, J. “The Federal Reserve Responds to Crises: September 11th Was Not the First.” Federal Reserve Bank of St. Louis Review. March/April 2004, 86(2), pp. 27-42. Web. 18 November 2013. Pittman, Mark. Goldman. “Merrill Collect Billions After Fed's AIG Bailout Loans.” 29 Sep 2008. Bloomberg. Web. 18 November 2013. Schwartz, Nelson D. “Striking Gold in Stock Options.” The New York Times, April 3, 2010 Web. 18 November 2013. The Center for Public Integrity. “Who’s Behind the Financial Meltdown? The Top 25 Subprime Lenders and their Wall Street Backers.” The Center for Public Integrity. 2013. Web. 18 November 2013. Ugolini, Stefano. “ What do we really know about the long-term evolution of central banking? Evidence from the Past, insights for the present.” Norbes Bank’s Bicentenary project. Working paper 2011/15. Web. 18 November 2013. http://www.norges-bank.no/Upload/English/Publications/Working%20Papers/2011/WP_2011_15.pdf Appendix I The Top 25 in Subprime (Subprime loans approximately) 1. Countrywide Financial Corp. $97.2 billion 2. Ameriquest Mortgage Co./ACC Capital Holdings Corp. $80.6 billion 3. New Century Financial Corp. $75.9 billion 4. First Franklin Corp./National City Corp./Merrill Lynch & Co. $68 billion 5. Long Beach Mortgage Co./Washington Mutual $65.2 billion 6. Option One Mortgage Corp./H&R Block Inc. $64.7 billion 7. Fremont Investment & Loan/Fremont General Corp. $61.7 billion 8. Wells Fargo Financial/Wells Fargo & Co. $51.8 billion 9. HSBC Finance Corp./HSBC Holdings plc $50.3 billion 10. WMC Mortgage Corp./General Electric Co. $49.6 billion 11. BNC Mortgage Inc./Lehman Brothers $47.6 billion 12. Chase Home Finance/JPMorgan Chase & Co. $30 billion 13. Accredited Home Lenders Inc./Lone Star Funds V $29.0 billion 14. IndyMac Bancorp, Inc. $26.4 billion 15. CitiFinancial / Citigroup Inc. $26.3 billion 16. EquiFirst Corp./Regions Financial Corp./Barclays Bank plc $24.4 billion 17. Encore Credit Corp./ ECC Capital Corp./Bear Stearns Cos. Inc. $22.3 billion 18. American General Finance Inc./American Intl. Group Inc. (AIG) $21.8 billion 19. Wachovia Corp. $17.6 billion 20. GMAC LLC/Cerberus Capital Management $17.2 billion 21. NovaStar Financial Inc. $16 billion 22. American Home Mortgage Investment Corp. $15.3 billion 23. GreenPoint Mortgage Funding Inc./Capital One Financial Corp. $13.1 billion 24. ResMAE Mortgage Corp./Citadel Investment Group $13 billion 25. Aegis Mortgage Corp./Cerberus Capital Management $11.5 billion Source: The Center for Public Integrity Read More