The Possible Causes of the Financial Crisis - Term Paper Example

Introduction The current crisis in financial markets is considered as one of the serious crises being faced by the developed world owing to the failure of its financial system to properly manage the various institutions responsible for operating the financial system. The current crises have raised many important considerations for the regulators of the financial markets because of the potential impacts of such a crisis can have over other macroeconomic variables. (Campbell, 2008). The carryover impacts on other macroeconomic variables are invariably getting hurt due to these current crises which El Gamal (2008) cite as the “Crisis of confidence” because of the complexity of the inter-linking macroeconomic variables. Subprime mortgage problems may be just one of the apparent reasons for a current crisis. However, deep down; there are multiple reasons for these crises as it has been a collective failure of the financial institutions as well as their supervisors who relied too much on the market forces to determine the outcome of the market. Further, the integration of financial markets due to globalization has the correlation effect on different markets. Therefore, the crisis which emerged from US has been able to make its impact felt into UK also. However, what is also critical to understand that the increasing greed to earn more profits and subsequent entry into markets which were non-bankable suggest a very casual approach from the bank officials in carefully managing the affairs of the financial institutions. This paper will critically explore the causes of the current crisis in financial markets by discussing six possible causes of the crisis. Current financial crisis Before discussing the causes of the current financial crisis, it is critical that a historical review of the apparent reasons of the crisis shall be discussed. It has been understood and perceived by many that the core cause of the current financial crisis is the over-lending into subprime mortgage market. Sub-prime borrowers are the borrowers with relatively higher risk profile and are considered as mostly non-bankable under the conventional banking practices. However, due to higher risk associated with such borrowers, there is also an opportunity to earn higher reward too. Based on this assumption and due to relaxed regulatory environment, financial institutions attempted to tap that niche and started to lend to subprime borrowers. What was also considered at the time of making such a lending was the assumption the housing markets would continue to appreciate or would remain at their existing levels. Therefore, even in case of bankruptcy of the customers, the available collaterals would provide sufficient cushion to realize the loans advanced to the subprime borrowers. What is also important to under however is the fact that financial institutions started to securitize their subprime mortgage portfolio in a bid to recoup the liquidity drained due to lending made to the subprime borrowers. This so called innovation however proved detrimental to the financial institutions because of the mass scale default of the subprime borrowers which resulted into the current crises and started the financial meltdown which is threatening the financial systems of the developed world. The following section will discuss some of the reasons behind the current crises in financial markets. Failure of Financial Regulatory Agencies The circumstances surrounding the failure of Northern Rock suggests that the regulatory risk is one of the key risks which the financial system as a whole has to manage. The failure of the financial regulatory authorities to effectively check in the latest developments into the financial markets gave rise to increased systematic risk in the overall financial markets of UK. (Mcllroy, 2008). While discussing the causes of the current crises, one argument which has often bubbled up is the supposed role of regulatory authorities. As per the IMF’s reports that the regulatory response from the different regulatory authorities towards the rapid financial innovation was lagging behind which basically provided the necessary room to financial institutions to take risks beyond the capacity. (Schifferes, 2008). It has been further argued in the same report that securitization is not the only cause of the credit crunch as the lax standards of financial regulatory agencies allowed financial institutions to engage into complex product development which was not only complicated but also put financial institutions at more risk. UK’s regulatory set up include Treasury, Bank of England as well as Financial Services Authority or FSA. FSA has the final responsibility of framing the Prudential Regulations as well as other regulations aimed at regulating the financial sector in UK. FSA’s role in the failure of Northern Rock has greatly been criticized because of its inability to properly assess the risk of the model used by the Bank, and as such it has failed to clearly warn the Bank as well as the general public of the potential risks involved. (Campbell, 2008). Further, Campbell (2008) has also argued that there was a complete lack of coordination between the various regulatory authorities although technically they were supposed to work closely with each to regulate the financial system of the country by remaining within their own regulatory parameters. The regulatory role of FSA and other regulatory bodies have remained only to assess and regulate the legal form of the financial institutions rather than their economic substance. This therefore created a wider gap between the regulatory environment and the actual banking practices because of the lack of understanding of the financial transactions done by the name of regulatory compliance by financial organizations. (Turner, 2009). It has also been argued that the role of FSA has been to facilitate the investors to come to UK rather than putting forward a rule based environment which not only allows the investment activity to flow in but also provide a regulatory shield to them so that they can improve their ability to absorb external shocks.(Lastra,2008). The overall role of FSA has therefore remained focused on facilitating the financial institutions rather than putting forward a regulatory framework which has the potential to assess the risk correctly as well as responding to such risks in the most appropriate manner. The overall attitude of FSA can be judged from the following quote: “Indeed, the regulators themselves were divided. In its two 2006 Risk Reports, Britain’s super regulator, FSA drew attention to the huge profitability of the banks as a reason why investors need not worry about credit implosion. The banks had never been so profitable, so now the world was safe. This proved to be a myth. When the realization dawned that those American Subprime loans were worth just pennies in the pound, the brakes were slammed on. Mortgage lenders cut back their exposure, credit card limits were slashed and the US economy fell into recession in 2008, with growth in Britain strangled. With its huge exposure to the financial sector, the UK would prove more vulnerable than almost any other Western economy bar US” (Brummer,2008). Brummer was right in pointing towards the fact the FSA was too pre-occupied with the fact that banks were never so much profitable at, they were at that point in time, and it was because of this complacency that it largely remained ignorant of what was really happening in the financial sector as BBC’s Ian Pollock (2008) remarked that FSA’s internal auditors lacked the ability to conduct the audits in the most effective way. The role of FSA specially in the Northern Rock episode is more of a complacent and inefficient organization which due to its internal inefficiencies failed to keep a tight lid over the management of the Bank despite knowing that Bank was heading towards a disaster which can potentially a threat the whole financial system of UK. Integrated Financial Regulations As discussed above that there are basically three regulatory authorities which are basically regulating the financial sector in the country. In 1997, UK attempted to separate the monetary policy regulation from the supervision of the financial sector therefore Bank of England was credited with the mandate to be the sole regulator of monetary policy in the country whereas a new regulatory institution was established with the name of Financial Services Authority responsible for the overall regulation of the financial sector in the country. Due to this split of responsibility, FSA was entrusted with the duty of regulating Banks, Insurance companies as well as other securities companies. Treasury of the Government however, still maintains its responsibility of maintaining and overseeing the infrastructure of the whole financial system of the country. However, despite such a sound financial regulatory mechanism in place, this tripartite agreement of three regulatory authorities potentially failed to detect and assess the potential risks taken by most of the institutions in UK. (Lastra, 2008). The integration of the various regulatory authorities however provided different protections to the deposit holders in case of any adverse run on any bank. Therefore, banks acted more in terms of market participants rather than highly regulated institutions. What is however also important to understand here is the fact the UK’s existing financial regulatory structure gives too much power to FSA with a little role assigned to Bank of England in bringing in financial stability into the system? Globalization of Financial System Dr. Partha Gangopadhyay of University of Western Sydney (2005) is of the opinion that the current financial crises could have been averted if the regulators of financial markets concentrated on the affects of globalization on the financial markets. He is of the opinion that the monetary policy authorities in advanced countries cannot exercise the conventional means of controlling monetary policy in the country. The increased integration of financial markets. Therefore, not only creates risks external to the economy but also do not allow regulatory authorities to exercise substantial power over international financial institutions. The impact of globalization of financial markets was so intense that it brought a complete shift into the business models of banking organizations where there was a complete shift on developing an equity culture in order to achieve the faster growth into the share prices of their respective organizations.(Wignall et.al, 2008). The introduction of BASEL II allowed further integration of the financial markets across the world as it allowed banks and financial institutions to engage into cross border trading activities by packing and selling securitized products in international markets not only to gain diversification but also take benefits of the higher spreads available in international markets. (Wignall et.al, 2008). Considering the above situation, the correlation between the financial markets therefore created the spillover effect of the crisis emerging from US on the financial markets in other parts of the world too especially on UK. As according to Dr. Patnaik of Centre for Economic Studies and Planning at India that the integrated free market economies lack the ability to distinguish between the enterprise and speculation activity. Therefore, same speculative activity was carried over to the UK and other markets also and resulted into the same level of crisis for UK as they were for US. As mentioned above that the globalization brought a fundamental shift into the business model pursued by international banks by focusing more on the appreciation of share prices. Therefore, it encouraged the speculative activities not only in domestic markets but at the international level also which invariably created a chain reaction of crises spread all over the developed world including UK also. The globalization of the financial markets therefore, also allowed banks in UK to replicate the practices of Banks in US and started to lend into areas which were traditionally considered as non-bankable. This practice was also bolstered by the fact that under BASEL II regime, mortgages provided an additional comfort level in terms of capital adequacy to the Banks. Therefore, most of the financial institutions started to concentrate their portfolio into mortgage market which invariably due to the correlation of financial markets with each other. One of the most critical impacts of globalization on the current financial crises emerged since it created fluctuating cycles of booms and busts due to capital flight from one country to another. Due to reduced cost of financing as well as lax regulatory environment leveraging of assets at an international level increased which invariably fueled the asset prices across the markets. Globalization on the other hand made the whole process more complicated by interlinking the financial markets across the globe which resulted into the carryover affects on one market to another. (Wheeler, 2008). The crises which emerged from US therefore had the impact on the financial institutions in the UK also because of the inter-linked nature of the financial markets with each other. Executive Compensation While analyzing the reasons for the current financial crisis one argument which has been put forward is that of the role of the executive compensation in the whole episode. As discussed above that the globalization changed the old business models upon which the banks tend to work with a new and more equity focused business was adopted. However, as Wignall(2008) has argued that the role of risk managers was assumed by the people relating to sales. Therefore, not only the risk element of the banking transactions was ignored but also in a bid to make more money through transaction fees and commissions, the so called sophisticated financial engineers took bets which were not only speculative in nature but also potentially threatening to the health of the financial institutions due to their relative size.(Keller & Stocker, 2008). The penchant for achieving short term goals at the cost of long term stability therefore was the motto of the new breed of executives who preferred to achieve short term profitability without considering the impacts of their actions on the long term sustainability of the financial institutions for which they were working. Keller & Stocker (2008) also argued that it was even mentioned by the OECD that this shift towards short term profitability is basically a result of the existing pay structure prevailing in the financial markets which encouraged executives to focus on the short term goals of achieving profitability. One of the arguments which have also been put forward is the assumption that with the increase in the scope of the activities of the financial institutions, the CEOs of such organizations become more responsible towards their shareholders. Therefore, they were compelled to cook the figures into the financial statements in order to magnify the results achieved.(Giardia & Gonela,2008). Nature of the Investment Process As mentioned above that the most of the financial institutions engaged into securitization of their mortgage portfolio by packing and unpacking different securities in order to sell them as financial derivative products. However, from its very nature, financial derivatives are considered as most leveraged investments because of the relative degree of debt involved into such transactions. What were also ignored were the fundamental weaknesses of the different risk as investment models used to assess the risk as well as reward of investment decisions made? Too many reliance on theories and a sort of blind faith on the scientific accuracy of such models gave rise to a false sense of euphoria to investment managers as well as regulators regarding the capability of such models in predicting risk. (Panzner, 2007). The role of the credit rating agencies has greatly been criticized too because of their failure to correctly assess the risks involved in the potential transactions because of their inability to correctly assign credit ratings to individuals according to their repayment capacity. This inherent weakness of credit rating agencies allowed banks to take bets on such borrowers who were riskier and did not possess the capacity to sustain the long term impacts of their debt repayments. Further, the mortgage products were designed in such a way that they have the option to offer flexible as well as fixed installment options with different variations. The inability of the borrowers to understand the complexities of such products forced them to take such options which however resulted into increased monthly mortgage payments which were beyond their repayment capacity.(Coheo,2007) such structuring of products therefore provided an inherent incentive to default. Suggestions Considering the above causes of a current financial crisis, following steps may be taken: Improved role of Central Bank As discussed above that the separation of regulation of a financial sector and monetary policy resulted into lax regulatory environment as central banks were not directly involved into regulating the financial markets. In order to avoid such episodes fro recurring, it is therefore critical that the role of central bank as well as the regulatory role and influence of the government are increased. Leaving financial markets solely to the market forces may result into another such episode if market forces are left unchecked. The regulatory role of government through monetary as well as fiscal policy measures shall be increased in order to broaden the scope of regulatory infrastructure to promote a culture of responsibility and accountability. Revamping existing regulatory environment Failure of existing regulations suggest that there is a need for completing revamping the existing regulatory framework by making it more risk sensitive. The adaptation of BASEL II may provide a uniform framework. However, it still has been certain theoretical as well as technical difficulties, and it is not also binding on the member countries to follow it in its letter and spirit. However, revamping Financial Services Marketing Act may further improve upon the existing regulatory environment. This will not only further restrict the authorities of the executives of the financial institutions besides imposing certain further restrictions so that they can be restricted from taking any speculative bets. Improved Management Practices As it has been demonstrated above that the financial institutions were largely run by people belonging to sales backgrounds with little or no understanding of the risk management perspectives of the banks. However, in order to improve upon the internal management of the financial institutions, it is necessary that the management practices shall be more driven by the long term sustainability of the financial institutions rather than achieving the short term goals. As such the focus shall be on maintaining the downside risk of the lending portfolio rather than focusing on short term measures. References 1. Campbell. Andrew (2008). the run on the Rock and its consequences. Journal of Banking Regulation. 9 (0), 61-64. 2. El-Gamal. Mahmoud (2008). Economist Says Current Financial Crisis Is First And Foremost A Crisis Of Confidence. Available: http://www.sciencedaily.com/releases/2008/09/080925122353.htm. Last accessed January 30,2009. 3. Cocheo. Steve (2007). Can subprimes casualties be saved?. ABA BANKING JOURNAL. 0 (0), 28-35. 4. McIlroy. David Halliday (2008). Regulating risk: A measured response to the banking crisis. Journal of Banking Regulation. 9 (4), 284–292. 5. Turner. 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