Developments in Banking and Finance - Essay Example

Developments in banking and finance Introduction The first salvo of the approaching global meltdown of the financial markets was the crisis in the sub-prime mortgage during 2007. The swift development of the developing economies of Asia, particularly since 2002, invoked expectations amongst development experts. They visualized that from then on an economic downswing in the developed West would not ensue in an extended recession because the up-and-coming Asia would mitigate the fall. Consequently, when the sub-prime mortgage catastrophe hit the U.S. in the 2007 summer it did not significantly decelerate the pace of development in the economies of the developing countries. But the whole picture altered radically in the last section of 2008 with the crumple of the monetary markets in the U.S., and the U.K., accompanied by crises in other modernised countries like Europe and Japan. If the least has to be said then the percentage slumps in the securities markets indices of the developed and the developing countires have been reasonably harsh. An appraisal of the reasons for the fall of the Financial Markets An assessment with regard to the collapse of the Financial Markets had been in the offing for decades due to the U.S. Federal Reserve System, Fed, effectively relaxing its monetary strategy in support of “free market”. This loosening effect allowed the financial conglomerates prescribe the flow of strategies. The safe monetary policy was nailed with the ratification of the Financial Services Modernization Act of 1999. This Act permitted the banks to take on all vistas of financial markets, like securities trading, investment banking, and insurance which were previously barred under the Glass-Steagall Act of 1933. The sub-prime mortgage crisis gave the first signal of the financial crisis to follow in July 2007 in the U.S. This should have been taken as a warning by the financial markets operators to harness the unrestrained behavior of the financial markets but instead they had got used to such financial engineering that the signal was ignored. The financial experts also cheered the financial market operators and the media supported them. Some media news went on to claim that the Dow Jones Industrial Average (DJI) may attain the height of 36,000 (Begley, 2009). It looked as if the financial markets’ aces together with the Wall Street manipulators had discovered a miracle package of integrated investment vehicles which was complete with investment funds grade valuations and insurance which had the ability to produce high profits for themselves and their customers. But it failed to work for long. A recent remark by the Dalai Lama on the disaster embraces the essence of the trouble quite well. He said that “this global economic crisis was caused by: One, too much greed, second, speculation, third, not being transparent. These are the moral and ethical issues.” (Hamm, May 18, 2009: 16). The Economist (2008, pp. 79-81) also issued a brief statement that conquers the theme is, “The crash has been blamed on cheap money, Asian savings and greedy bankers. For many people, deregulation is the prime suspect.” Sub prime Mortgage Crisis Mortgages were supplied only by the building societies. They were non-profit institutions and encouraged only the members for the grant of loans. So the people who were members and had contributed to an extent for a considerable period of time, got loans easily. Soon these societies had to compete with the banks and other financial institutions specialized in granting housing loans. This price war resulted in a greater demand for owner occupied houses and consequently, the demand for houses grew stronger, resulting in a substantial increase in price. (The UK Housing Market - Factors Influencing the Housing Market: Mortgages). “Slackened underwriting standards, with practically no oversight by regulators, made it possible for lenders to sell real estate without down payments from the buyers” (Mayer, Pence, and Sherlund, 2009). The borrowers were not aware of the fact that if interest rates increased then the lenders would compensate with the monthly payments rising it to make good their costs as such loans were based on adjustable rates (ARM). This took place as Fed started to increase interest rates to fight the fear of inflation in June 2004 and advanced it 17 times by 2006 to a high of 5.25% (Bernanke, January 17, 2007). Interest Rates The central bank sets a fixed interest rate by which it lends money to financial institutions and depending on this interest rate, individual banks and other financial institutions set up their own interest rates, which apply to the whole economy. This step is of indispensable importance to the economy, as this is very widely used to contain inflation. The only purpose behind such a step is just to contain undue inflationary levels prevailing in an economy. The point to be noted here is that, this interest rate set by the Bank of England is so effective and powerful that it chips in to regulate the whole economy. It affects the stock and bond prices and also influences the asset prices throughout the country. This interest rate also regulated the savings in an economy, which eventually results in capital formation and reinvestment. It must be borne in mind that when interest rates are high, people prefer to invest money in government deposits that are less risky in nature than the stock markets. Likewise, high interest rates boost up the savings. Lower interest rates make asset and real estate prices go up, as people start ignoring conventional saving instruments and make use of the high growth ventures like shares and houses, which pushes up their prices. Interest rate change also affects exchange rates. It is interesting to understand the process of how the bank sets interest rates. The primary step in this direction starts with the estimates of the money flow that takes place between the government and the Central bank, and the Central bank and commercial banks. The Bank of England makes sure to rectify all the imbalances, which arise along the path on a daily basis. There can be two phases to the money flow that takes place between the system, first, when more money flows from banks to the government and second, when more money flows from government to the banks. In the first case, liquid assets come down, which affect the short-term instruments of money market. And in the second case, the market finds itself with a cash surplus. The diagram given below explains better Source: http://www.bankofengland.co.uk/monetarypolicy/how.htm#top The above diagram explains the concept of system regulation. It shows that the official rate, which is set by the Bank of England, influences many parts of an economy such as market rates, asset prices including the house prices, expectations, and exchange rate. This gives rise to demand which is the sum total of domestic plus external demand which in turn gives rise to inflationary pressure resulting in inflation. Another important point shown, which deserves a mention is the relationship between the exchange rate and import prices, or the price paid for imports. As explained above, the stronger the exchange rate the lesser the price paid for imports and the weaker the currency the higher the price paid for imports. (How Monetary Policy Works). A change in interest rates is mostly used to contain inflation, which is the result of lavish expenditure by the country. When interest rates are high, people prefer to invest money in government deposits that are less risky in nature than the stock markets, and similarly, high interest rates boost up the savings. Sub prime Crisis and Its Effects The sub prime crisis started with the sub prime lenders lending at higher rates than usual to the borrowers with bad economic history and lesser ability to pay back. The sub prime lending functions on the principle of no collateral, but involves higher rates of interest. Debt instruments are then traded and are passed on to other banks or institutions which are ready to take them for the higher interest they get out of them. Due to the passing on of the debt instruments some prominent hedge funds have failed to declare their current asset values. The markets witnessed BNP Paribas announce that it had frozen 3 of its hedge funds due to evaporation of liquidity, totalling around 1.6 billion pounds. The reason was that, it was not possible for the bank to value units of the funds due to the affect of the US sub prime market on them. The funds contained the bundles of sub prime loans, the demand for which have fallen drastically over the last few months. Banks around Europe feared a total liquidity crunch as they feared that they might run out of cash to sustain day to day lending. ECB went to the extent of injecting 155 billion pounds to ease the system. Investors around the world started backing off from the markets fearing the ill effects of over exposure to the mortgage markets. (How the US Sub prime Mortgage Crisis Affect Irish Markets). The high liquidity crunch faced by UK prompted The Bank of England to cut rates to 4.5 percent in its latest monetary policy. This resulted in the housing prices falling in the UK as the buyers were not able to raise mortgage finance and sellers were forced to cut down their asking prices. The collapse of Bear Sterns affected their London operations with over 2,000 jobs in London. The problem of Lehman Brothers and American International Group filing for chapter 11 bankruptcies has also had a very deep impact on the equity markets across the globe that has tumbled down to their lowest levels in as many as 6 years. Dow Jones had plunged to below 8,000 levels for the first time after 2003. Recession UK experienced recession due to the downward growth originated in the last two successive fiscal quarters. The confidence of the consumers had gone down drastically. More than 84% of the consumers believed that the country was gripped in economic recession. The faith of the consumers came down at such an alarming rate, and this negative trend tended to be the main reason for recession. But economists attribute the blame for this unprecedented phenomenon on the media for creating this sort of change in the attitude in consumers. They put forward several arguments in support of their allegation. They criticised that the media had given large scale coverage on the rise in fuel prices occurred during the first few months of 2008. As a result of this, an adverse impact was brought into the minds of the consumers of all levels to build a lack of confidence in them. They gave unwanted importance to the lay off of the companies and the loss of employment. Their reports added oil to fire and the resultant panic frightened the working mass and this affected the purchasing potential of the consumers. They propagated that the unemployment happened due to recession. But they kept mum on the real facts underlying the unemployment situation. They have hidden the facts purposefully and ballooned irrelevant aspects, and clouding the issues at the same time. Thereby they tactfully distracted the attention of the general public away from the basic issues. The media ignored other burning issues relating to the economy of the country and dragged the people along with them to satisfy their whims and fancies. Instead, they could have brought proper awareness to the people about the genuine reasons for unemployment and also the causes of inflation. If they have disseminated news in the right path providing exact information about the decrease in inflation rate results would have been different. The extensive use of the phrase ‘credit crunch’ showed that the media was obsessed with the term, and highlighting this in the cover stories compelled the people to think they were entering a dooming stage and were about to experience major financial crisis. This inadvertently formed the real cause for the decline of consumer confidence. (“Marketing in a recession”). Credit Crunch Credit crunch is said to happen when the capital input or investment of a company fails to be collected back from the market or target group. Due to this, the financial institutions such as banks, money lending companies and capital investors show hesitation and exhibit fright in lending funds to individuals, companies and corporations. The borrowers will find it difficult to cope up with the financial needs, and subsequently, this will affect the inflow and outflow of money in the market. The price of the debt products and instruments will increase, because of this. Moreover, the money lending companies will face bankruptcies and defaulted payments which will affect the overall performance of them. The slow recovery process will naturally shrink the credit supply. The frequent losses sustained by the money lending institutions will force them to stop lending further because of the inconsistency, and the mortgaging banks may foreclose the mortgages frantically to sell the mortgages. As a result, the value of the property may go down. If they sell the properties at a reduced value to retain the required level of liquidity, their capital position will be weakened, and the ability to lend will either cease or be slowed (“Credit crunch”-Retrieved from http://www.investopedia.com/terms/c/credit crunch .asp, viewed on 22 March, 2010). The rules and guidelines set by governmental bodies may also become instrumental to credit crunch. The statutory orders to increase the capital for running financial institutions in lieu of the want of capital liquidity to quantify the risk-weighted level of assets may force them to increase capital reserves. If this happen, it will make them cut the lending levels. And at the same time there are chances that they hike the interest rates too for the loans made available to ward off any possible risk. Thus the borrowers are curtailed from accessing loans and this will affect the financial flow in the market. The resultant credit crunch slowed down the overall economic growth and the companies wound up one by one causing the recession move to the worst. U.S. Financial Markets Meltdown and the Global Impact On Exchange Markets The effect of the break down of the U.S. financial markets on the sureties markets all over the globe was immediate. Table 1 shows the market data for picked out months for a number of countries’ exchanges between 2006 and 2008. On examining the data it can be seen that from the last of the third quarter of 2007 till the starting of January 2009 majority of the financial market indices encountered loss of considerable amount of their values. This was due to the impact of the sub-prime mortgage crisis which was felt all over the globe. Table 2 gives the decline in these indices and it reveals percentage changes between 2nd January and 3rd June 2009(Zaman, 2009). On close examination of the Table 2 it can be seen that between January 2 and June 3 JSX of Jakarta, RTSI and BSE Sensex made up most of their losses in the indices and this was followed closely by Hang Seng of Hong Kong, Shanghai SSEA, and ISE of Turkey. Thus when the exchange indices are only considered then the emerging economies of Turkey and Asia seem to fare better in their recovery efforts after the financial market meltdown. But the US financial institutions who were the main responsible creators of the crisis depict the least recovery till now (Zaman, 2009). On the Economic Growth Economic growth in the GDP during the 1st quarter of 2009 was dismal. This is shown in Table 3. The decline in the developed countries was very severe led by Singapore and followed by Japan, Taiwan, Germany, Hong Kong, and Sweden. Among the developing countries the worst performer was Russia, Mexico, Thailand, Malaysia, and Turkey. But the three most capable emerging economies of China, Brazil, and India witnessed growth in their economies during this period (Zaman, 2009). References 1. Begley, S. 2009. “Why Pundits Get Things Wrong,” Newsweek, February 23, p.45. 2. Bernanke, B. (2007). “The Sub prime Mortgage Market,” Board of Governors of the Federal Reserve System Testimony, May 17, www.ferderalreserve.gov 3. Bhide, A. (2009). “Why Bankers Got So Reckless…” Businessweek, February 9, p. 30.CFD.net.au (2009). “U.K. Financial Bailout Totals 1.4 Trillion Pounds, Equaling GDP,” http:/cfdmarket.wordpress.com/2009/06/15 4. “Credit crunch”-Retrieved from http://www.investopedia.com/ terms/c/creditcrunch .asp, viewed on 22 March, 2010 5. Economist, The, 2008. “A Short History of Modern Finance: Link by Link,” The Economist, October 18, pp. 79-81. 6. Hamm, S. (2009). “The Dalai Lama on the Economic Crisis,” Businessweek, May 18, 2009, p.16. 7. “How Monetary Policy Works” bankofengland. Retrieved from http://www. Bankofengland .co.uk/monetarypolicy/how.htm on 22 March 2010 8. “How the US Sub prime Mortgage Crisis Affect Irish Markets”. Irish Mortgage Brokers. 2009. Retrieved from http://mortgagebrokers.ie/index.php?a=mortgage_ article_view& article_id=21 on March 22, 2010 9. Marketing in a recession”, retrieved from http:// makingtimemarketing. com/knowledge/highlight3recession.html, retrieved on 22 March 2010 10. Mayer, C., Pence, K., and Sherlund, S.M. (2009). “The Rise in Mortgage Defaults” Journal of Economic Perspectives, Volume 23, No.1, winter, pp. 27-50. 11. 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