Reasons That Triggered the Global Financial Crisis - Assignment Example

Explain the reasons that triggered the global financial crisis, elaborating in detail on the flaws in the management of risks by banks. Answer Many causes created the global financial crisis. In the United States of America, Sub-prime mortgage loans and the real estate bubble became the root causes (Lannuzzi & Berardi, 2010). Additionally, soon after the attacks of 9/11, the Fed reduced the interest rates to the level of 1 percent with an aim of supporting the labour market. In the late 1990s and the early 2000s, many developing countries put a large amount of savings into the US banks and other financial institutions (Shomali & Giblin, 2010). Consequently, liquidity became common; this facilitated the concept of innovative finance (D’Arista and Griffith-Jones, 2008), putting more funds into risky investments. Sub-prime loans were easily available before the emergence of financial crisis. Udell (2009) explains that the sub-prime loans were easily available in America. Basically, this type of loan is given to those people who do not have positive credit worthiness. And, banks and other financial institutions do not provide loans and other short-term credit facilities to those people or institutions who have negative credit worthiness or who are unable to repay loan. In the United States of America, before the beginning of financial crisis, many were unable to receive loans due to these factors and they resort to sub-prime loans. Initially, there were a few people and small institutions were giving sub-prime loans. With the passage of time, from local to multi-national banks and other financial institutions started giving sub-prime loans. Since higher interest rates were charged on the sub-prime loans, many banks and financial institutions saw it as an opportunity to earn more profit. The attacks of 9/11 were economically dangerous as well. The magnitude of attacks was sufficiently negatively on the economy of America. The entire American economy was damaged; the Fed came under pressure to economically manage the situation and devise such economic short-term policies to minimise the impacts of 9/11 on the American economy. With this aim in mind, Greenspan of Fed decided to reduce the interest rate to the level of 1 percent. The reduction of interest rates further allowed ordinary Americans to avail the benefit of interest rate reduction. This reduction further directly increased the risk of default and bankruptcy. Savings of developing countries further aggravated the availability of excessive liquidity. In the late 1990s and early 2000s, many developing countries poured their funds into the different American banks and other financial institutions. As a result, banks and financial institutions faced the problem of excessive liquidity. Normally banks face shortage of liquidity, and to fulfil their daily requirements, banks try different means to obtain funds. But, before the financial crisis, most of the banks and financial institutions were filled with the excessive liquidity. Now, banks were required to invest the excessive liquidity for the purpose of earning returns. The inflow of excessive liquidity was so huge that many banks totally compromised on the risks associated with different types of investments. Banks and other financial institutions were desperate to utilise the availability of excessive liquidity at the cost of safe and secure returns. Banks and other financial institutions did not give an appropriate consideration before going to invest; even they overlooked the possibility of default, which could shake their commercial existence. Banks and other financial institutions started lending to those individuals and institutions that were lacking to fulfil the requirements of creditworthiness. Consequently, these factors contributed to the inception of global financial crisis, which did not remain within the boundary of the United States of America, but spread to other countries. Many shortcomings did exist in the risk management policies of banks. Too little understanding of exposure to liquidity and exposure to market risk was given by the banks. Second, the practices of due diligence were poor, including putting excessive reliance on credit rating agencies. Third, insufficient public disclosure was there; funds were raised by using some off-balance sheet means (The Interim Report of the Financial Stability Forum presented by Italian Central Bank Governor Mario Draghi at the G7 meeting in Tokyo, quoted by Felton, 2008). Due diligence was totally compromised. Banks did not give much importance to the practice of due diligence. Due diligence is a tool of compliance and it is defined as a process of investigating into the details of a potential investment by examining the material facts in a professional manner. The main objective behind the practice of due diligence is to ensure the proper management of risks associated with the activity under-passing the process of due diligence. With the help of due diligence, all possible and relevant associated risks are carefully and critically analysed; and on the basis of this critical analysis, the risks are determined and highlighted. Subsequently, some recommendations are determined. And, on the basis of these recommendations, whether a particular investment should be taken or not, an investment decision is taken. If the risks are beyond the range of management, it could be decided not to go with the proposed investment. But, unfortunately, this entire process of due diligence was totally compromised by banks for the purpose of attaining more profits. Additionally, the credit rating agencies played very negative role. Good ratings were sold at particular price by the credit rating agencies. When the credit rating agencies were reached by the banks, the banks were informed and given positive credit ratings. As a result, those institutions and individuals whose credit rating was negative, they did manage to buy and bring positive outlook into their credit worthiness. Even if some banks were aware of the fact that the ratings were being sold a particular price, they did not take it very serious threat to their policy of risk management. Supervisory authorities did not discourage the build up of off-balance sheet exposure of risk. Banks’ risk management tool became a part of the problem. Banks were totally compromising on the required steps of the policy of risk management. Also, the regulatory authorities were indirectly supporting to the causes that created the global financial crisis. The regulatory authorities did not care about, or they simply overlooked them, the hidden contingent liabilities that were being incorporated into the banks’ balance sheets. Insuring adequate risk management of complex financial institutions is a joint responsibility of financial institutions and regulatory authorities. If the banks or other financial institutions fail to comply with the certain elements of risk management, it becomes the responsibility of the regulatory authorities to make banks and other financial institutions comply with the elements of risk management. If risk management proves insufficient, it highlights a joint failure not just a failure of management. Describe how the crisis affected financial markets (e.g. money, stocks, bonds, derivative markets etc.), institutions and their links. Answer The subprime crisis in the USA has been labelled as the worst financial crisis since the Great Depression by many including the International Monetary Fund (IMF), Joseph Stiglitz and George Soros (Jaffee, 2008; Tong and Wei, 2008). And, the crisis was so severe that it hit at the core of the global financial system (IMF, 2008). And the global financial markets were no exception; they were severely hit by the recent wave of global financial crisis. Alone in the United States of America, since the start of 25 July, 2007 to the end of 2008, a total of 40.50 percent decline was recorded in the S&P500 index; the FTSE100 index of the United Kingdom 31.30 percent, Nikkei225 index of Japan 50.39 percent, KLSE index of Malaysia 36.45 percent, and Jakarta composite index (JCI) of Indonesia 43.39 percent observed declined in the corresponding period (Bloomberg Database, 2008). Financial markets provide a place where securities are traded. The examples of securities are stocks, debts; debentures, loan notes and other short-term and long term financial instruments are bought and sold among different market participants. Basically, there are two types of financial markets- money market and capital market. And within these markets; there are further two types of market exist- primary market and secondary market. Money market facilitates trading on short-term government and private debt securities. These securities have maturity period of less than one year. On the other hand, capital market provides a place to buy and sell long-term debt and equity securities like, stocks and bonds. Here, a long term maturity means a financial security which matures after a period of one year. A primary financial market observes the purchase and sale of securities, which are bought and sold for the first time. Whenever a company or government wants to issue new securities, the primary market is used for that purpose. Here, funds are raised and arranged with the sale of new securities. On the other hand, in a secondary market, existing securities and those securities which have crossed the stage of primary market are bought and sold. The secondary market does not provide a source of raising additional funds, but facilitates the existing securities to be traded on. The purchase and sale of securities, in the secondary market, do not increase the aggregate amount of financial assets outstanding (Horne and Wachowicz, 2003). However, an efficient and viable secondary market enhances the liquidity of financial assets. By increasing liquidity of the financial assets, the secondary market facilitates efficiency and working of the primary market for securities. New York Stock Exchange, the New York Bond Exchange and the American Stock Exchange are the examples of secondary market where existing securities are traded. Additionally, the over-the-counter (OTC) market is a part of the secondary market (Horne and Wachowicz, 2003). The OTC market is used to facilitate trading on stocks and bonds which are not listed on an exchange. Brokers and dealers use the OTC market to buy and sell securities at quoted prices. Securitization brought the impact of global financial crisis to the financial markets. Securitization is a financial technique which converts non-liquid assets into liquid securities like, bonds (banque-credit, website). The converted liquid assets enable the investors to trade on them on the stock markets. This financial instrument is mostly used by many banks. With the purpose of earning huge profits, banks borrowed even more money. To earn more profit, many banks had stopped relying on the savers money; they were mostly relying on borrowings. And the borrowed money was securitized. Some investment banks; like Lehman Brothers jumped into the mortgages; buying with an aim of securitizing them and trade on them (shah, 2010). These securitized stocks were channelized towards financial markets for the purpose of buying and selling. As a result, the financial markets became filled with such securities that were created through the process of securitization. Before the start of the financial crisis, the global financial markets were increasing with the trade of these securities, especially, in the United States of America where the process of securitization was pursued hectically. On the basis of securitization, most of the securities were traded. Since the entire structure on which these securities were trading on in the financial markets was based on securitization of non-liquid assets, which was comparatively more risky than the other means, as a result, global financial markets collapsed as soon as the default of mortgages and other loans surfaced with large quantities. Interestingly, the role of rating agencies was significantly disappointing. It was the role of rating agencies that significantly contributed in bringing the wave of global financial crisis. It is the rating of these agencies on which many financial institutions, banks, and other individuals considerably depends on the issued ratings. Evan Davis, who is the former BBC’s economic editor and presenter, highlighted in a documentary called The City Uncovered with Evan Davis: Banks and How to Break Them (January 14, 2008), explains that rating agencies were bribed to rate the financial products; and these rating agencies accepted bribes and provided good credit ratings to them, facilitating people to take these risky financial securities up (shah, 2010). Discuss new trends on the financial landscape and changes in institutions' behaviour towards risk. State your opinion on whether the new economic conditions will affect the way financial markets and institutions function and towards which direction. Answer Government bailouts, strong regulatory and supervisory controls and disclosure requirements are devised to address the financial problems posed by the global financial crisis. Globally, many governments provide bailouts to many financially unstable corporations. The main purpose of assisting such corporations is to minimise the impacts of the global financial crisis. Governments face dilemma if they don’t provide financial assistance, unpleasant consequences like a rise in unemployment, a reduction in aggregate production of goods and services, would further aggravate the global economy. Since economies are inter-linked, any negative impact on one economy would pass on its effect to other economies as well. In order to decrease this chain effect the global financial crisis, the US government has provided the following financial assistance: in October 2008, Congress passed the Emergency Economic Stabilization Act. The amount of $700 billion has been allocated to address the financial crisis. This and other such steps are short-term and immediate ways to handle the crisis. G20 leaders agreed that currency exchange rates must be allowed to represent their true economic realities (Bureau of International Information Programs, web). It was agreed in this meeting that it would be in everybody’s interest to allow these currencies to represent the market fundamentals (President Obama at G20 meeting). The participants agreed that the developed economies must stabilize their reserve currencies, while the developing economies need to allow for currencies that are market driven (President Obama at G20). In this meeting, President Obama provided his strategy to tackle the global financial crisis. He said that financial system is needed to be reformed, and this reformation must ensure that banks should have only capital that help them to withstand shocks, simultaneously they must not taking excessive risks that could trigger another wave of the global financial crisis. Banks have started to implement more stringent risk management policies than ever before. Since much of the shock was faced by many investment and commercial banks and some of them had lost corporate image and corporate existence as well, the existing banks have come with more stringent measures. For instance, before going to extend a loan or other form of credit facility, banks perform the process of due diligence. By implementing this step, many banks have become in a position to control and manage risks: Banks understand that any further compromises on the risk management would be more costly than ever before. The regulatory bodies have become stricter in ensuring the appropriate disclosures and transparency of financial statements. They have to ensure that all relevant standards are fully understood and followed by the corporations. It is being greatly emphasized that the role of regulatory bodies must be performing and playing its part in order to ensure the compliance of regulatory standards. These factors have greatly changed the aggregate behaviour towards risk. The pre-global financial crisis behaviour towards risk was lax and compromising from the side of risk managers and from the side of regulatory authorities. But, now this behaviour has considerably changed on both sides. The risk managers have realised that any further compromises would only lead towards another wave of global financial crisis. And the same sort of realization is being felt by the member of regulatory authorities. The current change may not substantially affect the financial markets. The global financial crisis put its effect on the financial markets and subsequently, most of the financial markets crashed in response. The financial markets did not provide the main cause for the global financial crisis; rather, they became the victim of that financial problem. However, some sort irrational financial markets behaviour did contribute in the financial crisis, but that was not much in comparison with the contribution provided by the sub-prime loans. Current financial markets perform under strict surveillance. The demand of sufficient transparency and disclosure has put considerable impact on the minds of the shareholders, investors, and other market participants. Before going to make any significant investment decision, investors have become more cautious and more careful. In the initial days of the global financial markets, the investors and shareholders did not participate in trading activities of the financial markets. They preferred to stay dormant and avoid doing any sort of buying or selling of securities. The impact of global financial crisis was so devastating that the financial markets continually recorded the downward trends in the stocks till the end of 2009 and to some extent to the first quarter of the year of 2010. But, this attitude changed when the financial institutions and the regulatory authorities came to play their respective roles. Strong focus on risk management and the role of regulatory authorities have facilitated investors to put their confidence on the financial markets and financial systems; previously investors have lost their confidence on the financial systems and financial markets. However, now they have started putting their confidence again, but still most of the investors avoid investing on the risky investments; they prefer to invest on more safe and secure investments. References 1. Jaffee, D.M. (2008), "The US subprime mortgage crisis: issues raised and lessons learned", The Commission on Growth and Development, Washington, DC, Working Paper No. 28, pp.1-36. 2. Tong, H., Wei, S.-H. (2008), "Real effects of the subprime mortgage crisis: is it a demand of finance shock?", NBER, Cambridge, MA, NBER Working Paper No. 14205, 3. IMF (2008), World Economic Outlook, International Monetary Fund, Washington, DC. 4. Bloomberg Database (2008), The Bloomberg Professional Service, Bloomberg, New York, NY, 5. Iannuzzi, E & Berardi, M., 2010, Global financial crisis: causes and perspectives. EuroMed Journal of Business, 5(3), 279-297. 6. Udell, GF, 2009, "Wall Street, Main Street, and a credit crunch: thoughts on the current financial crisis", Business Horizon, Vol. 52 pp.117-25. 7. D'Arista, J, Griffith-Jones, S 2008, "Agenda and criteria for financial regulatory reform", Initiative for Policy Dialogue, Columbia University, NY,  8. Shomali, H & Giblin, G R 2010, “The Great Depression and the 2007-2009 Recession: The First Two Years Compared,” International Research Journal of Finance and Economics, Is. 59. 9. Shah, A 2010, “Global Financial Crisis.” Global Issues, Updated: 11 December, [Accessed: 21 March, 2011] 10. Felton, A., 2008. The first global financial crisis of the 21st century, London: Centre For Economic Policy Research (CEPR). 11. “G20 Agrees on Ways to Prevent Future Economic Crisis”, 2010. 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