The Current Financial Crisis from Macro and Micro Aspects and Introspect from Crisis - Essay Example

CAUSES OF CURRENT FINANCIAL CRISIS Introduction The current financial crisis or economic crisis is believed to have begun in early 2007. It mainly happened in areas such as a credit crunch when many investors from United States of America and other parts of the globe lost confidence in the value of sub-prime mortgages. This led to the liquidity crisis not only in the United States but also in other parts of the globe. As a result, US Federal Bank was forced to inject much capital into financial markets. By the end of 2008, this condition had worsened as stock all the world had started crashing and became highly volatile. There was a drop in the consumer index as everyone struggled to deal with the situation with even greater fears of what laid ahead. According to England (2011), the current financial crisis in the world is believed to be the worst the world has ever experienced since the Great Depression of 1930s. For the young generation, the experience is quite new as the misery of Great Depression is nothing more than a distant myth. This crisis is said to have begun after the collapse of two Bear Steams Hedges in early 2007. This exposed what later came to be known as a crisis of subprime mortgage which ushered in an era where banks experiences many failures, private defaults, massive layoffs and many credit crunch. The crisis affected almost all parts of the world attracting extensive coverage in the world media. This effect could be felt from Beijing China to Rio de Janeiro. Macro Aspects of the Current Financial Crisis Financial Crisis and Global Imbalances Financial crisis has spread its roots from financial markets into real economies all over the world. Governments are now focusing on short-term measures to contain different damages brought about by the crisis. Various world economies are fighting and crafting financial bailouts and various stimulus packages to try and address immediate problems that have been a policy for economic policy makers. Policy makers are forced to go beyond mere steps and tackle; one of today’s financial crisis cause; and the imbalance that exist between saving and investment in several countries. The nature of these imbalances occurs when some nations such the United States run huge current account deficits, which others, such as China, have large surpluses. There are three features in international financial systems that have made the imbalance persist. These features involve both floating and managed exchange rates and the issuance of reserve assets (Nardo, 2011). In particular, the United States is an issue of such assets and this has enabled to finance its current account deficit. Lewis, (2009) claims that there are some steps that can be used to address the problem of global imbalance. Beyond the stimulus package around the world, the world should adopt measures to raise savings, especially government savings, in USA, reform product and labor markets in Japan and Europe to increase flexibility and competition while boosting domestic consumption in China. Finally, the International Monetary Fund should be improved through coming up with better monitoring methods. This monitoring will check member countries’ economic policies through reduction of the role of the Fund’s executive board and also depoliticizing selection of top management. Financial Crisis and Shadow Banking A major player in the current financial crisis is the shadow banking system. Shadow banking is a collection of different financial institutions including hedge funds, investment banks, money-market funds; finance companies structured investment vehicles (SIVs) and newly invested asset-backed conduits (ABCs). Shadow banks were not part of the formal banking system. They were also not subject to the strict bank regulations being applied to different banks. Due to this reason, shadow banks were in a position to employ high leverage to get fast and large profits in goods but also bad losses in bad times. On April 28th, 2004, the US Securities and Exchange Commission removed the net capital rule for largest banks. These banks included Goldman Sachs, Bear Steams, Lehman Brothers, Morgan Stanley, and Merrill Lynch. The waiver allowed these banks to take as much debt as their needs would call for depending on their internal risk management analysis. By the end of 1997, the capital rule limited financial firms to a debt of not more than 15 to 1 (PetrovicÌ & Tutsch, 2009). As a result of these changes, all the five investment banks increased their leverage dramatically. Bear Sterns increased its leverage to 30 to one which was double the net capital rule. Therefore, the shadow banking system was not a niche element in the credit markets. Indeed, these banks are believed to have provided more than 60% total lending with commercial banks providing only 40%. Financial Liberalization The current credit market crisis reflects system-wide problems in the trading and hedging of credit risks. It started in the US mortgage market, but it has spread more into other credit markets, where perceived counter-party risks between financial institutions have risen, impairing their operation. This is an international, systemic problem, which has become more severe as time has passed (Simon, 2012). Several studies have shown a link between financial liberalization and current financial crisis especially in the emerging economies. Most of these economies are also becoming more structurally vulnerable to banking and currency crisis. Emerging economies are gradually becoming more susceptible to banking and currency. This has been deduced from data collected from 27 emerging economies from as early as 1973 to date. Several univariate and multivariate analyses have been conducted to determine the depth financial liberalization has contributed to the current economic crisis (Roubini & Mihm, 2010). According to the research, there are high chances of economic and banking crises to increase due to the current conditions. Liberalization gives room for more liquidity to get into the economy. This in return finds its way to a more productive and speculative projects. What is most common between the two crises is an excessive increase in speculative financing. Speculative financing, in return, leads to an increase in borrowing ability. Therefore, the general outflow of international capital increases. Such conditions pave way for more financial crises that might even lead to a global crisis. Most crises that emerge due to this factor come as a result of changes in short-term loans after the financial crisis. In case an economy over-values its currency, there is an increased probability of emergence of banking or currency crises. Faulty Risk Management Credit derivatives play a very significant economic role in financial markets. ABS provides investment opportunities that were previously not available for various market participants. These opportunities access to debt capital that spur real economic growth due to increasing in finances for underlying collateral pool. CDS were created to allow market participants to have more easily accessed short sell debt. This increase information and efficiency of various debt markets (Watkins, 2013). It is believed that CDOs were created to take advantage of debt market mispricing that existed in the credit agencies. It was almost impossible to foretell whether CDOs will continue to succeed in the financial market after the removal of the lack of good debt rating with the high cost of constructing the CDO’s PSV. Synthetic CDOs provide a platform where transaction cost minimizing method for investment in diversified pools of ABS can take place. They, therefore, help to facilitate allocation of debt funds. It is evident that a faulty risk management has played a significant role in the current financial crisis. Employment of poor risk management methods in curbing financial problems has resulted to more trouble in different world economies. If the risk is not analyzed early enough, it might result to serious financial problems. Financial institutions should come up with management tools that will be used to handle financial problems. In addition, financial institutions should be in a position to foresee potential financial risks and plan for them in advance. Micro Aspects of the Current Financial Crisis Role of MBS, CDO, CDS in the Crisis Asset-backed securities (ABS), credit debt obligations (CDO) and credit default swaps (CDS) are closely related to the current financial crisis. These credit derivatives have played a significant role in the current financial and economic crisis being experienced all over the world. These derivatives have significant economic roles with a credit crisis as an illustration. According to a report released in 2007, the ABS provided many previously unavailable investment opportunities to many markets participants which facilitated access to debt capital that spurred real economic growth. If closely collateralized, CDS are also beneficiaries as they allow various market participants to easier short sell debts. This increases the information about efficiency of credit markets. In addition, CDO provides investors with sufficient cash at reduced transaction costs. CDO was also used in different situations to exploit markets mispricing that are brought about by poor ratings of structured debts by the credit companies. The poor pricing can be attributed to the complexity of CDOs and presence of dysfunctional regulatory and institutional structures that are present in the economy. Recessive Government Guarantees Many studies have been conducted to determine the causes of banks failure during the current financial crisis. During the current crisis, several banks have failed in crisis management, especially the use of guarantees and spillovers that exist between credit qualities and in different states and banking systems. Many dialogues have emerged about recessive government guarantees and the policy solutions. According to Foster & Magdoff (2009), any advanced economies guaranteed banks bonds starting from early 2008 that were aimed at supporting banking systems. However, these plans severely affected bank funding and prevented a credit crunch. These guarantees caused many distortions in the cost of banking borrowing. According to many renowned world economists, their reintroduction might reduce the current pressure on banks that have been caused by debt crisis. For the plan to work, pricing mechanism employed should be a level playing field. In addition, state guarantees have played a part in the current financial crisis as seen from Government Guarantees and Financial Crisis Containment analyses. There have been many commitments from the international community to improve the world’s economic state. Many well-though out mechanisms have been put in place to reduce financial risks that might be triggered by the application of recessive government guarantees. One of these efforts is the financial framework that includes ongoing financial innovation. Comparison between the Current Financial Crisis and the 1930 Depression Despite huge bailouts from different world economies of both insurers or banks and the recent stimulus package, stocks have continued to fluctuate. The fluctuation has led to raising concern regarding the widening global crisis. Some economists are comparing this crisis with the Great Depression of 1930. There are many things in the current financial crisis that differ while others relate to the Great Depression. Similarities According to Bryant Simon, a professor of history at Temple University, there are many similarities between current financial crisis and the Great Depression. According to him, the two are all time lows especially for Wall Street. However, the anti-Wall Street language that took place in the 1930s was more directed and pointed. Both were triggered by speculations failure of confidence and unregulated financial markets. Unemployment that is now experienced may be attributed to financial missteps and a number of deeper structural problems that have worsened the crisis and made recovery more difficult. Differences The Great Depression was much more severe compared to the current financial crisis. This was because the depression hit a country without any safety nets. When a country fell, there was nothing to hold it from dropping. Later the safety net was built in the form of the New Deal. The New Deal helped the world from collapsing again (Watkins, 2013). This gave people confidence to continue spending unlike how the situation was before the deal. Additionally, the society in the 1930s was a little bit better organized. It comprised of various social groups such as small business groups and labor groups. The existence of these groups made it possible to push back against the congress on various financial activities. This push against the congress by the tightly-knit social infrastructure might be the reason that led to the New Deal bailing out of both banks and homeowners. Introspection of the Financial Crisis Various financial institutions have been making efforts to take the blame for the current financial crisis. They have been suggesting areas they feel if reviewed can stop the situation. These efforts are intended to reduce the number of regulations in the banking industry. According to a report published by the Institute of International Finance (IFF), an organization represented by more than 375 world class companies, claims that there exists significant problems in risk management. Risk management is one of the key functions of any bank. There is a problem in the setting how bankers should be paid, in the use of stress testing to tell the bank’s ability to cope with different financial times, in making sure that banks and other financial institutions hold enough liquidity for borrowing and the application of credit ratings. There are many interesting issues such as bank liquidity and risk management that need to be addressed if the crisis is to end. Bank liquidity has been a major concern since the introduction of barriers between depository financial institutions and investment banks in 1999. The barriers were applied due to Depression to prevent several speculation intended to spoil depositors’ savings. According to reformers, investment banks should be continually regulated just like ordinary banks. This is because they are required to maintain a significant amount of cash for borrowers. Following significant losses and many becoming bankrupt, new regulations had to be put in place to avoid the occurrence of such phenomenon (Lewis, 2009). Poor risk management has also been one of the main causes of the current financial crisis. CDOs and other subprime investment vehicles received large sums of money that later sank were rated to be class AAA. However, these were not risky investments. Even more regulated financial institutions such as credit unions, thrifts, and pension schemes that are heavily restricted from making risky investments were forced to purchase these instruments with the notion that they were AAA rated. Both banks and investors were limited by the way the programs lacked transparency after discovering how the underwriting were done in a shoddy manner especially in the subprime mortgages. This has even created fear between banks as banks cannot now lend money to each other because they are afraid of what is reflected in the other bank’s balance sheet. The current financial crisis has caused several chaos. One of them is what will be a recession in the United Sates and the global economic slow-down that is being experienced at different parts of the world. Financial institutions have been the most affected and are trying hard to fix the situation. Deregulation of the banking industry has been a daily norm in the United Sates for the last 25 years. The public had placed all their trust in various financial institutions Taylor (2011) claims that if Great Depression had been taken as a lesson in the financial industry, it could have avoided event of the current crisis. Occurrences that took place during this depression should be a mirror and light to guide financial institutions in making sound decisions. If the lessons could have been applied in the right manner, the current economic crisis could not have occurred or could be mild. In addition, banks should emulate economic tactics that were employed to bring the crisis to a halt. This can go a long way in avoiding a repeat of the same mistakes. Several reasons have contributed to the current financial crisis. Both micro and macro-economic factors have played a role in the crisis. Some of these factors include shadow banking systems, high speed of financial liberalization, and lack of financial regulations, faulty risk management, and recessive government guarantees. According to several researches, banks and financial institutions are the most affected. Among the countries that were mostly affected includes USA, China, Japan, and many emerging economies. There is a lot that can be compared between the current economic crisis and the Great Depression of 1930. There exist both similarities and differences that can be deducted. One of the open similarities is that both were triggered speculation failure. The major difference between the two is that the Great Depression was much more severe than the current financial crisis References England, R. S. (2011). Black box casino how Wall Sreets risky shadow banking crashed global finance. Santa Barbara, Calif.: Praeger. Foster, J. B., & Magdoff, F. (2009). The great financial crisis: causes and consequences. New York: Monthly Review Press. Kamin, S. (2009). The current international financial crisis: how much is new?. Washington, D.C.: Board of Governors of the Federal Reserve System. Lewis, M. (2009). 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