Financial Engineering Reason for the Financial Crisis - Case Study Example

National and international policy makers should try to reduce the frequency of banking and financial crises. Argue for three different policy measures that would be helpful to reduce the frequency of banking and financial crises. In each case indicate whether the measure you propose requires international coordination or could be implemented in individual countries even if other countries declined to implement the same measure.” Introduction Financial crisis are sown when countries liberalize their financial systems, usually several years before the crisis hits (White, 2008). This theory can be seen unfolding in the US economy which is responsible for the financial crisis that gained global proportions. The government policies as well as the banking sector can be largely held responsible. Paul Krugman, a Nobel Prize winning economist wrote in the New York Times that after the 1997-98 Asian Financial Crisis, countries in that part of the world started protecting themselves against future currency corruption by creating huge reserves of foreign revenue and assets and by exporting the added capital to the West. This export of assets was in terms of real estate primarily, thereby driving up the prices of real estate in the West by leaps and bounds (Krugman, 2009). Another event that led up to the financial crisis in the USA also has its origin in Asia. Asian economies generated large current account surpluses that they invested in US dotcom stocks leading to a boom in the NASDAQ. This created a dotcom bubble which burst in 2001. The US Federal Reserve responded by easing monetary policies between 2001 and 2004. The repercussion of this led to a bubble in the housing sector “Risk premia hit low levels and leveraged deals became common as investors chased yields in an environment of lax regulatory oversight” (McKibbin & Stoeckel, 2009) The Sub-prime Factor Alan Greenspan, former Chairman of the Fed, described in Congressional testimony as a “once-in-a-century credit tsunami”. The tsunami from the 2007-2009 financial crisis, not only flattened economic activity, producing the most severe world-wide economic contraction since the Great Depression, but it also seemed to sweep away confidence in the ability of central bankers to successfully manage the economy (Mishkin 2011). The basic causes for the sub prime crisis can be traced back to the practice where in banks began acting not out of characteristic caution and restraint but on the basis of greed and the urge to make quick money (Crawford and Young, 2006). Traditionally banks have used deposits received through customers to finance their mortgage loans. This allowed only limited amount that could be used for the purpose of mortgage lending. In the past decade however the practice underwent serious change where in banks functioned on the premise of a new model of doing business. The idea was to sell the mortgages to the bond markets thereby making the funding of additional borrowing much easier and more convenient as compared to the past (Crawford and Young, 2006). These innovations in mortgage securitization enabled loan originators to sell high-risk assets to downstream financial institutions around the world, thereby globalizing the American subprime crisis. Each time a crisis arose, the US Federal Reserve came to the rescue by significantly lowering the federal funds rate, in order to pump liquidity back into the market and avert any further deterioration. After the 1987 stock-market crash, the Gulf War, the 1994 Mexican crisis, the 1997-98 Asian financial crisis, the LTCM debacle of 1998 and the 2000-01 bursting of the internet bubble, the response was always the same. Investors increasingly came to believe that when things went bad, they would be protected by monetary policy in what came to be known as the "Greenspan put" - low interest rates, high liquidity and the protection of asset prices. Easy monetary policy was seen as savior that would stabilize the market for market instability and in fact it made cheap money available for lending. Lehman Brothers bankruptcy on September 15, 2008, the AIG collapse on September 16, the run on the Reserve Primary Fund on the same day, and the U.S. Treasury’s struggle to get the TARP plan approved by U.S. Congress led to the financial crisis becoming a global crisis that caused a sharp drop in economic activity in the United States –The unemployment rate shot up to over 10% in the United States and in many other advanced economies, with the unemployment rate remaining stubbornly high (Mishkin 2011). This led to the IMF predicting that the developed economies would contract for the first time in 60 years and this would lead to mass unemployment across OECD. While the ILO predicted that 100 million people would be pushed into poverty. Solution “Even before the crisis, there was no question that asset price bubbles have negative effects on the economy” (Mishkin 2011, p19). It has been argued that central banks must raise the interest rates to slow a bubble’s growth as this would cause less severe bursting. However this does not seem to be the solution as there is likely to be a larger output gap. In order to reduce leverage capital ratios should be increased and in the same way to increase liquidity there can be regulatory liquidity ratios, and if it is required the ratios can be increased to dampen housing prices as also loan to ratio values can be decreased. Margin requirements can be increased in case there is an increase in stock prices. So it is better to use the policy rate for inflation and aggregate activity and to use these specific instruments for composition, financing and asset price issues. (Claessens et al, 2009) As part of steps to prevent further financial crises, one of the major steps to consider in economic governance is the prudential regulation and supervision of banks, given especially the fact that they are the main institutions that gather and process information about the financial state f businesses and households solving the asymmetric information problems in the financial markets. Deterioration in bank’s balance sheets caused by the proliferation of bad loans and declines in net worth can lead to blaming crises in which banks cut back on lending. Since financial institutions like banks are at the core of what can trigger a financial crises, prevention of financial crises must start with a government providing prudential regulation and supervision of the financial system (Crawford, Perry and Young, 2006). There was a clear need for international co-operation as the sub-prime financial instruments that originated in the US found there way to other banks in Europe and Asia also. Housing market vulnerabilities came home to roost in several countries, notably Europe. “In the U.K., with a similar housing boom as in the U.S., mortgage lenders came under intense pressure—beginning in fall 2007 with a bank run on Northern Rock, which had been heavily reliant on interbank markets–rather than deposits–for funding. Large pressures hit Iceland, Hungary and the Baltic countries where imbalances were more pronounced” (Claessens et al, 2009). Financial Engineering Reason for the Financial Crisis The process of financial engineering itself is the result of the process that was once initiated through mathematics by economists like Robert Merton and Myron Scholes, showing the usage of share prices for valuation of derivatives (The Economist, 2009). This led to the formation of hybrid securities that promised hefty returns to investors. In a situation characterized by the lack of comprehensible regulation of such securities that are speculative in nature it became easy for the unscrupulous and engaged in trades of banking with help to market these instruments to people and institutional investors. The thing with credit default swaps was that the transactions in themselves would tend to be highly lucrative, despite the fact that they were risky. Incidentally, when a transaction would go south, the bank would still have to put value to the commitment it made. This would mean that the loss would need to be made up for, through the use of the process of drawing down of the bank’s equity which was in no way equitable for covering demands such as these. The transpired result therefore would be the inevitable bankruptcy as in the case of Lehman Brothers that were allowed to go under or bailout such as the kind offered to Citibank and the Bank of America by the US government. In the case of credit swap, the primary problem therefore was the absence of a regulatory mechanism supporting scrutiny of these transactions that could be termed shady and backhanded. According to Frederic Mishkin (2011) the financial crisis created an unconventional monetary policy in which four things happened. The central banks expanded lending to banks and other financial institutions. Assets were of both government securities and private ones were bought to lower the borrowing costs for households. Central banks expanded their balance sheets leading to quantitative easing. Central banks also kept their policy rates very low for a long period of time. To act in the public’s interest, prudential regulators and supervisors have to limit currency mismatch, restrict connected lending, ensure that banks have enough capital through government support and public funding if need be, and ensure that banks do not take too many risks (Mishkin, 2010). They also must not engage in regulatory forbearance allowing financial institutions that are broke to continue to operate, because such an approach creates enormous incentives for banks with almost nothing to lose to take on even more risk (Mishkin, 2010). It is essential for prudential supervisors to quickly stop undesirable activities by financial institutions and even more importantly, to avoid regulatory forbearances and close down institutions that do not have sufficient capital (Mishkin, 2010). There is a need for international understanding as global financial integration has inbuilt financial risks. Cross border spillovers occurred through liquidity pressure, global sell off in equities and in the depletion of bank capital which surfaced in BNP Paribas in France and IKB in Germany. This crisis then spread to other markets and institutions through the “common lender effect” Emerging markets that relied on external funding were especially affected through capital account and bank funding pressures. Institutional deficiencies in many other countries also came to light. Low interest rates and low spread of risks was a global occurrence and booms had also taken place in other economies like Japan. Government Interventions to Resolve the Crisis The crisis prompted large government interventions, both to restore confidence in the financial system and to contain the fallout of the crisis on the real economy. As asset prices, across markets plummeted, the ripple effect prompted financial meltdown governments in all developed countries became more concerned about solvency than liquidity and realized the need for recapitalization. Intervention involved purchases or exchange of non-performing assets of banks, injecting capital into banks and ensuring liquidity through collateralized lending. The amounts involved were huge and governments across the board followed a liberal fiscal policy. However these could not entirely control the decline and most developed countries continue to feel the affects of the financial crisis. Initially the crisis was managed well but the measures are only stop gap. There is however no long term strategy in place that will address financial regulation, inequality and global governance. The Keynesian-style revolution was not affected which is worrying for the macro-economy. Banks, governments and international institutions went back to “business as usual” (Fitoussi 2010) Macroeconomic Factors for the Financial Crisis While recognizing the fact that economic crisis originated from the financial turmoil linked to the real estate bubble in the United States, and the ensuing lack of trust in the existing banking credit and instance systems in the United States and by extension in the other Western market economies, the widening and deepening of the crisis into a worldwide global recession resulted primarily from the presence of macro imbalances in the fairly integrated, but poorly regulated global financial market (James, 2007). Shriveling trade flows enlarged even more the deflationary impact of the crisis. As a result, the gravity of the downturn relieved the need for a thorough overhaul of most national and international aspects of the present systems of economic governance (The Bush Recession, 2003). The financial crisis and the rapid economic slowdowns in advanced countries continued to affect the global markets. This happened through both cross-border, hedge funds and also through real economic channels. The drop in demand in the developed countries affected world markets leading to a huge drop in exports from the emerging markets and so the export led growth diminished rapidly or disappeared and so those countries with large foreign exchange exposures were deprived of recovery. Financial sectors around the world were affected which gave rise non-performing loans and this weakened liquidity. Cross-border exposures led to weakening of banks in many markets. Solution It has to be understood in this context that the present systems of global economic governance were designed to a large extent in response to the global realities that were being faced more than 60 years ago. Since then the world has changed beyond recognition but the multilateral institutions of economic governance have changed little or have adapted slowly (Begley, 2009). In order for them to respond to the challenges being faced there are reforms that are needed. For one thing, democratic deficits as regards voice and voting power need to be redressed in recognition of the growing weight of developing countries in the global economy. But the actual functions of the major institutions also need reform (Clark, 2004). The primary goal is to close the yawning gap between the increasingly global dimension of most sectors of human activity and the inadequate nature of international governance. This is most conspicuous in the economic and the financial areas (Yilmaz, 2008). There the problem afflicts nearly all multilateral organizations set up since the World War II including the international monetary fund (IMF) and the world trade organization (WTO) as well as the UN Food and Agriculture Organization (Tindall, 2009). The financial sectors of many developing countries are rife with connected lending. Risky loans expose institutors to potential losses. The idea should therefore be implements restrictions on connected lending (Zamaan, 2009).  An example would be the strong efforts to increase disclosure of connected lending and to increase the authority of bank examiners to verify the accuracy of loan information in controlling, what could essentially be termed a moral hazard (Covel, Jurek and Stafford, 2009) If impending dangers to the world economy are to be detected early then there has to be cooperation among international agencies to identify key risks and vulnerabilities. Agencies must exchange information with each other so that a clear picture emerges and they can clearly articulate risks and propose remedies. The crisis has underlined the importance of going beyond traditional statistical approaches to obtain timely and higher-frequency real and financial indicators, at least for systemically important countries and financial institutions. This requires enhancing the accessibility and timeliness of existing data, developing new sources, and promoting transparency and disclosure more generally” (Claessens et al, 2009) Conclusion Joseph Stiglitz Chairman of the UN Experts Commission on global economic crisis said in 2009 that the global crisis required a global response, but, unfortunately, responsibility for responding remains at the national level. Each country will design its stimulus package in such a way as to benefit its own citizens and will not work to reduce the global impact. The size of the stimulus will be assesses according to their own budgets and will want to see growth and employment in their own economies. Since small open economies are likely to benefit the stimulus packages are not only going to be decidedly smaller but poorly designed too and that is why a globally coordinated stimulus package is needed but that seems a difficult proposition. At their November 2008 summit the G20 all committed to not indulging in protectionism but a World Bank study reports that that 17 of the 20 countries too new protectionist measures, most notably the US with the "buy American" provision included in its stimulus package. There are also concerns that the US reserve currency system needs to be changed as it is showing signs of fragility. The UN commission hopes to see a new global reserve system References Begley, S (2009) “Why Pundits Get Things Wrong,” Newsweek, February 23, p.45. 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