The Bank Crisis Which Began in 2007 - Essay Example

Appraise the proposition that the bank failures and crisis of 2007-8 could have been foreseen from academic work published prior to 2004 11, March, 2010 Introduction The bank crisis which began in 2007 gained full momentum by 2008 as it became one of Wall Street’s biggest crises. As the number of bad debts started to raise, many of the banks worldwide; large and well established banks eventually became victim. The credit crunch started when banks suffered immense losses associated with the housing and real estate market. Under these circumstances most banks even refused to lend other banks money. At this point the situation only got worse. The governments in various countries moved in to rescue some of the biggest banks from collapsing, which would otherwise have sent shockwaves through the national and international financial systems. In the United States, the Federal Government was left with no option but to initiate a bailout program to secure the financial markets and control the crisis before it spread to other parts of the world. Over a period of time the crisis became a global financial crisis and many banking institutions around the world felt the shock. As the financial system faced rapid deterioration, many causing factors came to surface. There are many factors which have been pointed out as those which contributed to the banking crisis. This paper aims to analyze the literature which was developed prior to 2004 which contained information which could have been used to avoid the current bank failures and crisis which have reshaped the economy of the world. This paper will look at some of the root causes of the banking crisis and the ways in which it could have been avoided, while looking at the literature which was available prior to 2004 which could have been used to predict the crisis. Causes of the Banking Crisis A report by the Inter American Development Bank (2004) states that in order to avoid costly banking crisis it is essential to understand what causes them in the first place. One of the prime reasons for the banking crisis was the deregulation. In the past there have been incidents where deregulation of a particular industry showed similar trends. One such example is the airline industry which did well initially following the deregulation but eventually some of the airline service providers were forced to face bankruptcy. This is one example which could have been used to determine what the outcome of unmonitored banking and mortgage lending practices could have resulted in. Secondly banks did not consider the integrity of the borrowers when lending them huge amounts of money. Even individuals who were not fit to obtain loans were approved large sums of money. Madel (2009) provides the following reasons for the banking crisis in the United States. A) The US boom was totally funded by foreign money: Households were the major contributor to the United States economy, but since 1999 the trend shifted from households being lenders to becoming borrowers. Households took more money out of the financial system than they were putting in. This was the point where foreign investors stepped in to make investments. B) Foreign investors preferred to put their money into investments that were perceived as having low risk: Investors from foreign countries avoided riskier investments and invested in areas which they felt were secure. Foreign investors made all less risky investments, and when they were out of options, bankers created more options for the foreign investors to hold them; this was done by selling more bonds. This later backfired as the investors were able to purchase both bonds as well as security, and the US banks and investment banks were left with the obligation to pay off the bonds and derivatives. C) The fact that the counterparties are overseas means that out of the three options: bailout, bankruptcy, or nationalization—none are satisfactory: The bankruptcy option seems like the most suitable and is pushed by politicians, but it did not work out well when tried on Lehman Brothers. The Lehman bankruptcy almost shattered the financial global system and created worldwide panic. Similarly the nationalization option puts pressure on the government, leaving them with the only option of using tax payer money to clear the debts. How the Crisis Could have been Avoided With the causes of the banking failures and crisis identified, it is easier to look at possible steps which could have been taken to avoid the situation. One such tool could have been careful regulations and the monitoring of the stocks and mortgage which would have helped in preventing the current banking crisis. In the absence of these appropriate regulations the financial institutions were left to do as they please, brining in huge amounts of money for a few individuals, without considering the long term effects of their actions. There was also a need to establish legislations which would have controlled the activities of the financial sector as well as the Wall Street. When the profits were noted to be rising beyond believable and realistic value, steps should have been taken to curb the activities which pushed the world towards the banking crisis. There was clearly a need for financial regulations of the financial services industry; not only for one particularly country but internationally since the banking crisis is not the result of the actions of any one nation. There was need for international cooperation for stronger regulations and rigid controls over the activities of banks across the world. It is believed that the banking crisis is nothing more than the result of the negligence and carelessness of the senior banking personnel. If an appropriate strategy had been put in place when it was needed there was a possibility that the current situation would not have occurred. Lastly but most importantly the banking crisis could have been prevented from lessons in history. Historically there have been many incidents where the world witnessed some form of crisis in the financial industry. Economists had done a great deal of work and ample academic material was produced following the previous crisis. Analysis and understanding of this material could have helped in foreseeing the banking failures and crisis, while at the same time presenting indicators which hinted at the emerging crisis. Academic Work Published Prior to 2004 Could have been used to Avoid the Banking Failure and Crisis Earlier work on the previous banking crisis developed relations between macroeconomic conditions, financial sector reforms and financial crisis. These studies also highlighted the steps which could have been taken to prevent and deal with the financial crisis. Balino and Sundararajan (1991) in their work examined the various banking crisis in seven different countries, namely; Argentina, Chile, Malaysia, Philippines, Spain, Thailand and Uruguay. An analysis of the crisis revealed several common factors and three core lessons highlighted by the writers. These included: 1. The rectifications of the regulation framework and the central bank policies and operating procedures and portfolio qualities in the financial system are important to ensure the effectiveness of adjustment policies. 2. Growth and stability can be ensured by sound prudential policies and their effective enforcement. 3. There is a need to develop measures to recapitalize banks and to deal with problematic loans and there is also a need for enterprises to maintain monetary policy independence for better loan recovery, reduced moral hazard as well as industrial restructuring (Balino & Sundrarajan, 1991). Poor lending decisions, excessive risk taking and the materialization of credit risk are all factors which contribute to the emergence of banking crisis. Banking decisions which eventually concentrate on more self-fulfilling also often result in bank failures. Other factors mentioned are the drastic changes in relative prices which severely affect the quality of the bank assets (Inter American Development Bank, 2004). According to Inter American Development Bank (2004) there are two main causes for banking crisis; adverse selection and moral hazards. Some feel that the poor regulation of the banks and their borrowers is the key factor which fuels bank failures whereas others feel that it is the liquidity shocks which are responsible for triggering banking crisis. But still most banking crisis emerges from bad banking decisions. The same report also states that in the past it was seen that financial crisis usually occur when banks fail to make appropriate decisions regarding the borrowers. This happens when banks fail to loan money to the productive investors as a result of which economic activities are influenced. Banks which fail to identify profitable investors get involved in heavy risk taking. Higher interest rates are another factor which results in adverse selection of borrowers. Borrowers with risky projects tend to accept loans with higher interest rates. Other factors include the lack of adequate banking information which confuses the borrowers about the bank’s riskiness at the time of recessions; when depositors expect a large number of banks to fail at the time of the recession they feel insecure about depositing. Das and Quintyn (2002) in their report for the International Monetary fund state that another factor which leads to bank failures is the inability of the authorities to recognize the problem as it begins. When the government agencies and the regulatory authorities are in denial concerning the state of the financial industry, most of the problems begin to worsen. This usually happens when the personal interests of those concerned are given priority over the interests of the economy. There was inadequate supervision of the banking and financial sector. There was a need for early detection of root problems in banks which eventually were forced into the crisis. There was failure to identify these issues in their initial stages which allowed the problems to grow and develop into more severe ones. Lack of forecasting and high levels of uncertainty are also contributing factors to the banking crisis (Balino & Sundrarajan, 1991). According to the Organization for Economic Cooperation and Development (OECD) report (2002)The chances of banking crisis occurring in emerging markets is much higher since these markets are more volatile in terms of trade, which results in negative effects on their debt servicing capabilities. A World Bank Publication by Caprio and the Federal Reserve Bank of Chicago and the Economic Development Institute of Washington D.C. (1998) holds that, the two main causes of banking crisis, which are common in all cases, are bad macroeconomic policies and bad regulations. Bad macroeconomic policies take the form of insufficient monetary policies or bad exchange rate policies. Bad regulations take form of ill planned government policies which promote moral hazards which occur under poor supervision. Although some influencing factors cannot be avoided, both these causes of bank failures; bad economic policies and poor regulations; can be prevented. Another cause of bank failures is the lack of foresight. Banking crisis can be attributed to two main factors, bad banking at the microeconomic level and bad environment at the macroeconomic level. Bad banking refers to poor lending practices, poor governance, lack of internal controls, more focus on market share than profitability excessive risk taking and mismatches between the banks and the borrowers. These activities usually occur under poor supervision and regulation which results in incompetent management inadequate loan valuation and portfolio mismatches among many other problems. The macroeconomic problems faced by banks stem from lending booms, such as those for real estate and steep changes in interest rates (Ingves, 2003). The concept of moral hazards refers to banks which avoid proper diligence believing that the government will manage their losses and mistakes. In this way banks fail to take responsibility for their actions. This eventually results in imprudent decisions on their part, which sometimes result in high risk related failure which threatens the banks’ solvency (Hughes & MacDonald, 2003). The moral hazard issue which results in the banking crisis is a product of the combination of lender of the last resort and deposit insurance. When these two factors combine they encourage imprudent behavior by some of the finance executives, by engaging in careless behavior. It is argued that the depositors lack information which is necessary for prudence of bank management and the overall quality of the bank’s portfolio (Kapstein, 1994). Supervision and regulations are important tools which prevent banks from taking extreme risks which threaten the stability of the entire financial system (Brealey, 2001). Conclusion Bank failures are catastrophes which are not only economic and financial in nature but also have an immense social impact. The occurrences of such situations hurt the economy and harm businesses which exist in these economies. Banks in trouble are mostly forced into liquidations, as a result of which their assets and securities are sold off for far less than their actual value. This harms investors in many ways by creating insecurity as well as resulting in heavy financial losses. Bank failures are not matters to be taken lightly. The failure of one bank, not only affects that particular bank but also other financial institutions in the country and even those across borders. The damages which an economy local as well as the global economy suffers as a result of bank failures are severe and governments across the world strive to avoid and manage such problems before irreparable damage is caused. Appropriate foresight instead of hindsight would have helped in preventing the banking crisis. A great deal of literature about the previous banking crisis is available, which presents indicators to bank failure and as well as the measures which can be used to avoid such a disastrous situation. Supervision is needed at both the micro as well as the macro level; which means that banks need to have tight controls and supervision in terms of management and the overall banking activities should be monitored closely by regulatory authorities. The legal and judicial frameworks dealing with banks should be aggressive and should keep a close eye on the activities of the financial sector. There is also a need to strict and appropriate marketing practices along with controlled and monitored auditing and accounting practices. Time and time again the issue of regulation and the role that regulatory authorities play in preventing bank failures is mentioned in previous literature. This highlights the importance of having better regulation and monitoring of financial institutions and their activities. In this academic work there was great deal of significance placed on monitoring the activities of the banks. Government needs to adopt policies which are able to control majority if not all the external factors which impact banks and financial institutions. There is a need for accountability and transparence in the government and regulation policies so that the appropriate interests are given priority over personal interests. It can be seen that mistakes were repeated; despite the work done earlier which carried lessons for the future attention was not paid to these issues. The issues of bad banking practices and moral hazards prevailed despite the problems these factors had caused in the past. Academic work and literature on causes of bank failures prior to 2004 could have been used to predict the current financial crisis and could have helped banks, governments and regulatory bodies take necessary actions required to prevent the instability of the financial systems worldwide. References Sundararajan V & Balino TJ (1991). Banking crises: cases and issues. International Monetary Fund. Inter American Development Bank (2004). Economic and social progress in Latin America : 2004 report, Volume 2005: Economic and social progress in Latin America. Inter-American Development Bank. Das US & Quintyn M (2002). Crisis prevention and crisis management: the role of regulatory governance, Issues 2002-2163. International Monetary Fund. Organization for Economic Cooperation and Developent (2002). Forty years experience with the OECD code of liberalisation of capital movements. OECD Publishing. Caprio G (1998). Preventing bank crises: lessons from recent global bank. World Bank Publications. Kapstein EB (1994). Governing the global economy: international finance and the state. Harvard University Press. Mandel M (2009) A Simple Guide to the Banking Crisis. Retrieved 30 December, 2009 http://www.businessweek.com/the_thread/economicsunbound/archives/2009/03/a_simple_guide.html Brealey RA (2001) Financial stability and central banks: a global perspective. Routledge. Ingves S (2003) Banking Crisis from an International Perspective Retrieved 10 March, 2010 from http://www.imf.org/external/np/speeches/2003/040803.htm Hughes JE & MacDonald SB (2003). International banking: text and cases. Routledge. Read More