The Global Financial Crisis of 2007 -2009 - Essay Example

The global financial crisis of 2007 -2009 Background and causes Growth of housing bubble The global economic crisis began with the bursting of theU.S. real estate bubble; mortgage interest rates experienced a great decline, then houses became more affordable. However, the demand increased dramatically, leading to the housing prices rising up quickly. The greater availability of mortgage funding led to greater demand for housing, as people who never have qualified for credit received loans (subprime borrowers); combined with easy credit, a money inflow of several types of loans such as mortgage, credit cards were not difficult to obtain. Therefore, a large number of loans were extended and consumers assumed an unprecedented debt load. However, when interest rates began to rise and housing prices started to decline, refinancing became more difficult and subprime borrowers were unable to make their mortgage payments, which resulted in a continuous subprime cycle throughout all markets in the United States. 2. Financial innovations Subprime borrowers were unable to pay their mortgage payments, so several financial institutions made the effective financing approach by issuing financial agreements called Collaterized Debt Obligation (CDO), mortgaged-backed securities (MBS) and a form of credit insurance called Credit Default Swaps (CDS) to sell to investors across the world to invest in the U.S. Graph 1 illustrates that the growth of CDOs issued increased dramatically from 2004 to 2006, then dropped slightly in 2007. These types of financial innovations derived value from increasing in mortgage payments and housing prices, becoming popular. The usages of the product expanded dramatically. The financial innovation was carried out by firms whose activities were not regulated. The transactions became too complex and the policies were inclined to support deregulation of the financial market, sometimes being loose of supervision. The subprime mortgage crisis thus became a full-fledged financial crisis, and turned to a collapse in financial markets. Graph 1: The growth of CDOs Source: SIFMA Impacts of the global financial crisis 1. Impacts on financial institutions As the subprime crisis intensified, financial institutions faced difficulties in raising capital forced default protection, and sellers (such as Northern Rock and American International Group (AIG) were reducing credit ratings. This left depositors with no confidence in the stability of financial institutions and they began to withdraw their deposits, which was the main cause of bankruptcy of financial institutions. For example, due to the bankruptcy of one major institution like the AIG, it brought down the whole financial system. In the beginning of 2008, “The Bear Stearns Companies, Inc.”, one of the biggest global investment banks, securities trading and brokerage collapsed and fired sales to JPMorgan Chase. The credit crisis also affected many of the primary and secondary mortgage lenders such as Lehman Brothers, Washington Mutual, and Wachovia; bankruptcy was filed in September 2008. As a result, there was a complete closedown of the global inter-bank market and a rapid credit crunch which led to the collapse of the global banking system. 2. Impacts on financial market As a result, many financial institutions went bankrupt, resulting in a dramatically drop in the money-market; the loss-confidence of investors had an affect on many stock markets whose securities had large losses during late 2008 and early 2009 (graph 2) and decreased in bond yield curve (graph 3). Graph 2: FTSE 100 and DowJones Source: Yahoo Finance Graph 3: USD T-Bond Yields 3. Real Economy Banking crisis was the transmission of the crisis to the real economy and its interaction with the more general economic crisis now emerging that can create a recession in the U.S. and in other developed economies. Indeed, job losses lowered household income and spending. This drop in demand leads to a corresponding fall in output. Where are Central Banks heading to reheat the markets? 1. Quantitative Easing/Credit Easing During 2001-2005, the Bank of Japan introduced the Quantitative Easing (QE) concept and purchased government bonds to inject the money into the economy. After the collapse of Lehman Brothers in September 2008, most central banks implemented the Credit Easing (CE) policy. Unlike the Bank of Japan, their credit easing approach focused on the mix of loans and securities that they held, and on how this composition of assets affected credit conditions for households and businesses. However, the implication is that credit risks are transferred from banks’ balance sheets to the central banks’ balance sheets. While Quantitative easing is meant to bring down long-term interest rates through buying long-term government bonds, Credit easing is used to revive the flow of credit through the purchase of commercial paper, corporate bonds and asset-backed securities. Comment: 1.1 Investing in bonds, commercial paper, corporate bonds and asset-backed securities made it seem like there was plenty of money supply in the economy. However, they never disappeared from the economy; the situations of each bank are unknown. When the economy turns normal and the yield curve becomes constant, the central banks have to recognise loss from the market price, which effects making profit for the central banks in the future. 1.2 Pushing money supply into the economy may bring an inflation crisis in the future. Then the central banks need to issue the policy to prevent this situation before it happens. 2. Discount Window Lending and Deposit Insurance Discount Window Lending allows eligible institutions to borrow money from the central bank, usually in the short term basis in order to meet their temporary liquidity. Deposit Insurance has been issued in order to protect depositors from the instability of the banks. Comment: 2.1 Discount window lending was a good way to risk sharing resulting from making bank assets more liquid, but a moral hazard problem was the problem for the central banks. 2.2 Deposit insurance seemed to be the method of contingent transfers rather than enhancing liquidity. 3. Interest on Reserves For the U.S., on 6 October 2008 the Federal Reserve announced that it will begin to pay the interest on depository institutions’ required and excess reserve balances. Paying interest on required reserve balances should essentially eliminate the opportunity cost of holding required reserves, promoting efficiency in the banking sector and helping institutions meet temporary funding requirements. Chairman Ben S. Bernanke, “In principle, the interest rate the Fed pays on bank reserves should set a floor on the overnight interest rate, as banks should be unwilling to lend reserves at a rate lower than they can receive from the Fed”. Comment: 3.1 The impact to this policy dropped the federal fund rate below the interest on reserve. This reflected the excess reserve by the fact that depositing money with the FR made more interest than lending between banking sector. 3.2 The objective to maintain the overnight rate close to the target is not effective due to the higher interest rate on reserve. 3.3 Most banks would like to save their money as excess reserve, leading to spending declining or an economic slowdown. Financial regulatory reform in the UK, US and Europe UK Europe US Impact Restructuring of financial institutions -The FSA Chairman suggested that the following measures could be used instead of changing the structure of financial institutions; increased capital and liquidity requirements, recovery and resolution plans and raising a levy from surviving firms after the event in the form of either a general taxation or a specific recovery. -The European Commissions consultation discussed the issue of whether the implementation of the Recovery and Resolution Plans ("RRPs") should automatically force the simplification of legal structures of large institutions. -Requirements to segregate financial activities permissible under the Bank Holding Company Act from commercial activities, also risk-based capital requirements and leverage limits, liquidity requirements. -Prompt corrective action is performed. -Quarterly stress tests with results reported to an agency, and annual tests conducted by the Federal Reserve. -Structure measures to contain the spread of risk across the system and improve crisis resolution framework to limit the impact of bank failures. Resolution of financial institution -Internal resolution actions during the two to three weeks prior to failure focused on amplification, rationalisation and reconciliation. -Require the preparation of contingency and resolution plans. -Require financial companies subject to stricter standards to develop resolution plans designed. -Improving perceptions about banking sector resilience. UK Europe US Impact Capital requirement -The quality and quantity of overall capital should be increased, resulting in minimum regulatory requirements significantly above existing Basel rules, which now requires a bank holding company must have a Tier 1 capital ratio of at least 4%, a combined Tier 1 and Tier 2 capital ratio of at least 8%, and a leverage ratio of at least 4%. -Capital required against trading book activities should be increase. -Additional capital requirements to reflect size and complexity transaction. Same as the UK -The Senate Bill, however, does not require U.S. federal banking agencies to adopt "counter-cyclical" capital requirements. -More capital requirement and liquidity may bring the difficult operation for banks because they have to reserve the money for these objectives instead of using in another ways. Liquidity -The FSA has assured firms that the UK regime will be developed as appropriate as international rules are agreed. -The measures are broadly the same as the Basel proposals. -The House Bill requires the Federal Reserve to apply "heightened" liquidity requirements on any financial institution deemed systemically-important. Same as above UK Europe US Impact OTC Derivative Markets -Greater standardisation of OTC derivative contracts is forced. -CCP usage targets should be set and progress monitored instead of mandating CCP clearing. -On-exchange trading adopted for all standardised OTC derivative contracts. -Mandatory reporting of all transactions to trade repositories is required. -Authorises the SEC and the Commodity Futures Trading Commission ("CFTC") to regulate swaps, swap dealers, and certain end- users referred to as "major swap participants”, or whose outstanding swaps create substantial net counterparty exposure that could have serious adverse effects on the financial stability of the U.S. banking system or financial markets. -Stricter standard of derivative contracts will prevent the crisis from the complex transactions. Investment/ Fund managers -The requirements introduced by the Directive for disclosure to supervisors by managers should take into consideration the different types of alternative investment funds. -Compulsory authorisation of fund managers located in the EU is approached in order to manage funds. -Ongoing reporting obligations to regulatory authorities must be done. -The House Bill does not require private investment funds (such as hedge funds or private equity funds) themselves to register with the SEC as investment companies under the U.S. Investment Company Act of 1940. -The reform can bring the limitation to them but investors are protected. UK Europe US Impact Credit rating agencies -Credit rating agencies should be subject to registration and supervision to ensure good governance and management of conflicts of interest and to ensure that credit ratings are only applied to securities for which a consistent rating is possible. Same as the UK Same as the UK -Whole economy will get the right information to prevent the crisis. New trends on financial landscape 1. The change to banking consolidation Due to the transformation of the banking sector through consolidation, large banks started to merge. To assess the implications of the consolidation process on the stability of the financial system, the following was required: i. Effects on competition, ii. Effects on financial risk, iii. Effects on efficiency, iv. Impact on financial sector consolidation on monetary policy, v. Impact on the structure of the banking system. 2. The transform of new financial market pattern The main activity of the banking sector has changed from the last decade, transforming from lending activity to financial derivative trading. This led to another aspect of embedding financial market where the structure of the market is more complex and required more capital than before. Risk management issue needed to reconsider, which this paper will discuss later. Behaviours of financial institution toward risk The impact of the crisis resulted in more concern on banks’ regulations in order to reduce and manage systematic risk as most investors and all regulators require. The most common strategies on organising risk by financial institution are risk decomposition (individual risk) and risk aggregation (risk diversification). This paper will focus on 4 categories of modern risk management: I. Market risk II. Interest rate risk III. Credit risk IV. Liquidity risk I. Market risk Market risk is exposure to the uncertain market value of a portfolio mostly seen in financial institutions. It is the risk that the value of the portfolios may decline over a period of time due to a large market swing which can cause uncertainty. This article presents four procedures to evaluate market risk. 1) Value at Risk (VaR) : A technique used to estimate the probability of portfolio losses. The main approaches to compute VaR are i. Historical stimulation approach ii. Model –building approach. 2) Backtesting : The procedure consists of calculating the number of times that the actual portfolio returns fell outside the VaR estimate, and comparing that number of the confidence level. 3) Stress Testing : A risk management technique used to evaluate the potential effects on an institution’s financial condition of a specific event. Also, stress testing uses pre-specified scenario probabilities, enabling proper risk management actions to be taken. 4) Stop Loss Order : An order placed to be sold a security when it reaches a certain price. A stop-loss order is designed to limit a banks loss on a security position. II. Interest rate risk The risk occurs by an interest-bearing asset, such as a loan or a bond, due to uncertain future interest rates. In general, as rates rise, the price of a fixed rate bond will fall, and vice versa. This article presents two procedures that banks use to prevent interest rate risk. 1) Calculating bond’s holding duration Interest rate risk is commonly measured by the bonds duration, measuring the sensitivity of percentage in the bound’s price to change in its yields. Normally, banks calculate the bonds duration in order to hedge their risk. D = ∑ͪi=1 ti [(ci e –yti )] ̸ B D is the duration of the bond B is the market price y is a bond yield c is cash flow which consist of the coupon and principle payment of the bond at time ti The equation presents the ratio of the present value of the cash flow at time ti to bond price where the bond price illustrates value of all cash flow. Therefore, the duration is the average time when the payments are made, with the weight applied to time ti being equal to proportion of the bond’s total value provided by the cash flow at time ti. A zero coupon bond that last ƞ years has duration of ƞ years (John C. Hull, 2007). 2) Asset liability management(ALM) ALM is a common name for the complete set of techniques used to manage risk by organizing the mismatched maturity pattern of the assets and liabilities by hedging and securitization. III. Credit risk (Counter party risk) The risk of loss due to the potential that a bank borrower or counterparty will fail to meet their obligations in accordance with the agreement term. Counterparty risk, otherwise known as default risk, is the risk that an organization does not pay on a contract. This article presents two tools to identify and monitor counterparty risk. 1) Credit rating In order to estimate default risk probability and recovery rate, there are three main credit rating sources provided as a source of information. i. Credit rating agencies : the creditworthiness of corporate bonds such as Mood’s, S&P and Fitch. ii. Internal credit rating : involves profitability ratio and balance sheets. iii. Altman’s Z-score : a statistical technique to predict defaults from accounting ration. (John C. Hull, 2007). 2) Credit scoring Credit Scoring is an instrument used to estimate the likelihood of customers whether they achieve the banks’ criteria or not. After the credit crisis, both large and small banks have studied weaknesses from the past experience; as a result, a revised more stringent model was designed. IV. Liquidity risk Bank liquidity is the ability of institutions to meet obligations under normal business conditions. This article presents four procedures to manage liquidity risk. 1) Holding liquid assets. 2) Dissipating withdrawal risk by diversifying funding sources. 3) Seeking low volatility ratio: VL-LA/TA-LA where VL volatile liabilities, LA liquid assets, TA total assets. Prudent banks have ratio < 0. 4) Backup: capital adequacy to ensure creditworthiness maintained in face of shocks. Will the new economic condition effect on financial markets and institutions function toward what direction? I. The greatest benefit of consolidation, such as increased competition driving inefficient banks out of business, increased efficiency also from economies of scale and scope, and lower probability of failure from more diversified portfolios. However, there are still some drawbacks to consolidation, for example, elimination of community banks may lead to less lending to small businesses, and banks expanding into new areas may increase risks and different regulations. II. To transform the main activity from lending to financial derivatives, trading may lead to a larger and more severe crisis in the future. III. The crisis leads to changes in financial institutions’ behaviours towards risk, which results in a well diversified and a quicker profit. (word count : 3,000) Reference: Brummer, A. (2008) The Crunch The Scandal of Northern Rock and the Escalating Credit Crisis. Chatham: Random House Business Books London Hull, John C. (2009) Risk Management and Financial Institutions. Massachusetts: Prentice Education, Inc. 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