The Global Financial Crisis of 2007-2009 - Essay Example

The Global Financial Crisis of 2008 Introduction This discussion shall examine the global financial crisis of 2007-2009 which plunged the globaleconomy into a period of deep recession. The study begins with a recounting of the historical background of the crisis and its incipience in the American financial landscape. A recounting of events from the Crash of 1927, and the stringent regulations issued since then. Developments are traced through the gradually and increasingly liberal banking legislations, to the present, The next section provides a perspective on the causes of the crisis, highlighting the more important aspects and the responses and remedies that governments have sought to impose over their jurisdictions. An assessment of whether or not these measures are expected to succeed or not, with an explanation as to their potential issues or concerns, is incorporated in the subsequent discussion. Concluding remarks are thereafter given. Since the occurrence of the crisis in 2007, numerous papers have been written as to the phenomena that accompany the event. There are several schools of thought on the cause of the crisis, ranging from the philosophical to the financial and economic, from the realm of business ethics to the political. In this discussion, there will at one point or another be a tendency to take one perspective or another from among all the topics attributed to it, in an attempt to capture the implications and nuances of this significant event, and draw insights from there. In the end this paper hopes to answer the question as to how and why the crisis began and how it may be prevented from happening again. At this point it is best to provide a definition of the 2008 financial crisis, the most comprehensive of which is provided by Prof. John Head (2010): “The Global Financial Crisis of 2008-2009…revolves around private-sector financial institutions and public-sector regulators. This crisis featured the development of imaginative and complex new financial products, the collapse of major U.S. investment banks when those new financial products suddenly lost value, the spread of financial panic from the United States to other countries, the freezing up of credit, the frantic efforts of national regulatory authorities around the world to stop the bpanic by thawing credit and saving certain large financial institutions, and the desperate collective actions taken by international authorities to prevent the crisis from leading to another Great Depression.” (pp. 45-46) Expansive as such a definition might be, admittedly it still leaves out the whole range of economic problems and traumas resulting from these developments (Head, 2010, p. 46), considerations which are still relevant in setting up a new regulatory and ethical governance framework. 2-Historical Background 2.1 Early beginnings Viewed from its broadest perspective, the global financial crisis of 2008 can be traced back to the Great Stockmarket Crash of 1929. That event marked the fall of one out of every five banks in the United States. It was because of this crash that the Glass-Steagall Act was promulgated. This law banned commercial banks from engaging in the underwriting of securities. The main function of a commercial bank was to operate as a financial intermediary, the principal business of which was to accept deposits from small savers as well as corporate clients, for the purpose of lending to borrowers, and charging interest thereon. Securities underwriters, on the other hand, dealt with investments by discharging a brokerage function, in the course of which a significant amount of risk is assumed (Bexley, James & Haberman, 2010, pp. 4-6). For the next thirty years there had been hardly any dissent in this prohibition (Bresser-Pereira, 2010, p. 3), and the restrictions even became more stringent with the passage of the Bank Holding Company Act which prohibited companies that owned two or more banks from engaging in non-banking activities. By the seventies, however, while banks were restricted from brokering activities, brokerage firms on the other hand began offering money-market accounts and engaging in quasi-banking functions. This began obscuring the distinction between banking and brokering institutions, and from the eighties increasingly liberal rulings by the Federal Reserve Board permitted banks to gradually engage in limited brokering activities, no longer prohibiting them from brokering but merely prohibiting them from brokering as a principal activity. Banking liberalization From the time Alan Greenspan, former director of J.P. Morgan and vocal advocate of banking deregulation, became chairman of the Federal Reserve Board, the demarcation between commercial banking and so-called investment banking or brokering was greatly relaxed. It was increasingly accepted that as long as there was a “very effective” SEC in operation, investors were knowledgeable, and “very sophisticated” ratings agencies were functioning (Frontline, 2003), then these outside checks were sufficient to contain any corporate misbehaviour among the banks. Greenspan assumed the Fed chairmanship in 1987, and by 1989 the Fed Board allowed J.P. Morgan, Bankers Trust, Chase Manhattan, and Citicorp, all commercial banks, to deal in debt and equity securities, but the underwriting activities was limited only up to 10 percent of its total business. This limit was raised to 25 percent by the Fed by the year 1996. By 1997, the Glass Steagall act was repealed, but only after much lobbying by Citicorp, owner of Citibank. Citibank was then eyeing a merger with Travelers insurance which owned investment house Salomon Smith Barney, and was therefore keen on repealing Glass Steagall because this stood in the way of its merger. As a result of the high profile lobby, the House passed in 1998, by a margin of 214 versus 213, a law that allowed for the merging of banks, insurance companies, and securities firms. Years later, the cause of the emergence of the large, “too big to fail” conglomerates would be directly traced to this development in 1998. In 1999, the Graham-Leach-Biley Act was signed into law, formally repealing Glass-Steagall Act (Bexley, James & Haberman, 2010, pp. 4-6). The regime pursuant to Graham-Leach-Biley, and subsequent reforms In hindsight, the repeal of Glass Steagall is the greatest single event that contributed to the 2008 financial crisis. This is because commercial banks were allowed to engage in risky investment brokering, which exposed savers and borrowers who are served by commercial banks to the risks of losses due to speculative activities. During the more than six decades that Glass-Steagall was in effect, there had not been any major financial crisis in the United States that was not quickly addressed. However, only eight years after Glass Steagall was repealed, the US succumbed to the greatest financial crash since the Great Crash of the 1929. Banking conglomerates typically had more than 80 percent of their business in intermediation (deposits and loans), but most of their losses in the commercial banking business (Kluza, 2011). It is not surprising, therefore that one of the laws that were quickly passed in the aftermath of 2008-2009 was the Dodd Frank Act (more specifically, the Dodd-Frank Wall Street Reform and Consumer Protection Act), that effectively repealed Graham-Leach-Biley and imposing restrictions that seek to regulate those liberties granted under the latter. Despite such measures, however, recovery remained flat (Khademian, 2011, p. 841). While the liberalization of banking activities appears to be the principal cause, this was amplified by other developments that undermined what were supposed to be the safeguards against abuse that Graham-Leach-Biley counted upon. These are the credit rating agencies, the bank regulators, and the accounting and auditing profession. The first, the credit rating agencies, of which the most popular are Standard and Poor’s, Fitch, and Moody’s. The problem with these agencies was the practice that developed of late, that the securities issuer, whose securities are being rated, are those who are charged with the payment of the service. In short, it was the rating agencies who were obligated to pay for the raters’ fees. While it should not be the case, raters tended to give higher than deserved ratings in order to please the issuers and ensure return business. The financial returns to the issuers become the motivation for the rating, rather than the desire to conduct a full and fair assessment of the issue. The reforms to bank regulation are addressed by laws such as Dodd-Frank and the Basel III regulations, among others; also, the accounting and auditing functions were remiss in identifying likely weaknesses and alerting the management and regulators on the irregularities that were slowly developing. The need to effect full and accurate disclosure of material information is a task that must be addressed by accounting (Barth & Landsman, 2010, p. 399). 3-Recent proposals/Discussions : Financial Regulation In the United States, one of the most important and at the same time the most controversial of financial reform legislation is the Dodd-Frank Act. At the same time, there are reforms being planned and drafted in the European Union, which more or less parallels the philosophy espoused by the American law. The Dodd Frank Act, the most concrete regulatory initiative to date, has established several principal reforms, three of which are discussed here. (1) The Modified Volcker Rule was named after Paul Volcker, former Fed chairman before Alan Greenspan’s term, who staunchly disapproved initial attempts to repeal Glass-Steagall or at least render it ineffective. This rule called for the separation of proprietary trading from the accounts pertaining to other activities in the balance sheet of banks, as well as introduced rules that further restricted trading on derivative products. It attempts to restore a separation between the intermediary function performed by commercial banks (that is, accepting deposits and lending these out to borrowers in return for interest). By this measure, the regulation seeks to prevent banks from speculating with the use of depositors’ funds, which are insured by the state through the Federal Deposit Insurance Corporation of FDIC. Apparently, banks use deposits to speculate, the gains of which are enjoyed by the firm as profits instead of earning on the interest of loans that should have been created out of these funds. What the new law did was to impose a limit of three percent of total assets on private equity trading, as well as hedge fund trading (Tropeano, 2011, p. 46-47). (2) Dodd Frank also imposes new restrictions on the trading and clearing of derivative products. To this end, Tropeano (2011, p. 48-49) made the following impositions: a. Require clearing and exchange trading of many derivatives; b. Impose additional margin and capital requirements on uncleared derivatives c. Establish a comprehensive framework for the registration and regulation of dealers and ‘major’ nondealer market participants d. Prohibit proprietary trading in certain derivative instruments by some regulated financial institutions; and e. Prohibit certain swap market participants from receiving federal assistance. It is also stipulated in the new law that all swap dealers and principal swap participants are required to register as such with the Securities and Exchange Commission or the Federal Trade Commission. (3) Another important thrust of Dodd Frank is the redefinition of the role of the Central Bank as well as clarification of systemic risk. The traditional role of central banks is as lender of last resort, as guarantor of all bank debt and consequently as insurer of banks’ dealings with the public. Under the new law, the power of supervision of the central bank had been reinforced, but at the same time more regulatory bodies had been specified and a new council created to address systemic instabilities. These have resulted in some confusion as to the structure and role of the regulatory system that is supposed to impose discipline on this unruly industry. The European Union and the G20 In April 2009, the London G20 summit was held at which time a series of measures were proposed to reform the international financial system, among which involve the commitment: (1) To establish a new Financial Stability Board (FSB) with a stronger mandate, to succeed the Financial Stability Forum (FSF). It will include all G20 countries, FSF members Spain, and the European Commission; (2) That the FSB collaborates with the IMF in providing an early warning of macroeconomic and financial risks and the actions needed to address them (3) To reshape regulatory systems, to enable authorities to identify and account for macro-prudential risks; (4) That supervisory colleges for cross-border firms shall be established, as well as the implementation of the FSF principles for cross-border crisis management; (5) To extend regulation and oversight to all systematically important financial institutions, instruments, and markets (House of Commons Treasury Committee, 2009, p. 9). To date, there have been efforts among EU member countries to pave the way for the Financial Stability Board, and the fact that financial regulations shall be tightened. These measures are along the same direction as those adopted by the U.S. Accounting and financial reporting As earlier mentioned, parties to which the public had been reliant for information, ratings, and guidance had been remiss in their responsibility to carry out their duties. These result in the public being misled or misinformed, which impairs a necessary requirement of the free market that all participants be fully informed. There had been comments that fair value accounting is deserving of at least some of blame for the financial crisis. Barth and Landsman (2010, p. 399) state that this is not so, having found in their research that fair value accounting had no role in the financial crisis. What was lacking was transparency of information that is crucial in gaining an understanding of asset securitization and derivatives, without which investors would not be able to properly evaluate the value and degree of risk of an asset – crucial parameters for judging potential investment alternatives. The absence of a common accounting standard, to which the International Accounting Standards Board (IASB) and the Financial Accounting Standards Board (FASB) in the U.S. have exerted efforts, can be a cause of misunderstanding concerning the fine points of companies’ financial value and performance (Jordan, 2011). Such difference could not be faulted for the financial crisis, however. What is needed is a reporting standard related to asset securitizations. To address this, the IASB has come up with an Exposure Draft that compels banks to recognize those assets and liabilities that had formerly evaded reporting. For this, the reporting method will have to depart from the strictly accounting framework and instead disclose the underlying economic realities associated with the securitization transaction (Barth & Landsman, 2010, p 399). An important measure that may be adopted is the reporting of financial derivatives which as of traditional reporting methods are not reflected in the financial statements. Barth and Landsman suggest a disaggregated method of reporting where investors may be afforded information concerning the counterparties to a contract, the side the reporting bank holds in that contract, the nature of the obligations created, the amount of leverage involved, and the considerations for which the counterparties are obligated. Such a report will aid in the risk assessment of investors. The performance of monetary policy The financial crisis of 2008 is more than limited to merely economic terms, but involves also the geopolitical sphere that is encompassed by countries’ monetary policies. Historically, poor monetary policy performance is attributed in part to the ease with which money is made a political issue (Macesich, 1992 as cited in Mohsen, Abdulla & Jalal, 2011, p. 103). A particular parameter where countries tend to have conflicting political agendas about is the control of the interest rate, and its use in responding to the fluctuations in the financial markets. For instance, during the 1997 Asian financial crisis, most countries responded in the exact opposite manner as that of the U.S. faced with the same situation. The reaction of the Federal Reserve Board is to lower interest rates to enable liquidity to flow freely; for the Asian markets, the reaction was to increase interest rates to stave off a sale of local currencies and arrest the impending hoarding of international currencies. Such conflicting approaches to monetary policy may create weaknesses that aid in the further propagation of the contagion effect in a global crisis (Mohsen, et al., 2011, p. 103). There are other ways by which monetary policy exacerbates the effects of a crisis which otherwise should have been contained, and that is when such policy is used to advance political interests (Sanchez, 2011, p. 523). In the case of the U.S., for instance, the use of Fannie Mae and Freddie Mac – or rather, the abuse thereof – to extend credit to high-risk individuals for the purpose of acquiring housing through mortgages they could not afford – sent the wrong signals to the banking community that the government is going to extend all-out support and subsidize such mortgages. Banks were lulled into a sense of confidence that the sub-prime mortgage market was a no-risk, win-win situation with the government guaranteeing against possible defaults. For this reason, mortgages were contracted at ridiculously low interest rates and easy terms (Aronson, 2010, p. 276). When the terms suddenly tightened and interest payments shot up, people were caught off-guard and defaults ensued leading to the sub-prime crisis. There can be no standard regulation to address how governments should craft their monetary policies, but there are repercussions when large countries with wide economic reach mishandle theirs. In the case of the U.S., a failure of monetary policy, seemingly in violation of the normal prudent fiscal sense, appeared to have been arrived at to serve a narrow political purpose but ended up plunging the entire world into financial morass. 4-Critical analysis of reform progress: With the weaknesses in the banking industry already undermining the resiliency of the financial system, all that remained was for an event to trigger the crisis. This event came in the form of the credit default swaps and other similar derivatives, which exacerbated the risk in faulty sub-prime lending policies. The crisis gained momentum in the context of the highly complex securities and exotic derivatives that have permeated the market. The problem with these instruments is that they were little known and understood even by their inventors, the banking conglomerates searching for new sources of revenues, or the regulators who had turned a blind eye and allowed their trading in the name of the free market economy. The non-banking institutions are a principal channel by which the subprime crisis had been propagated. Because of the high returns being offered by nonbank financial institutions, more of savings were channelled to them; these institutions, on the other hand, used these funds to purchase assets of dubious value. In a great many instances, derivative products, the valuation of which are highly suspect because of the vagueness of the underlying asset, are used as collateral in repurchase agreements. This practice has greatly contributed to the reluctance of financial institutions to enter into transactions with other financial institutions (Tropeano, 2011, p. 49). United States As earlier mentioned, the Dodd-Frank act is the strongest measure adopted in the U.S. to address the imperatives of the financial crisis. It appears to concentrate, however, on the banking industry and neglects other weaknesses in the non-bank sectors. According to Tropeano (2011), it is also a cause for concern that neither the Dodd-Frank Act nor other proposed measures in Europe deal with the problem of shadow-banking and non-bank financial institutions (p. 49). These remain largely unregulated participants in the financial system which perform quasi-banking activities, but do so “under the radar” so to speak, beyond the reach of existing regulatory legislation. Lacking in the rules are any provision for the central bank to regulate the money market, as well as the commercial paper, repo, and money market mutual funds. A further weakness in the provisions in Dodd-Frank is that they have been criticized as being vague as far as the new regulatory structure is concerned. There already exist many regulatory bodies even prior to Dodd Frank, and the law has increased this number even more, without necessarily providing a framework by which they may be coordinated in one comprehensive regulatory structure. The principal drawback that may be facing the Dodd-Frank act is that it seeks to re-establish a regime which many banking institutions have already evolve past, and may not feasibly return to again. This is of course speaking of the demarcation between the bank intermediary function (commercial banking activities) and the brokering and trading in securities. It appears, however, that this is being remedied by means of procedural measures that creates a “China Wall” between the two functions, even within the same company. The EU and the G20 The EU is confronted by a special dilemma, not only in addressing the crisis but in every aspect of its development. The EU is still a work in progress, so to speak, and its member-states struggle with the problems of harmonization of their national laws and the EU directives and regulations (Jackson, 2010). The same is true with the efforts at responding to the financial crisis. Some concerns that may limit the effectiveness or the current proposals in Europe are the following: (1) The national law of the individual member states and the regulation promulgated by the EU are often at odds, and regulatory arbitrage results when based on their differences different locations compete with one another as to which country offers the best location for financial market activity. (2) The fact that national governments concede power to an international body (the EU in this case) requires that a great level of political faith and trust, something which is hardly evident in the degree possible among the member countries. Furthermore, the poorer member states which have little to lose and much to gain would tend to be more openly pro-Union than those among the member states which are the most developed and have the most to lose and least to gain. This explains the seeming reticence of countries such as Germany (acknowledged to be the strongest European economy) to extend more support than a certain limit, in the interest of maintaining its own stability. (3) The substantive issues that new regulations are supposed to contain are forgotten in the discussion on what structure the regulatory framework should assume (McCormick, 2011, p. 143). (4) Most importantly, there is the continuing struggle of reconciling national sovereignty and the right of self-governance, vis-à-vis the need to comply with the EU’s mandates and directives. It becomes incumbent upon a member state, as a matter of duty, to comply with the Union’s Committee or the otherwise assigned agency, even when majority of the population feel that such directive may be contrary to their customs and the structure of their laws. (5) Finally, the reconciliation of national laws and those of the international body are not the mere province of grammar of phraseology, but of socio-cultural nuances which take time to evolve and adjust. Expediting the process may be unfavourably looked upon by the people of that country The problems of the EU in addressing the impact of the financial crisis is complicated by the difficulty of integrating the different economies which are at various stages of development, but which have a single currency. Case in point is the continuing economic crisis in Greece which was not only the result of contagion from the United States fallout, but likewise because of its own economic instability. If it had its own currency then it would have easily devalued its monetary unit and regained some added stability by making its trade competitive again. This is not an option available to it now, however, because of the unified currency (Prorok, 2011, p. 22). Should the situation worsen, then there is the real prospect of having to leave the European Monetary Union. A final concern pertains to the institutions which support the financial industry, such as the ratings agencies and the accounting profession, or rather the establishment of unified standards between the IASB and the FASB that allow for the reporting of economic value. These institutions being in the periphery, there is a chance that they shall not be given the same intense attention as has been devoted to the banking industry and other financial institutions performing quasi-banking functions. For the credit rating agencies (i.e. Moody’s, Standard and Poor’s), new regulations should be imposed that these agencies should be funded not by the same issuer whose securities they are to rate, in order to maintain the independence of thought and discretion. As for the matter of financial reporting, the profession and government regulators should come to an agreement about how the auditor may report his or her findings with a greater leaning towards economic value reporting. One of the misapprehension of the risks of assets during the financial crisis was the absence of these risk factors in the balance sheets of companies. A great amount of leverage had been hidden away, thus there were no checks to its continued growth, although it proceeded to subsequently undermine the companies themselves. A new definition of full disclosure should be emphasized, and this obligation linked up with the duties and powers of the executive level in the firm, dischargeable in relation to their accountability to shareholders. Beyond the individual provisions and measures, there is a need to create a standard of corporate governance that should be mandated upon the multinational financial institutions in particular. This is not an easy task and there is no clear cut approach to it, but it is only with the realization that candor, ethics, good faith, and full disclosure are necessary to creating trust and confidence in business and industry, and for a repeat of the global crisis from happening again (Zohny, 2010). 5- Conclusion: One thing that may be said about the crisis is that it may well be attributed to an over-reliance on markets, and not enough regulation; it may be directly traceable to the deregulation policy of the United States and the idea that markets are self-correcting. Economic activity should not be centered on wealth creation, but rather on “increasing the well-being of human beings” as the foundation upon which the new financial order must be built (Prof. Amartya Sen, cited in Iqbal, 2010, p. 37). As to the question of whether or not a similar crisis is looming in the future, sadly this is a real possibility, partly because it is the nature of economic activity to perform with some cyclicality, and partly because during periods of prosperity, which is inevitable after this crisis is over, the feeling of overconfidence that nothing could go wrong lead both the public and the regulatory authorities to once again commit the same mistakes. Hopefully, with the reforms gradually being instituted today, future crises will not be so severe. This paper examined the global financial crisis that began as the subprime debacle in the U.S. housing market, and was transmitted through the financial system by the network of banks and non-banking institutions operating in a deregulated regime. It inquired into the likely causes and the factors that contributed to its further deterioration, then addressed the measures and responses that were resorted to. Finally, an assessment was arrived at concerning the likelihood that the financial crisis shall no longer recur. 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