The Financial Global Crisis
The cause of the global crisis can generally be traced in the free trade fundamental defect with regard to its lack of capacity to differentiate between enterprise and speculation. Free trade tends to be dominated by mere speculators whose interest were speculation rather than in the long-term yield of assets. Specifically, the current crisis is as a result of inadequate regulation of financial markets and real estate. The real estates were allowed to form bubbles which uncontrollably inflated.
The mortgage lending was not adequately supervised, credit risk was improperly modeled, financial market players were allowed to develop complex financial derivative that few understood, and credit regulating agencies failed to carry out their fundament roles. (Dabrowski, M. 2008). Though there were regulations they failed to adequately assess the true level of risks that were involved in issuing sub-prime mortgages and their securitization. Indeed, the perception of ever-rising property and land values in most markets has been greatly responsible for the prevailing financial crisis.
People were encouraged to borrow excessively speculating that the value of their property would increase. That perceived increase in value resulted in speculative bubble. Easy access to cheap credit worsened the situation by abnormally increasing demand. The increasing demand was fuelled by expectations of further price hikes. The situation would not have been so severe if houses prices had been remained depended on fundamentals prevailing in the market.
Investors failed to adequately understand and assess the instruments they were buying and consumers failed to evaluate and weigh the risks exposure that was associated with buying inflated property with innovative mortgages. (Greenspan A. 2004). Another factor that contributed to global crisis was globalization. The role of State has been undermined and ignored altogether. Due to that, government intervention through fiscal policies, as a means of sustaining growth, was replaced by globalized finance.
De-regulation and an alternative paradigm was adopted whereby “bubbles lead to booms” instead of financial and macroeconomic stability which are the products of sound long-term economic policies. The cause of the crisis can also be primarily traced from regulations and regulatory institutions that could not match the rapidly developing financial market. These institutions were somehow segmented. Some countries were having more than one supervisory bodies like US with federal and state. Lack of consolidated financial supervision weakened the regulatory institutions.
. (Greenspan A. 2004). The blame should also be borne by rating agencies that failed to understand the nature of innovative financial instruments and that provided shortsighted risk assessment that did not take adequately into account the actual risk distribution in the long chain between the final borrower and creditor, thus underestimating the actual risk. Nevertheless, the same rating agencies that gave exaggerated positive grades to financial institutions at the times of boom hastily started to downgrade their ratings at the time of distress fueling market panics.
(Dabrowski, M. 2008). The reason the crisis could not have been contained had everything to do with the fancy financial packaging and creative marketing techniques that were employed by those coming up with those debts. The urge to develop new and unsound methods of debt financing was motivated by greed. The urge to participate in accumulating what appeared to be easy, unethical profits, was brought by excess liquidity that was injected into the financial markets by the major central banks.
The final effects of the above actions and reactions led to dramatic change in the ability to create new lines of credit, which dried up the flow of liquidity and slowed new economic growth and the buying and selling of assets. This hurt businesses, individuals and financial institutions hard, and many financial institutions were left holding mortgage backed assets that had dropped tremendously in value and weren’t bringing in money needed to pay for the loans.
This dried up their reserve cash and restricted their credit and ability to make new loans of debt . it ended up created hundreds of billions of dollars in wealth through paper shuffling, but not creating anything tangible of value. Later, unemployment and speculation on oil prices further increased inflation. (Dabrowski, M. 2008). The crisis management were short term and centered on calming nervous financial markets rather than addressing fundamental challenges like the massive liquidation of financial institutions.
The lack of international institutions that could manage and coordinate regulatory and macroeconomic policy led to rushed national actions as was undertaken by the Irish government’s decision to provide deposit guarantees, prompting other European Union governments to follow suit or by the Iceland-UK conflict over cross-border deposit guarantees. The abrupt cuts in Federal interest rates at the beginning of 2008 are another example of short-sighted policy. The cuts fueled inflationary pressure and led the commodity markets bubble in many places in the world especially developed countries.
And when combined with yen and euro appreciation, it ended up exporting the risk of recession to Japan and Europe. Indeed, US government wasted time that was needed at that moment on employing ineffective fiscal and monetary policies such as tax rebate and cut on interest rate with intent of stimulating the economy and providing liquidity. It could have concentrated more of its resources on fixing the financial institutions that were becoming insolvent on a daily basis. The current global economic crisis should provide an opportunity to evaluate economic arrangements and existing economic rules.
The reason for the current problems in the developed countries are due failures in corporate governance structures that led to non-transparent incentive schemes that encouraged bad accounting practices. There needs to be reform in the governance of the international economic institutions and standard setting bodies, like the Basle Committee on Banking Regulation. The reforms undertaken, for example in IMF governance, so far have been inadequate. Unless far more fundamental reforms are undertaken, it will not be possible for these institutions to play the role that they should.
To address the problems brought about by the global economic crisis requires expertise, of the kind associated with specialized agencies like the IMF and the World Bank. But in the past, these institutions have been concentrating too much on particular economic perspectives, which assumed that markets were self-regulating; they paid too little attention to economic perspectives which had pointed out the risks in the kinds of policies pursued in recent years by advanced developed countries. (Stiglitz, Joseph E. , 2008),
When developed countries, especially the United States, relaxed financial regulation in the past 20 years or so, all kinds of increasingly opaque and complex investment products, including the now notorious toxic assets based on the sub-prime mortgages, have been flooding financial markets in the name of financial innovation. The market proved vulnerable to a situation leading to a suicidal path without efficient regulation Alan Greenspan was of the view that central banks could not detect asset price bubbles and therefore were ill-advised to prick them. They could only clean up the mess afterwards.
It so turned out that the mess was too big for the Fed to clean up and that led escalation of the global crisis worldwide. The Financial regulators were not adequately equipped to see the risk concentrations and flawed incentives behind the financial innovation boom. Neither market discipline nor regulation were able to contain the risks resulting from rapid innovation and increased leverage, which had been building for years. Policymakers were not able to sufficiently take into account growing macroeconomic imbalances that contributed to the buildup of systemic risks in the financial system and in housing markets.
Central banks focused mainly on inflation, not on risks associated with high asset prices and increased leverage. And financial supervisors were preoccupied with the formal banking sector, not with the risks building in the shadow financial system. Solutions The perimeter of financial sector surveillance needs to be expanded to a wider range of institutions and markets, possibly with differentiated layers to allow institutions to graduate from simple disclosure to higher levels of coordinated oversight as their contribution to systemic risk increases.
Mechanisms also are needed to allow for the assessment of, and the response to, systemic risks posed by unregulated or less regulated financial sector segments. Government should encourage incentives that support systemic stability; discourage regulatory arbitrage and adopt a broad concept of systemic risk, factoring in the effects of leverage, funding, and interconnectedness. . (Greenspan A. 2004). Capital, provisioning and liquidity norms should be more demanding in good times to build buffers that in bad times can help to offset cyclical pressures.
It will be necessary to develop a methodology to link the stage in the cycle to capital requirements in a non-discretionary way, and to accommodate the demands of accounting and other standards. Regulators need better information on a much wider range of financial institutions, including ‘off balance sheet’ risks (involving better consolidated supervision), and the Risks of financial interlinkages. Investors also need more disclosure in information provided. Careful consideration will have to be given to the costs and benefits of enhanced information collection and disclosure, especially the additional information that regulators require.
(Stiglitz, Joseph E. , 2008), Also progress is needed in tackling political and legal impediments to the regulation and resolution of cross-border institutions. Developing harmonized insolvency regimes governing the resolution of large cross-border financial firms and early remedial action frameworks would be a desirable feature of a reformed crisis management framework of the future. Absent action on these fronts, the risk is that national authorities will begin to resist financial globalization.
Greater flexibility for central banks to provide liquidity and also to focus greater attention on credit and asset booms is needed. The breakdown of markets has highlighted the need for a better understanding of the monetary policy transmission mechanism, including whether central banks should support liquidity in term markets. For central banks in many emerging market countries, facing capital outflows and exchange rate pressures, the provision of additional liquidity can be more complex as it may fuel a drain of foreign exchange reserves.
. (Greenspan A. 2004). The current crisis underlines the need for better crisis responses. Actions taken by national authorities have at times appeared piece-meal and uncoordinated both within countries and internationally, which has risked undermining confidence, weakening the impact of policy responses, and distorting markets. Increased concern about credit risk, and the realization of losses, underscores the need for fiscal support during the containment and restructuring process.
This has included enhanced depositor protection and government guarantees for certain wholesale bank liabilities; bank recapitalization; and in some cases the direct purchase by government or the central bank of bank and other assets. (Greenspan A. 2004). A clear exit strategy to allow the authorities to withdraw market support and a transition to a new and more stable financial market structure will require careful planning and international cooperation in order to avoid market distortions and to promote a revival of markets at a reasonable level of systemic risk.
More work on the approach to this is required by Ministries of Finance, central banks, and regulators. In general, private sector and market-oriented solutions, like arranging the take-over of a bank in trouble by a new private investor if available at a given time, will always prove a better solution than its nationalization. (Dabrowski, M. 2008). All nations and mostly the developed countries where the crisis originated will need to consider reforming their regulatory structures. They should do away with Self-regulation which has miserably failed.
Attention needs to be paid to ensuring better incentives, reducing scope for conflicts of interest, imposing counter-cyclical restrictions on leverage, imposing limits and imposing adequate provision, (Dabrowski, M. 2008), International financial institutions were not successful in achieving cooperation at the international level. This compounded the inability to spot growing vulnerabilities and cross-border links. First, the scope of regulation needs to be expanded to encompass all activities that pose risks to the economies.
Regulation should also remain flexible to keep up with innovation in financial markets, and it should focus on activities, not institutions. Risk concentrations should not be allowed to develop beyond the regulatory perimeter. Secondly, market discipline needs to be strengthened. Other steps could include less reliance on ratings to meet prudential rules, and resolution of systemic banks should include early triggers for intervention and more predictable arrangements for loss-sharing.
Thirdly, increasing the amount of capital required of banks during upswings would create a buffer on which banks can draw during a downturn. Supervisors should also routinely assess compensation schemes to ensure they do not create incentives for excessive risk-taking. In addition, accounting rules should be improved by acknowledging potential for mispricing in both good and bad times. And lastly, information gaps should be filled and greater transparency in the valuation of complex financial instruments is needed (Stiglitz, Joseph E.
, 2008), REFERENCES Dabrowski, M. (2008), The Global Financial Crisis: Causes, Channels of Contagion and Potential Lessons, CASE Network E-Briefs 7, /21929649_E-brief_072008. pdf. Greenspan A. (2004), “Risk and Uncertainty in Monetary Policy”,American Economic Review, Papers and Proceedings 94, 33–40. Stiglitz, Joseph E. , (2008), Towards A New Global Economic Compact: Principles for Addressing the Current Global Financial Crisis and BeyondSample Essay of StudyFaq.com