Assessing the Current State of the Worlds Financial System

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The world financial system, has suffered a severe and virtually unprecedented blow leading to the failure of a number of major institutions and forcing government intervention on a massive scale in a number of countries. Adrian Turner, chairman of the FSA in the UK attributes the current financial crisis to: ..an interplay between macroeconomic imbalances which have become particularly prevalent over the last 10-15 years, and financial market developments which have been going on for 30 years but which accelerated over the last ten under the influence of the macro imbalances. Peter J. Wallison observes that the current crisis has three noteworthy elements: It is worldwide, engulfing the economies of nearly all the developed countries. It is comprehensive in that it involves financial institutions of all kinds. Third of all it is characterized by doubts about the stability and solvency of most of the world’s major financial institutions. While he believes that the first two of these elements fit within the conventional notion of systemic risk, the third element is unusual and, perhaps, unprecedented. On the 9th January 2009, the OECD blamed the regulatory framework as “very poor” because not only did it fail to prevent the crisis but also contributed to it. One of the key triggers was the introduction of a new regime for supervising all banks, the Basle II regime, which significantly boosted the attractiveness to banks of lending money secured on residential property. That led to a rise in loans to sub-prime borrowers, which were then packaged into securities and sold to institutions. The OECD traced the roots of the problem to 2004, when there was “a veritable explosion” in residential mortgage-backed securities. Furthermore it was made easier for the poor to obtain mortgages. Tougher capital requirements imposed on the mortgage finance groups Freddie Mac and Fannie Mae, which triggered an invasion of banks into their territory. Thirdly the transition towards Basle II, made mortgage lending more attractive and fostered the creation of off-balance sheet vehicles. The final element was a policy shift by the Securities and Exchange Commission, which allowed investment banks to increase their leverage from about 15 to one to as much as 40 to one. Shortcomings in risk management, bonus schemes, governance structures, liquidity and counterparty risk need to be addressed, the OECD said.

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David R. Henderson believes that the triggering cause of the current financial crisis in the United States was the decline in housing prices that began in the summer of 2006. This decline in housing prices caused a large increase in foreclosures because many people owned houses with mortgages almost equal to the initial value of the houses. When the values of those houses fell and went below the amount of the mortgages, lenders often foreclosed on borrowers.

Since so many financial institutions owned securities based on these mortgages- mortgage-backed securities (MBS), the large decline in value of these MBS’s led to large losses for their owners. And because so many of the owners were financial firms that held only a tiny percent of the value of their assets in reserve, even a small percentage decline could, and did, destroy almost the whole value, and sometimes the whole value, of the financial firms that held these securities.

Henderson, however believes that: “The best evidence is that the problem was triggered by previous government regulation combined with an unrealistic belief on the part of many people that housing prices could only go up.” He rules out greed as well as deregulation as the causes for the financial crisis. On the contrary he argues that the culprit is regulation itself such as the Home Mortgage Disclosure Act and the Community Reinvestment Act amongst others.A He blames such regulation that placed pressure on banks to lend to people with weak credit histories and sketchy employment prospects.

Moral hazard was another contributor to the crisis. This is because lenders to government sponsored enterprises (GSE’s) assumed that the US government would guarantee the loans of Fannie Mac and Freddy Mac.A Fannie and Freddy had taken on riskier loans during the housing boom and were able to borrow, at a very low interest rate, the funds with which to buy these loans.A Because lenders to the GSE’s did not bear much risk in case the GSE’s bore large losses, they had little incentive to be careful in their lending, and the GSE’s had little incentive to be careful in their financial decisions.

Furthermore, there has been an explosion of world macro-imbalances, with very large current account surpluses piling up in the oil exporting countries, China, Japan and some other east Asian developing nations, and large current account deficits piling up in the USA, UK, in Ireland, Spain and some other countries. A key driver of those imbalances has been very high savings rates in countries like China; since these high savings are in excess of domestic investment, China and other countries must accumulate claims on the rest of the world. Since, in addition, those countries are committed to fixed or significantly managed exchange rates, these rising claims take the form of central bank reserves, typically invested not in a wide array of equity, property or fixed income assets – but almost exclusively in apparently risk-free or close to risk-free government bonds or government guaranteed bonds. This in turn has driven a reduction in real risk free rates of interest to historically low levels. They have helped drive rapid growth of credit extension in some developed countries, particularly in the US and the UK and particularly but not exclusively for residential mortgages with this growth accompanied by a degradation of credit standards, and fuelling property price booms which for a time made those lower credit standards appear costless. Secondly, they had driven among investors a ferocious search for yield – a desire among any investor who wishes to invest in bond-like instruments to gain as much as possible spread above the risk-free rate, to offset at least partially the declining risk-free rate.

Financial sector innovation.

The fundamental macro economic imbalances have thus stimulated demands which have been met by a wave of financial innovation, focused on the origination, packaging, trading and distribution of securitised credit instruments. It was from the mid-1990s that the system entered explosive growth in both scale and complexity. This was due to the huge growth in the value of the total stock of credit securities. An explosion in the complexity of the securities sold together with the related explosion of the volume of credit derivatives, enabling investors and traders to hedge underlying credit exposures, or to create synthetic credit exposures also contributed to the crisis. All of these developments, in different ways, seeking to satisfy the demand for yield uplift, and all predicated on the belief that by slicing and dicing, structuring and hedging, using sophisticated mathematical models to understand and manage risk, to “create value” by offering investors combinations of risk and return which are more attractive than those available from direct purchase of the underlying credit exposures. This explosion was supported by and in itself drove big increases in the leverage of major financial institutions – in particular investment banks and the investment banking activities of some large universal banks. As it developed the rapid growth began to drive and to be driven by one of those self-fulfilling cycles of falling risk aversion where credit spreads on a wide range of securities and loans falling to clearly inadequate levels. This crisis is the first major global boom and bust of securitised credit instruments. One of the crucial questions to ask is whether the originate and distribute model is inherently riskier than the one that it has partially replaced or whether, provided it is regulated more effectively, it is capable of being a more stable system, or indeed of delivering the positive benefits of increased financial stability which its advocates originally proposed. The IMF Global Financial Stability Report of April, 2008 makes it clear that the majority of the holdings of the securitised credit, and the vast majority of the losses which arose, did not lie in the books of end investors intending to hold the assets to maturity, but on the books of highly leveraged banks and bank-like institutions. What increasingly happened was that the credit securitised and taken off one bank’s balance sheet, rather than being simply sold through to an end investor, was bought by the A propriety trading desk of another bank, or sold by the first bank but with part of the risk retained via the use of credit derivatives, or used as collateral to raise short-term liquidity creating a complex chain of multiple relationships between multiple institutions, each performing a different small size of the credit intermediation and maturity transformation process, and each with a leveraged A balance sheet requiring a small slice of capital to support that function. Another striking development of the last several decades has been that a growing part of this maturity transformation has been occurring not on the books of regulated banks with central bank access, but on the off-balance sheets of banks, and on the balance sheets of shadow banks or near banks. SIVs and conduits performed large-scale maturity transformation between short-term promises to noteholders and much longer term instruments held on the asset side. While some of these developments – in particular the growth of SIVs, and investment bank balance sheets and mutual funds – were most prevalent in the US and less important elsewhere, the impact in a global funds market was felt throughout the world. Examples of this are Northern Rock and Bradford & Bingley who were directly or indirectly dependent on the maturity transformation function of US mutual funds and SIVs. Therefore the huge growth in securitised credit intermediation and a related increasing reliance of the total system on liquidity assured by marketability contributed to the credit crisis. In a securitised system, credits become marketable instruments, tradeable in liquid markets. All liquidA markets can be susceptible to swings in sentiment which produce significant divergence from rational equilibrium prices. Bond yields were driven irrationally low and prices irrationally high by irrational exuberance between 2002 and early 2007, and the yields subsequently soared, the prices collapsed. Since banks are highly leveraged they perform maturity transformation which exposes them to liquidity risk and they are involved in a process of continual rollover of new credit supply to the real economy without which economies will contract. It is therefore possible that the growth of the securitised credits intermediation model has increased some aspects of systemic risk in ways which are not just the result of poor execution – bad remuneration practices, inadequate risk management or disclosure, failures in the credit-rating process but absolutely innate. The more complex and globalised the world economy becomes, the more complex are the functions which the world’s banks have to perform in intermediating credit and other flows, and in themselves managing and helping corporates manage, the risks that arise from global operations, and fluctuating A exchange rates, A interest rates and commodity prices. The far bigger failure was the failure to identify that the whole system was fraught with market-wide, systemic risk. Regulators were too focused on the institution-by-institution supervision of idiosyncratic risk: central banks too focused on monetary policy tightly defined, meeting inflation targets. And reports which did look at A the overall picture, for instance the IMF Global Financial Stability Report sometimes simply got it wrong, and when they did get it right, for instance in their warnings about over rapid credit growth in the UK and the US, were largely ignored. From his end, Lloyd C. Blankfein sees three broad underlying factors contributing to the crisis: First, governments, particularly the U.S., explicitly supported homeownership through a variety of government programs and initiatives. Second, mortgage assets were considered relatively impervious to sharp downturns. And lastly, the creation of more flexible and varied mortgage products attracted even more capital in search of higher returns. These factors, to varying degrees, contributed to a housing bubble – not just in the U.S. but in many other countries as well. Furthermore, he believes that: “We rationalized because our self-interest in preserving and growing our market share, as competitors, sometimes blinds us – especially when exuberance is at its peak.” A systemic lack of skepticism was equally true with respect to credit ratings. An over-dependence on credit ratings coincided with the dilution of the coveted triple A rating. Furthermore, a lot of risk models incorrectly assumed that positions could be fully hedged and failed to capture the risk inherent in off-balance sheet activities, such as Structured Investment Vehicles (SIVs). Lastly, financial institutions didn’t account for asset values accurately enough. Given the size and interconnected character of markets, the growth in volumes, the global nature of trades and their cross-asset characteristics, managing operational risk will only become more important. Circumstantial evidence that supervisory boards of many large enterprises in the banking sector do not have the necessary know-how to perform their functions properly is also worrying. To what extent has recruitment been on the basis of connections and political expediency, and not on the basis of merit and know-how? It is widely believed that the current crisis is an example of systemic risk becoming reality and that to prevent a recurrence, greater regulation, covering a wider range of participants in the financial markets, is necessary. However, Peter J. Wallison believes that there is as yet no evidence that the current crisis was the result of systemic risk, which is characterized by a kind of contagion. Instead, he opines that the crisis appears to have arisen from the failure of traditional regulated institutions to limit their risk-taking. Consequently he argues that the current crisis provides support for better supervision of traditionally regulated industries, but no warrant either for a systemic risk regulator or for the supervision of other participants in the financial markets that have not previously been regulated. Wallison believes that understanding the current crisis as a solvency problem seems correct. The underlying cause was the collapse of the housing bubble in the United States, aggravated by the fact that weak subprime and Alt-A loans were major constituents of the housing-related assets held by banks and other financial intermediaries around the world. These mortgage loans, which are held mostly in the form of mortgage-backed securities (MBS) and collateralized debt obligations (CDOs), are defaulting at unprecedented rates. The difficulty of determining the value of the underlying mortgages has caused the market for these instruments to come to a virtual halt, and it has also engendered uncertainty about the solvency of the financial institutions that hold them. Until investors and counterparties are persuaded that these institutions are solvent, they will not be stable. He believes that seeing the crisis as a solvency problem rather than a liquidity problem also clarifies a lot about the major events of the last six months, beginning with the bailout of Bear Stearns. Therefore the underlying problem is not contagion or illiquidity but rather fear that others are not or will not be solvent or stable counterparties. The crisis instead arose from the fact that all these institutions invested heavily in the same weak assets-primarily MBS and CDOs backed in whole or in part by subprime and Alt-A mortgages.

Conclusion

The fact that the current financial crisis is caused by doubts about the solvency of almost all of the world’s major financial institutions sets it apart from any other financial crisis in history. The failure of a large number of insured depository institutions and investment banks shows that better regulation and better regulatory tools are warranted. The current crisis has demonstrated that globalisation is a real and irreversible phenomenon. We have a world market and a world system of trade that are interlinked in many ways. A crisis in the USA, or even in Iceland, is a crisis that affects us all. Solutions cannot be national, as has been adequately demonstrated over the last few weeks. They have to be co-coordinated. Greater preparedness and the ability to coordinate action on a global scale may yet prove to be the lasting legacy of the current crisis. But, across the world, regulators need to continually assess how evolving industry structures and institutional roles are changing the nature of risk, both for individual institutions and for the whole system, and if necessary to adapt the coverage ofA prudential regulation over time. All along, it has been known that market events and economic trends are interwoven on a global basis. But the events of the last year have shown that the connections are more direct and immediate than previously appreciated. All in all, I believe that it is safe to argue that though failure in regulation did contribute to the financial crisis, other criteria such as bad risk management practices, moral hazard, lack of transparency coupled with the greed of banks and self-interest of investors, lack of knowledge of the financial instruments being dealt with (CDO’s) as well as lack of monitoring of the credit rating agencies all contributed and aggravated the crisis to varying degrees.

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Assessing the current state of the worlds financial system. (2017, Jun 26). Retrieved August 11, 2022 , from
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