Recommendations for Bank Management and Government Measures Finance Essay

The financial crisis that started in the summer of 2007 in the U.S.A and U.K. has quickly expanded to the developed world and become a global financial crisis which led economies into recession. Financial crisis create weaknesses to different bank models. Banks went to bankruptcy and disappeared from banking scene or rescued by governments. By 2008, estimated that the losses of banks have reached $1,000 million in USA and government start for bank nationalization. Financial giants like Lehman Brothers, Merrill - Lynch, AIG, Citigroup, Fannie Mae and Freddie Mae disappeared. Goldman-Sachs and Morgan-Stanley becomes bank holding enterprises until end their existence in banking sector. The crisis that started in August 2007 began with the collapse of sub-prime mortgages and securitized products and then spread very quickly to other segments of credit markets, to bond markets and inter-banking markets. The market of sub-prime mortgages have experienced development in the previous 10 years with the housing prices to reach higher levels and with low interest rates that prevailing in USA and worldwide since the first decade of 2000. The cheap money was the most important factor for large number of borrowers to take mortgages and purchase homes. But for the "sub- prime" borrowers the applications for the loan did not include standards, for example if borrowers have poor credit records. The first signs for the crisis began in June 2006 when the central Bank of USA (FED) raised interest rates (from 1% in June 2004 to 5, 25% in August 2006). The higher interest rates leads to the costly borrowing. The result was a lot of borrowers not being able to pay for the loans, so attachment of property starts to increase. Banks having loans on their balance-sheets, try to create loans to outsiders in order to transfer the risk. This action called securitization. With securitization all the assets in illiquid form transformed into securities and sold to different investors. This combination of assets has the benefit of the diversification of risk which is associated with any assets. For example, subprime mortgage could be very risky, and with the above form sold as security. But with the global financial crisis of 2007-2009 securitized products collapsed. The National Bureau of Economic Research (dates the recessions all over the world) determined that the crisis began in December of 2007. Whenever it starts, the purpose of this study is to examine the causes of the global financial crisis of 2007-2009 and try to understand how affect the Management in banking sector. This study is organized as follows: At the beginning is described the causes that led to the global financial crisis with short reference to the condition that was prevailed before the crisis, then the study refers to the implications of the study to the bank sector and more specifically to the Bank Management and in the end it is said some conclusions about the condition and some measures in order to be stopped the negative impact of the crisis.

Causes of the global financial crisis

It is useful to start the analysis with the question "Where did financial crisis come from?" because analysis of causes is useful tool to understand the implications of global financial crisis. Today, it is common agreement that the root of the crisis is the housing market of the United States. More concretely, The Monetary Policy of the Federal Reserve Bank caused the boom to the prices of real estate, resulting in low interest rates(low interest rates prevail in USA and worldwide since the first decade of 2000) (Bofinger et al 2008 b: 119-121).High demand of real estate was impact of the cheap money. So borrowing rose to higher levels. Financial intermediaries have been at the centre of global financial crisis who contributed to the development of speculation. The housing prices increase because of the fair value accounting of banks. The credit crisis or ceilings stop to exist and the result from the above was the high-risk lending. Traditionally, banks had loan (indicated by their balance sheets), and in the above condition start to generate loans that was transferred to outsiders, with higher risk. This innovation in finance is known as securitization. Securitization is a process in which loans sold as securities to different types of investors in order to diversify the risk. In this way, emerged the known "Asset Backed Securities" (ABS) which is type of security by small and illiquid assets. With the process of securitization, loans sold individually and removed from the balance sheet of holders. One effect of securitization, regarding with theories of Basel Committee, was that equity for granted loans were circumvented. Banks transfer assets to the special purpose vehicles (SPVs) in order to achieve the off-balance sheet situation. So, lending becomes an activity without risk and this led to high leverage. Moreover, low interest rate induced high leverage ratios (Wehinger 2008: 2-6). The selling of Asset backed securities was possible because of the low risk of the structured products. The diversification of portfolio achieves the reduction of risk. The meaning of tranching was very important because this process contribute to the creation of assets with higher ratings than the average ratings. Portfolio had losses because of different tranches . Those different tranches called collateralized debt obligations (CDOs) which specialized in a unique type of debt. Most often are non-mortgage loans or bonds. A With increases of the federal funds, rates of mortgages start to experience an upward trend which was a negative point for households. So the housing bubble burst. The housing prices start to follow to levels below than the value of loans and the result was bankruptcies. Interbanks markets come under failure. Result of the financial crisis was the collapse of the American investment bank Lehman Brothers in August 2000, which was the first time that borrowers experienced losses. Money markets disrupted. Banks rates rose to levels above the returns on assets. Lending has been reduced. The investment started to reduce.

The Role of Basel Committee

It is important to be said the role of Basel Committee, the committee which called the supervisor of Bank Sector. From 1965 to 1981 in the United States, were approximately 8 bankruptcies. Banks, all over the world were lending continuously. In order to be the risk prevented, met in Switzerland (in Basel) in 1987 the Basel Committee which included supervisors and central banks. The primary objective of the Committee is to strengthen the capital adequacy and liquidity. Promote governance practices and stronger risk management in order to strengthen the market transparency. Basel Committee established by the Group of Ten Countries. Committee members came from United States, United Kingdom, Switzerland, Spain, Sweden, Luxemburg, Netherlands, Japan, Italy, Germany, France, Canada, and Belgium. The first accord was Basel Committee I which was issued in 1988.Basel Committee I focused on capital adequacy regulation, for example the capital that banks ought to hold in order to face with future losses on their assets. The regulation was adopted by all banks because in this way banks could have security and stability. The purpose of Basel Committee for capital ratio indicated by two Tiers. The first refers to the core capital that includes the equity of share holders for the balance of income variation. Core capital describes the capital adequacy. The second Tier refers to the supplementary capital that describes the capital adequacy too. The banks follow methods based on capital arbitrage that circumvent the rules of Committee about capital adequacy. Basel Committee, drawn up a proposal in order to review the previous rules. The revision of Basel Committee based on capital adequacy and comes from the developments in credit risk management. The Committee (Basel Committee II) discussed about the possibility the capital to be used for credit losses. The proposal is based on three pillars: The first pillar refers to capital requirement rules and more concretely the required capital shall be at least 8% of total risk assets. Also refers to the credit risks and to the supervision in order to be those risks decreased including the assets for the manipulation of operational risks. In the first pillar Basel Committee use two alternatives for the risks: the standardized technique which is easily applicable and refers to the diversification of loans in portfolio into risk tranches and internal rating based methods (IRB) which is based on internal information. The second pillar refers to the supervisory process. The new framework refers to the need of Bank Management to create on capital assessment process and putting goals. Supervisor ought to evaluate if the banks assess the capital adequacy beyond the first pillar. Financial institutions ought to have the appropriate amount of capital in order to cover the risk that they take. The third pillar refers to the market discipline. More concretely, the new framework tries to enhance the discipline of banks and set requirement about the way that banks calculate the capital adequacy. Unfortunately, the principles of Basel Committee were not applied properly by the banks, because a lot of banks try to escape from the authorities provided by Basel Committee with the main purpose to obtain higher profits, although it was said that the principles were insufficient. First of all, has observed that a lot of banks made off-balance sheet movements, by created companies where "toxic products" were transferred, so the former present to the Basel Committee the most appropriate balance-sheet. Banks exploited the possible weaknesses of the Committee and the result was that banks led to significant problems and generally led to the financial crisis.

Implications of global financial crisis

Global financial crisis has created a lot of impacts which have increasingly affected the banking sector (domino effect). Below indicated the most important consequences that have been caused in the financial institutions and disrupt the operations of banks. As it is mentioned above, subprime mortgages proved to be more risky that most investors think. Banks sold the above mortgages in order not to address the problems that will appear. As a result, the lending deteriorated. During the September - November 2008 (the peak period of financial crisis) lending fell by 37% and by 68% during the credit boom (March-May 2007). Opposite view have Chari, Christiano and Kehoe (2008) who stated that loans that are reported on the balance sheet of U.S. banks rose for the period September - November 2008 by $100 billion. It is important to be mentioned that banks with deposits in appropriate level, limit less the lending process during the crisis and extend more credit lines (Kashyap, Rajan, Stein, 2002).During the crisis, investors remove their money from uninsured funds and put their money to the banks as insured deposits. So, banks with large base of deposits, attrack deposits and have the ability to lend in addition with other banks. The recession and the uncertainty in the economy reduce the demand for loans by borrowers. One reason was the disability of bank during the crisis to find the appropriate capital. During the crisis the composition of bank capital obtained another form and raised the new capital in the form of debt. If leverage measured as the ratio of asset to common equity, then the leverage of the banks risen during the crisis. In particular, the depletion of common equity (through losses on portfolio of assets) is the main reason of banks to extend credit lines. The public contribution of bank capital become not with the structure of common equity but with the form of preferred equity. The contribution with the above form had the consequence that the leverage regarding to the common equity increased. After the massive bankruptcies of financial giants such as Lehman Brothers, Merrill-Lynch, Citigroup, AIG, investors start to make massive withdrawal of their deposits and start to liquidate everything they had such as bonds, shares, securities with the main objective to transform them into cash. So the main purpose of banks to provide liquidity insurance was failed. Banks without cash can not grant loans to individuals and to other banks too. Moreover, because of the crisis interest rates rose and the result was that the amount of lending dropped the volume of transaction become difficult because nobody could invest with higher rates and in this way liquidity crisis deteriorated. Also, another consequence of the crisis is the negative growth rate that be observed and the increase of unemployment. Specifically, a lot of banks led to dismissals of the staff because they could not pay additional salaries.

Recommendations for the Bank Management and Government measures

As it is said, global financial crisis caused a lot of problems to the financial markets. The irrational behaviour of banks with lending to individuals, other firms and banks without having the necessary funds led to the collapse of the financial system. Today, it is considering that should be made more effective supervision of the Bank operating. Better supervision would help, because in this way administrative and institutional framework would be strengthen based on better codes, practices and regulatory principles. The crisis has shown the need to the new principles. The Basel Committee is the most appropriate form for banking supervision and ought to formulate the supervision and practices in the most effective form, addressing the crisis all over the world. The condition in the banking sector with the liquidity crisis, the disability to lend, the absence of confidence between bank and investors and between banks may be deteriorated the next years. One measure that should be taken is the restructuring of banks in order to be restored the banking sector. One strategy could be the change of the framework of banks, by the nationalization of the institutions that do not operate properly. In this way bank sector, will be strengthening with improved regulations. The nationalization of institutions that work improperly will limit the accumulated losses and rapidly in this way the liquidity status will be improved because those banks will stop to borrow from the central bank and simultaneously, it will be mentioned increase of the confidence of investors and of other banks. In the current crisis because the accumulated losses are large, there is a need of new capital raised from the government. The raised capital would lead to the increase of the liquidity. When banks have money then do not have the need to increase bank internal rates. Any reduction in Euribor and interest rates would help the banks to borrow cheaper. Thus, increase their monetary reserves. The increase of available cash will lead to higher investment by providing loans. This will significantly help the development of the economy. Moreover, it is important to note that one measure is that the rates must be fixed, so investors not only will saving but also will invest because they will feel greater security under fixed rate conditions. It should be mentioned that already are made efforts by Institutions to tackle with the global crisis. The FED advanced to provide facilities with the policy "quantitative easing" in order to enhance the liquidity of banks. In addition, try to raise the liquidity by lowering interest rates to 0%-0.25%.

Conclusions

Since 1720, the economy has faced some periods of deep recessions that affect the whole world. For example, the recessions from 1873 to 1879 and from 1929 to 1933. Nowadays, the world faces the global financial crisis that appeared firstly in the beginning of 2006 with the collapse of housing market in U.S.A. Global financial crisis has created a lot of impacts to the banking sector and more specifically to the management of banks, disrupting the operations. Banks, because of the crisis faced a lot of difficulties. The lending deteriorated, banks have no cash, and because a lot of investors withdrew their money in order to deposit them more safely, between the banks there is no confidence and stopped the collaboration and has observed depletion of common equity. Measures should be taken in order not to be the condition deteriorated. First of all, it is considering that should be made more effective supervision of the Bank operating. The Basel Committee is banking supervisor and ought to formulate the practices and principles in the most effective form. Most governments ought to give capital to the bank sector to avoid more problems of the crisis. Already has given a large amount of capital for this purpose. Moreover, the interest rates start to have a declining in order to enhance the liquidity of banks. If banks reform their management into a better and more effective way and restructure the forms of the loans that be provided, then the management of banks could increase the profits.

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