What are the Challenges Posed to Financial Stability Finance Essay

Critically discuss the issues at stake with reference to actual case studies stressing their similarities and differences in the recent Bear and Sterns and Lehman case, the law and any policy guidelines available


Over the past decade international financial conglomerates have become an increasingly important feature of the financial landscape. Universal banking countries have long integrated the securities business with traditional commercial banking, but over the last decade most regulatory obstacles to combining banking and the securities business have fallen in Japan and the United States as well. More broadly financial liberalization has removed most statutory barriers that once prevented banking, securities and insurance firms from operating within the same financial conglomerate [1] (Joint Forum, 2001, p.69). Increasingly these combinations have included banking and insurance operations. Allianz in Germany, ING and Fortis in the Netherlands, Credit Suisse in Switzerland, and Citigroup in the US have all made important cross-sector acquisitions in recent years to combine banking and insurance activities [2] . Indeed, virtually all of the large, international financial institutions are to some extent financial conglomerates combining at least two of the three formerly distinct functions of banks, securities firms or insurance companies. In this paper we shall focus on international financial conglomerates that combine banking with financial activity in at least one other sector In recent years, the subject of financial stability has been a cause of extensive debate for policy makers and the indeed the world at large. One of the main reasons for this spur was the East Asian financial crisis of the late 1990s. Following that turmoil, the World Bank and the International Monetary Fund (IMF) introduced the Financial Sector Assessment Program (FSAP) in 1999, aimed at assessing regularly the strengths and weaknesses of financial systems in their member countries.   Despite this increased focus on financial stability issues, it is notable that a widely accepted definition of “financial stability” does not exist and the concept has generated a considerable amount of debate among academics, market participants and policy makers [3] .   Crocket defines1 financial stability as requiring “that the key institutions in the financial system are stable, in that there is a high degree of confidence that they continue to meet their contractual obligations without interruption or outside assistance; and that the key markets are stable, in that participants can confidently transact in them at prices that reflect the fundamental forces and do not vary substantially over short periods when there have been no changes in the fundamentals” [4] .

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In the dealings of market economies firms go bankrupt incessantly. The procedure of bankruptcy is dealt with speedily by bankruptcy courts, which follows that there is little or no attention given except where there are outrageous claims. So the question that beckons is: what makes the bankruptcy if financial firms different? The common reply to this question by economists is that the collapse of a financial firm or conglomerate poses risks to the financial stability of an economy. A collapse of such an institution can often lurk a contagion risk, giving that manner with which banks operate. The implicit effect of this is that other banks that might not necessarily have a direct relationship with the collapsing company might be affected. [5] This follows through to the issue of payments systems. There is a very likely chance that investments failures can affect payment systems through contagions. There is the possibility of narrow banking where all cash checking accounts is either explicitly on hand or backed by investment in completely safe easy-to-liquidate Treasury bills. And all other savings and investments are at risk and not eligible for government assistance in a narrow banking system. [6] There is however a second possibility, currently in use, is a marriage between the payments system and investment regulated and guaranteed by the federal government through the Federal Deposit Insurance Corporation (FDIC). In theory government monitoring allows banks to operate until their net worth is near zero. They then are taken over by the FDIC but no payments-system contag`1ion occurs. The advantage of the current system is that total investment can increase because all the money in checking accounts is invested rather than just sitting in the vault or in Treasury bills. The disadvantage is that customers no longer pay attention to what banks do with their money and assume that bank regulators and the FDIC figure everything out and prevent systemic risk. [7] With regards to banks like Lehman Brothers and Bear Stearns, some economists argue that because investment banks are not explicitly involved in the payments system their bankruptcy is no different from that of Enron or your local hardware store. There is no possibility of contagion and the government should not become involved. On the other hand others argue that the investment banks are integrally involved with each other through over-the-counter markets in financial derivatives, which are essentially insurance contracts tied to interest rates, currency exchange rates, and credit defaults. This is the investment bank equivalent of the checking account relationships between commercial banks. The central role Bear Stearns played in the over-the-counter derivative market is invoked by some economists as necessitating the federal guarantee of assets to facilitate the takeover of Bear Stearns by JP Morgan rather than bankruptcy. [8] This argument prompts the thought of the too big to fail syndrome.

Why can banks not be allowed to fail when they have taken wrong steps?

Why were some banks like American International Group (AIG), Bear and Stearns, Northern Rock bailed out while a similar bank like Lehman Brothers allowed to fail? Why was Lehman treated differently by the fed (Federal Reserve Bank)?

Are some banks really too big to fail?

The fed took a treacherous risk and establish a fallacious pattern in March when it concocted the takeover of Bear and Stearns by JPMorgan Chase and pledged $29 billion in potential losses. The argument to justify this act by the fed and chief Ben Bernanke (chairman of the federal reserve) is that Bear and Stearns was just too big to fail and the consequence of allowing it to so would have been nothing short of a calamity on the economy of the United States (US), tax payers and indeed the world. [9] It follows that if Bear was too big to fail and deserved a bail out, why then was Lehman which was the forth largest bank, a big player in backed securities and mortgages in comparison to Bear which was the fifth allowed to fail. The writer goes further by refuting support for the big bank that have made reckless decisions therefore should be allowed to enjoy the consequences. More so, the US runs a free market economy where companies should be allowed to fail. [10]

By all standards, AIG qualified as a “Too big to fail” candidate. What made Fed and Treasury officials apprehensive was not simply the prospect of another giant bankruptcy on Wall Street, but AIG’s role as an extensive provider of esoteric financial insurance contracts to investors who wanted to hedge potential losses on complex debt securities they bought. The problem insurance contracts take the form of credit-default swaps (CDS), which effectively required AIG to cover losses suffered by the buyers in the event of counterparty default. AIG was potentially liable for billions of dollars of risky securities that were considered safe in normal time. An AIG collapse would cause it to default on all of its insurance claims. Institutional investors around the world would instantly be forced to reappraise the value of securities insured by AIG against counterparty losses. This would require them to increase their capital to maintain their credit ratings. Small investors, including anyone who owned money market funds or pension funds that hold AIG issued securities, could suffer losses. On the day before the AIG bailout became news after market closing, the New York money market firm Reserve Primary Fund, with $62 billion under management, announced that it “broke the buck”, meaning that its net asset fell below the standard $1 per share, a development all mutual funds normally would do everything to avoid. During a day of emergency meetings at the New York Fed, the Treasury and Fed reversed initial reluctance to bail out another financial institution. Though unspoken, the underlying conclusion was that this was not a takeover, not a bail out. If anyone is being bailed out, it is the central bank, which is desperately trying to create a fire break to prevent a global capital market collapse that it may not have enough financial resources on its balance sheet to support. The Treasury had to announce that it is issuing $40 billion of 45-day Treasury Bills to help buttress the Fed’s balance sheet. More will be issued as needed by the Fed. There are signs that the government’s fire fighting measures are less than effective. Market sentiment suggests that more financial firms can be expected to fail before the crisis crests. Mark-to-market requirements for valuing structured finance instruments and portfolios that are structured to appear safe in long-term probability models reduce the prospect of disaster to a very short fuse. A hedge that would be considered safe over a period of a year can suddenly be reduced to a position of high risk in a matter of days or even hours by market volatility. In such a market environment, the Fed, rather than its traditional role of market stabilizer over the long term, is often reduced to an emergency fire fighter in raging forest fires in a financial landscape infested with elements that practice arson for profit. David Wessel [11] defends the too big to fail, saying there are financial institutions that are too big to fail and they cannot be allowed to fail because the country fall in trouble. George Sholts (former Treasury Secretary) says that ‘if they are too big to fail, they are too big’ [12] . The current thinking of the fed and treasury is that we are stuck with this situation because it not feasibly possible or indeed logical to make these organisations shrink to prevent them from putting the economy at risk. And forcing banks to resize would be putting the economy at a disadvantage because the global organisations do need big banks, having small banks in the US and big ones in other countries would not benefit the US economy. Wessel reiterated the fact that there are bank that are too big to fail but they should be regulated to reduce risk. The regulation should however not categorise some bank as being too big and some others not because this will cause big companies to be $2 shy of being too big to fail thereby defeating the purpose of the regulation. The regulation should be done by means of taxation that is taxing on size, so they hold more capital thus more durable to shock. [13] Being too encourages recklessness by bank as they would believe that government would bail them out therefore take reckless risks. A too big to fail company is a company that the government is afraid to let fail because of the economic consequence to the people outside the institution. [14] The financial crisis showed the world the extent of power the fed has in relation to liquid cash and the sort. The president of the US does not have the ammunition to fight a financial crisis, he only spends money allocated to him by the congress (the congress is not very reliable with rapid response due to its structure). The only system that can possible provide an enormous amount of cash rapidly at short notice is the fed and that essentially what they did. When AIG asked for help with regards a bailout, they were quick to see that Morgan Stanley, Goldman Sax would be next to fall if they did not do anything to help. Wessel also brought up an argument against Ben Bernanke and the fed on reasons AIG, Bear and Stearns could be bailed out but Lehman could not. Bernanke claimed not to have had the legal authority to safe Lehman. This begs the questions that why was the law stretched to save one but not the other? Wessel also believes that Bernanke made a lot of wrong decision, Bernanke like Roosevelt did what they thought was right in the situation they found their selves, Some of they were trial and error, which numerous people suffered the consequences and might suffer more in the future. However there are some decisions that did work, which is evident in the very slow revival of the economy. We see an unemployment rate of 10% as opposed to 20 or 25%, which is considered progress. [15] In their book 13 Bankers [16] , Simon and James, discussed extensively about the financial crisis, its causes, too big to fail and so on. They say in Obama’s attempt to resolve a financial crisis he puts in place a reform which they think is rather weak and does not tackle the too big to fail problem. However they Simon and James are in support of the fact that there should be new consumer agency vis-a-vie financial products. However the problem of banks being so big that their collapse creates an economic pandemonium such that they force the fed to rescue them, this problem is not solved. Simon further suggests that if banks are too big to fail, they are too big to exist. No bank or financial institution should exist if its collapse can cause economic disruption. Any such bank should simply be made smaller, which has no economic detriment to the economy. This implies that if an economy allows for financial aristocracy, there would be adverse consequences. Financial concentration will bring collapse as seen through Andrew Jackson in the 1830’s, Thomas Jefferson, Theodore Roosevelt (end of 19th century), Franklin Delano Roosevelt (1920’s boom and burst) [17] . If Obama does not the big banks, the future holds another great crisis. This is not to say that there would not be bumps in the financial system but the existence of these banks at that size is more detrimental to the economy. If these underlying core financial, political and economic issues that brought the country into the present financial crisis are not dealt with, the next financial meltdown is not far off. Challenge


The financial systems in developing economies however, have remained resilient to the financial woes in the US because business has still been done in the tradition way where individuals or companies need to have a good track record to be given credit or loans in these countries as a result the risk levels are very minimal. However, the impact would be felt in the real economy as a result of reduced demand for imports. This is likely to affect international market prices of such products. Banks in the developing economies will likely see their credit lines from foreign banks squeezed and the increasing financial flows that these economies have been experiencing are going to dry up. Dr Huang pointed towards the observed asymmetry in the speed of replacing positions after termination with Lehman and argued that this asymmetry caused the dislocations in the swap and repo markets. Dr. Huang noted that the market turmoil was avoidable, as there had been precedence for successful regulator intervention. The New York Federal Reserve could have minimized systemic risk by transferring Lehman’s matched books to another derivatives dealer as had occurred when Dresdner Bank and Refco Inc failed.

Impact on Swap Markets

In an interest rate swap (IRS), two counterparties exchange a fixed interest rate for a floating interest rate at regular time intervals. The floating rate is usually set to be equal to a short-term benchmark rate, like the USD LIBOR rate, while the fixed rate is set when the swap is initiated and reflects the market expectation of the level of the floating rate throughout the life of the swap. By convention, an IRS “receiver” is the counterparty that receives fixed and pays floating, and the IRS “payer” is the counterparty that pays fixed and receives floating. While the Federal Reserve did not immediately cut the target Fed Funds rate after the collapse of Lehman, cutting this rate was widely anticipated as a necessary measure to ensure liquidity in the markets. Counterparties to Lehman who were IRS receivers rushed to replace their long duration positions in the markets immediately, since such positions would likely increase in value, receiving the same fixed rate for an anticipated lower floating rate. The increase in value could then be used to hedge losses from other short duration positions in their portfolio. However, the converse was true for counterparties who were IRS payers. Due to bankruptcy regulations, the payers had already closed their positions with Lehman at a single closing price, regardless of the contract size. Since the short duration positions that IRS payers owned were probably used to hedge their long duration exposures, and long duration exposures were likely to rise in value, there was no incentive for the IRS payers to replace their loss-making hedges immediately. Under the Expectations Theory of interest rates, forward interest rates are what the market expects future interest rates to be. However, a few weeks after Lehman filed for bankruptcy on September 15, 2008, the long end of the term structure of the USD interest rates fell sharply. Between September 15, 2008 and October 17, 2008, the 30-year end of the two-week USD forward curve fell by about 30 basis points. While the rates at 30-years could be distorted by market expectations of future economic conditions, such as long-term inflation rates, Dr. Huang believed it was unreasonable for the markets to have such strong opinions on interest rates movement 20 to 30 years into the future that could affect 30-year forward rates so strongly. The more plausible reason for the drop in 30-year rates was the massive influx of IRS receivers looking to immediately replace their terminated Lehman swap positions, and the shortfall of IRS payers who were willing to wait to replace their loss-making swap positions. Since swaps are usually long-dated contracts, the demand and supply imbalance depressed the longer maturity end of the term structure. To illustrate the demand and supply imbalances, Dr. Huang utilized a quantitative model to generate an estimation of the fair value for the 30 year rates based on a linear combination of interest rates at four other standard maturities. The swap rate from the model is then compared to the 30 year USD swap rates. Since the market and model rates are supposed to track the value of each other over time, if the market rate is greater than the model rates, market participants would profit from entering an IRS as a receiver. The converse is true when the market rate is lower than the model rate. The results implied by the quantitative model are consistent with stylized facts, with market rates above model rates during periods of distress, such as the Russian default, with government cutting interest rates to prevent recession and market rates below model rates during times of stability, like before the Dotcom crash, with governments increasing interest rates to curb inflation. However, in contrast to previous crises, the market swap rates were below model rates in the case of Lehman’s collapse. This means that interest rates were too low relative to the model predictions due to IRS receivers rushing into the market to replace their long duration positions. The dislocation in the fixed income market was not limited to the U.S. Europe also experienced low 30-year EUR swap rates relative to the model, as defined benefits pension funds replaced their long dated receiver IRS in the market to hedge their liabilities. On the other hand, parties on the other side of the matched book, such as the economies with lower credit ratings including Greece and Italy, other banks and hedge funds postponed the issuance of new debt.Â

Impact on Repo Markets

In a repo, a borrower sells a security to a lender for cash and agrees to buy back the same security from the lender at a fixed price at a later date. This is essentially a collateralized loan. However, when Lehman filed for bankruptcy, all repos transacted through Lehman were terminated, and the lenders were left with the borrower’s assets while the borrowers were left with cash. If the borrower posted collateral consisting of an asset that is desirable in distress environments, they would likely try to replace the asset from the market immediately. If the asset that was posted as collateral would not perform well in a distressed environment, the borrower can choose not to replace their exposures and simply keep the cash that was borrowed. However, the lender in a repo is probably looking to generate some short-term interest and is not likely to have the expertise or an economic interest in managing the asset for the long-term. Hence, the lender will likely sell any collateral it owns from the termination of the repo to replace its cash position. As a result, the supply of all collateral assets would increase, but there would only be a flight to quality to the desirable assets. According to Dr. Huang, the above phenomena would be observable via the price of the undesirable assets falling relative to the price of the desirable asset. During periods of distress, both interest rates and the inflation rate are likely to fall. Hence, inflation-linked bonds are likely to be undesirable assets while fixed interest bond are likely be desirable. An inflation-linked bond can be converted into a synthetic nominal bond by shorting inflation rates using inflation-linked swaps. This synthetic yield should not have a significant spread over the nominal yield of a similar nominal bond under normal circumstances. However, when Dr. Huang charted the spread between the synthetic yield from U.K. inflation-linkers and the yield from nominal bonds, he discovered that the synthetic yield of the inflation-linkers traded at between 40 to 120 basis points above the yield of a nominal bond from the collapse of Lehman to December 5, 2008. This meant that the price of inflation-linkers fell relative to the price of nominal bonds, even after converting their real yields into synthetic yields. This observation lends credit to the hypothesis that the collapse of Lehman led to indiscriminate selling of collateral by lenders to recover their cash but only selective replacement of desirable assets by the borrowers. Dr. Huang added by saying that although matched book operations are risk-free for derivative dealers, sudden termination of matched book positions can lead to significant market dislocations as market participants replace long duration positions ahead of short duration positions in distress scenarios. Regulators trying to lower systemic risks should also be mindful of this fact when dealing with collapsing financial entities in the future. Furthermore, assets that are normally highly correlated with very similar cash flows, such as stripped inflation-linked bonds and nominal bonds, also diverged significantly in value. This has important implications for market risk management as regulators and arbitrageurs can make the markets more allocatively efficient and less volatile by buying up the undervalued assets and making price a better signal of value.  [18] In a credit crisis there is generally a ripple effect to the financial system of the country affected and indeed the world. This instigates that if there is a breakdown or a collapse of a financial conglomerate, which naturally has branches in major parts of the world, it will affect those parts. To ensure that other countries who suffer the punishment of reckless Banks do not suffer unjustly, there should be an information trickle system where updates about the goings on and major transactions of those companies are given to these branches. This ensure they have a say in the make or break of the company that its collapse can potentially disrupt their economy. Furthermore, the fed needs put a holt on they bailouts in order to allow the economy got through its natural cause. Crisis should be allowed to occur and collapse of any company should be accepted as the US runs a free market. This is implicit to the fact that any company that has been reckless should be left to fact the consequences so other can learn. In addition, a limit of 4% of GDP or $600 in assets should a implemented as this will return banks to where they are in the 1900’s when it can be said that the financial state of the country was fairly stable. This reduces or eliminates that too big to fail theory and provide more competition. At the moment there are about five organisations that dominate the derivatives market. If the number increase there could be more competition which would induce lower margins and better prices for customers.

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