Discuss Whether Financial Intermediaries Are Guilty Of Being The Root Cause Of Financial Crises

Discuss whether financial intermediaries are guilty of being the root cause of financial crises

Considered by many economists to be the worst financial crisis since the Great Depression of the 1930s, late 2000 saw the latest financial crisis, termed as the credit crunch in the UK. It resulted in the collapse of large financial institutions, the bailout of banks by national governments, and downturns in stock markets around the world. In the USA, the housing market suffered heavily, resulting in numerous evictions, foreclosures and prolonged unemployment. It contributed to the failure of key businesses, decline in consumer wealth and a significant decline in economic activity. Economies worldwide slowed down during this period as credit tightened and international trade declined. Governments and central banks responded with unprecedented fiscal stimulus and monetary policy expansion.

The financial crisis was triggered by a complex mixture of issues expressed in hindsight with varying weight assigned by experts. The United States Senate`s Levin-Coburn Report found that the "crisis was not a natural disaster, but the result of high risk, complex financial products; undisclosed conflicts of interest; and the failure of regulators, the credit rating agencies, and the market itself to rein in the excesses of Wall Street." It underpins the importance of subprime lending and the housing bubble, the easy credit conditions, predatory lending and the ones we will look in to more detail, deregulation and over leveraging in the grand scheme of complex interplay that forced the crash.

The U.S. subprime mortgage crisis was one of the first indicators of the crisis, characterized by foreclosures and the resulting decline of securities backed by mortgages. In an environment of abundant credit, low interest rates, and rising house prices, lending standards were relaxed to the point that many people were able to buy houses they could not afford. When prices began to fall and loans started worsening, there was a severe shock to the financial system. Individuals should know what they could afford; one could argue that the banks only did what was natural to them. The public were too easily enticed into mortgaging and remortgaging. It is evident that individuals acted irrationally to the low interest that was available.

Further adding to the problem was the complex credit default insurance that the banks packaged and traded globally. Critics argued that credit rating agencies and investors failed to accurately price the risk involved with such mortgage related financial products and further that governments did not adjust their regulatory practices to address modern financial markets. The complexity of certain financial products at the centre of the crisis meant investors were unable to make independent judgments on the merits of investments. Risks of market transactions were obscured and the lack of transparency about banks` risk exposures prevented markets from correctly pricing risk. Some firms separated analysis of market risk and credit risk. This division did not work for complex structured products, where those risks were indistinguishable. Furthermore, many advanced countries had invested in U.S. mortgage backed securities and consequently, globalization spread risks across assets, institutions and countries. Moreover, it has been suggested that global imbalances and looseness in monetary policy were both necessary pre-conditions for the crisis (Bean, 2008; Brunnermeir, 2009; Morris, 2008)

Prior to the crisis, financial institutions became highly leveraged, increasing their position on risky investments and reducing their buoyancy in case of losses (Services, March 2009). Much of this leverage was achieved using complex financial instruments such as off balance sheet securitization and derivatives, which made it difficult for creditors and regulators to monitor and try to reduce financial institution risk levels.These instruments also made it virtually impossible to reorganize financial institutions in bankruptcy; they became "too big to fail" and contributed to the need for government bailouts.

The graph shows the high level of leverage in the industry, typical behaviour characterized by Merrill Lynch whose exposure increased sharply and as a result they only now survive as a subsidiary of Bank or America (Team, September 09).

Why/how was this allowed to happen?

In 2004, the Securities and Exchange Commission relaxed the net capital rule, enabling investment banks to substantially increase their debt, fuelling the growth in mortgage-backed securities. Financial institutions in the so called "shadow banking System" were generally not constrained to the same regulation as depository banks, allowing them to assume additional debt obligations relative to their financial cushion or capital base. Furthermore, in the year 2000 the U.S. Commodity Futures Modernization Act allowed the self-regulation of the over-the-counter derivatives market and laws such as the Gramm-Leach-Bliley Act and the Commodity Futures Modernization Act permitted financial institutions to participate in unregulated risky transactions to great extent. The laws were driven by an excessive faith in the robustness of market discipline, or self regulation. The SEC liberalized its net capital rule in 2004, allowing investment bank holding companies to attain very high leverage ratios.

Deregulation of the industry has allowed institutions the means with which they were able to leverage extraordinarily; it also allowed them to provide credit to consumers more readily which was the initial trigger for the collapse. Not only did banks rank up debt, but since they were providing credit readily, without taking the necessary protection for risk, it implied that households were themselves becoming more debt ridden. It is apparent that examining the mistakes that were made, banks and institutions acted frivolously in terms of providing credit and leveraging in order to profit without due diligence. However, is it correct to agree with a sweeping statement that they were the root cause of the crisis? One could argue that the banks were only doing what came naturally to them. It is the reason why capitalism works, given and increased margin to profit from any company will do just that, profit maximize, or they will lose out to their competition. Banks should have been able to foresee what was coming and should have not acted recklessly but that is not their nature and nor is it the industry`s.

Personally, the mistake lies with the bodies that allowed deregulation, the reforms greatly benefited the banks and did not have substantial benefits to the public as a whole (abundant credit does not necessarily have to be a positive). Regulators should have been more vigilant; they should have clearly understood the nature of the industry and should have foreseen the behaviour financial intermediaries will involve themselves in (Jickling, April 9, 2010).

The Financial Crisis Inquiry Commission (FCIC) is a ten-member commission appointed by the United States government with the goal of investigating the causes of the financial crisis of 2007-2010, agreeing with the Levin-Coburn Report concluded that the crisis was avoidable and was caused by "human action and inaction, not of Mother Nature or computer models gone haywire" (Commission, January, 2011). Widespread failures in financial regulation, including the Federal Reserve`s failure to stem the tide of toxic mortgages, the breakdowns in corporate governance (too many financial firms acting recklessly and taking on too much risk) resulted dangerous mix of excessive borrowing and risk by households and financial intermediaries that put the financial system under extreme stress when things finally went in an unfavourable direction. Key policy makers were ill prepared for the crisis, "lacking a full understanding of the financial system they oversaw; and systemic breaches in accountability and ethics at all levels."

References

Bean, C. (2008). Some Lessons for Monetary Policy from the Recent Financial Turmoil. Remarks given at a conference on Globalisation, Inflation and Monetary Policy in Istanbul on 22 November 2008.

Brunnermeir, M. (2009). Deciphering the Liquidity and Credit Crunch 2007-08. Journal of Economic Perspectives, 77-100.

Commission, F. C. (January, 2011). Final report of the National Commission on the cause of the financial and economic crisis in the United States.

Day, A. (Oct, 2008). The current financial crisis- causes and consequences. Market Oracle.

Jickling, M. (April 9, 2010). Causes of the Financial Crisis. Congressional Research Service.

Martin, C., & Milas, C. (June 2009). Causes of the Financial Crisis: an Assessment Using UK Data. Italy: The Rimini Centre for Economic Analysis.

Morris, C. (2008). Trillion Dollar Meltdown: Easy Money, High Rollers, and the Great. Public Affairs Books.

Services, P. F. (March 2009). Financial crisis: Q&A (UK).

Team, I. A. (September 09). The Economic Crisis in Armenia: Causes, Consequences, and Cures.