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The Failure Of Regulation The Global Credit Crunch Finance Essay

Corporate governance in its broad term suggests how an organisation is governed. It incorporates how decisions are made within the firm and how those decisions affect its community. Governments impose regulations and policies that help firms make the ‘right’ decisions, in not only the firm’s best interest but in the economy’s too.

What we, the majority of the general public, understand about the Global Credit Crunch and its causes are down to the media and their interpretations of the disaster. We are continuously flooded with reminders of how US firms failed in making the right decisions regarding lending and how this paved our path to a destroyed economy.

Sure, corporate governance played a massive role in causing the economic crisis but we need to look deeper to find the truth behind it all and once we have all the facts, can we start to point fingers. We must remember the processes and human factors that contributed to making those critical decisions in the lead up to the Global Credit Crunch.

The Global Credit Crunch

In late September 2007 news broke of Lehman Brothers filing for bankruptcy. This was the first major event that started arousing suspicion from the public. Lehman Brothers felt the wrath of their failed strategy to earn more money by giving away favourable mortgages to candidates that did not qualify for them. This caused global concern, banks stopped borrowing to one another, investors began extracting their capital and consumers started spending less, all of which contribute to economic growth.

Looking back, not only at Lehman Brothers, but at other financial Institutes, we can see that the crisis was foreseen yet no decisions, or lack of the right ones, were made. US banks were practically giving away mortgages, expecting to earn more interest on them. When housing prices started increasing and interest rates were declining, the banks started to panic. They stopped borrowing because they had no idea which firms held ‘toxic debt’ and lacked trust that they would be paid back. Northern Rock is one of the biggest failure stories in the UK. They were unable to lend money to sustain its mortgage commitments.

The global economy was brought to its knees. Firms were losing money in their investments, and later found they were bankrupt. Unemployment started increasing, jobs were being axed and people started to panic and wonder if their jobs would be next. People started getting depressed and more and more in the paper were headlines of bankers killing themselves. Moral was down, hope was dim and people lost trust in the banking systems.

Others suggest that these global banks were not the only ones to blame for the economic crisis. Other faults include the rising oil prices and the ongoing was in Iraq helped fuel the situation. Can we argue that if the government wasn’t financing the war, could they have spent the money helping the banks recover, or could we say that would have just delayed the credit crunch, making it more devastating?

Economists argue that large investments banks could have prevented the global crisis through proper research, implementing better contingency plans instead of relying on expected government intervention/bailout and by having better moral and ethical standards.

"It's unconscionable what they did – or more accurately what they didn't do. They didn't do their homework. If they knew there was systemic risk, why didn't they do anything about it?" says Joseph Stiglitz, Nobel prize-winning economist and author of Freefall. He suggests a more involved approach where financial experts, NGO’s and universities should be formulating economic regulations.

This is not the first time the financial sectors have seen a crisis. In 2001 Enron collapsed and were declared bankrupt. Their demise was led by misleading financial statements, fraudulent profit and

loss accounts and concealing debts. Eventually share holders starting pulling out and left Enron financial unstable to continue trading. After this embarrassing scandal, US government passed the Sarbanes-Oxley Act of 2002. Toughening the regulations, and tightening internal and external controls were the government way of improving corporate governance and preventing that type of disaster from happening again.

The credit crunch was an economic depression, and after two years, we are only starting to see a slight growth in the economy. UK had reported a sustained growth of 0.3% in the last three months up to April 2011. Ireland, Greece and many other European countries are still struggling to sustain their economies and because of the European Union this could affect the growth of the other nation members. China and Brazil are a few of the unsuspected countries that managed to emerge quickly from the recession and started to show signs of improvement. [1] 

Interests of Corporate Governance

Lets first consider what ‘good’ corporate governance is and how do we know if firms are doing it right? We need to look at a firm as a moral agent, and the people that drive the direction the firm takes. Firms must be held accountable for their actions that affect all their stakeholders, i.e. employees, customers, government and general public. Good corporate governance can be witnessed through the transparency of the firm’s culture, policies, processes and ethics.

Following the global credit crisis, governments (UK, US and Europe) have evaluated current regulations and begun changes to better protect themselves from potential threats.

Give shareholders more say as to who is on the board of directors.

Continuous director training and evaluation

Create a Corporate Governance Forum

Detailed disclosures on directors

In today’s business age, where consumer benefits should be at the heart of every business decision, corporate governance is a requirement. For organisations to continue to grow; attract investors/shareholders and build a strong brand and reputation they need to incorporate excellent and transparent governance and think of the long term effects instead of the short term gain.

What went wrong before the credit crunch? Firms argue that they followed all their regulatory requirements but in hind sight we can see that they failed in good corporate governance. Investors were given huge incentives for taking larger risks, directors failed to think of the impact their decisions would make on the community and its shareholders and they were driven by the financial gain they might have been awarded if those risks paid off.

Failed corporate governance is not a new concept, looking back into the past we can remember the savings and loan crisis in the US in the 80’s, Asian crisis in the 90’s, and Enron in the 00’s. These cases should have taught us valuable lessons in governance, yet we have written in The Global Crisis of 2008 into our history books. Unfortunately we cannot just put all the blame onto one failed area; we need to take a deeper look at the other contributing factors.

Other Factors to Consider

Blame cannot be directed only at the ‘city bankers’. Let’s consider the individuals who knew that they could not afford to borrow, yet took our outrageous mortgages anyway. Did they not add fuel to the fire? What about the government? Is it fair to say they not only failed in implementing the right regulations but hurt the economy by keeping interest rates low for far too long and encouraging borrowing. Instead of seeing the economy grow, we found ourselves in a recession.

Western economies are financially developed. Through globalisation and the ‘free-markets’ we can see that the US and UK financial crisis had an effect on the rest of the world. Developing countries that are governed by international organisations from the western world felt the effects of the crisis; companies in these countries that were owned by multi-national corporations affected by the crisis would have downsized, reducing costs but at the same time increasing unemployment in these countries.

It is not only corporate governance of financial institutions that we should be concerned with, but also organisations of other industries that contribute to the economic growth of the country. By employing more people, creating larger expenses and production costs and failing to manage their finances ethically made them more susceptible to liquidation when the markets crashed.

What about rising oil prices and the ongoing war in Iraq. Government funding or should we say the tax payers money, were spent in areas where the individuals of the country have mixed emotions. Yes, the war in Iraq is justified by the act of terrorism that took place on 9/11 in New York and on 7/7 in London, but the cynic in me always thinks of the other issues, the more political issues that pursued the war. We all know that for centuries, governments have been fighting over oil and I find it hard to believe that this does not play some part in the reason.

The ‘Human Factor’

Individuals are considered as moral agents and therefore organisations can too be considered as moral agents (French, 1979). Companies have a culture which they try to embed in their employees, if the wrong decision is made the individual is not the only one held accountable, the company will also face the consequences of its actions.

Rational behaviour is when decisions are made based on the highest benefits that it will achieve. Cultural studies have shown a direct relationship between human needs and desires and rational decisions. Individuals will only strive to achieve a higher level once they have reached their basic needs first (Maslow, 1943). It is not rational to purchase a laptop when I cannot afford the electricity bill.

We can assume that bank investors have achieved their basic levels, physiological needs, safety, belongingness, and esteem needs. The next and final level is self actualisation, seeking personal growth and creating new experiences. These are only concentrating on yourself, disregarding others from your decision making process. Were the CEO’s of the major financial institutes making rational decisions when they started lending money to companies and individuals that did not meet the criteria? Or were they trying to achieve self actualisation? [2] 

Either way we look at it, individuals, the ‘people factor’ contributed to the cause of the credit crunch. Although we cannot blame one individual, we can certainly say: “Power tends to corrupt, and absolute power corrupts absolutely.” – Lord Acton.

Can We Relate the One to the Other?

We would have to be completely ignorant if we did not see the correlation between corporate governance and the Global Credit Crunch. Although financial institutes can prove they followed regulations, they failed to put their shareholders interests and ethical commitments at the forefront of their decisions.

The fundament role of the board of directors should be control and evaluate the risks associated with their decisions. By giving large incentives we are rewarding reckless behaviour and encouraging investors to ignore their responsibilities to the community and its economy. Corporate governance must be monitored and promote healthy and risk free decisions in order for us to pull out of this economic crisis.

Although recent global figures show some countries across the globe are recovering faster than others, but there is still a need for innovation and government intervention regarding corporate governance. Why have Islamic banks shown little effect from the credit crisis? They operate on specific laws and regulations and do not compromise their beliefs and morals. Their corporate governance was sound and they seemed to make it through without any Islamic bank failing or requiring government assistance [3] . Coincidence, some might argue not so much.

Conclusions and Recommendations

The credit crunch started with bad decisions being made in the financial services sector of the US and UK. It left economies devastated across the globe and the aftermath of it all is high unemployment, low county moral (high suicide statistics), low interest rates and high debt values. It is considered the worst crisis since the great depression (1929-1939).

There are many factors that contributed to the economic downturn and we can pinpoint our frenzy from the news of Lehman Brothers collapse. This was an important landmark and banks started realising that they could be next because their ‘toxic debts’ were exceedingly more than their capital. The government did however step in and help bailout the banks debt, with the tax payer’s money nonetheless.

Fast forwarding a few years, more recently bankers are yet again being awarded, we can read in local newspapers that CEO’s of Barclays, Lloyds and HSBC are receiving millions of pounds in bonuses- hold on, have we not learnt our lesson yet? Where did the pressure and strict regulations from the government go?

At the end of the day, I agree that corporate governance and regulation did fail in the lead up to the Global Credit Crunch. The consequences of bad corporate governance and regulation, and lack of transparency will be a price that the public will have to pay for over the next decade. The proof is in the pudding.

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