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Theoretical Analysis of the Banking Crisis

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Published: Tue, 27 Feb 2018

Crisis in the banking sector

The current crisis and the Great Depression

Theories and the crises:

Several theories exist connected to the financial crises that have happened since the banking system was established. Some of them tried to explain the reasons and the origin of them however none of these theories could provide an acceptable solution how to prevent the crisis. To determine the continuity in the timeline and the spread of the crisis it was not enough to create just an economic comparison. The analysts set some mathematical and other type of model to investigate the behavior of the market.

The two mostly accepted models of banking panics are the Diamond and Dybvig model and the Calomiris and Kahn model. These models were set in the 1990’s as the reflection of the systematic banking crisis since 1970.Both of the two theories were accepted the fact that the banks’ liabilities are more liquid than its assets. In the Diamond and Dybvig model they set a hypothetical world without the banking system. The banks make contract to transform its illiquid assets.( Federal Reserve Bank of Minneapolis Quarterly Review

Vol. 24, No. 1, winter 2000, pp. 14-23, Dybvig: Bank Runs, Deposit Insurance, and Liquidity).The problems with the contract is that it doesn’t include any risk-sharing option. The deposit insurance is the only way to reduce the risk because it’s decrease the ability of the bank to transform its assets. The asymmetric information affects the liquidity demand. The final conclusion of this model is that the bank run is triggered only because patient agents believe.”This result is a self-fulfilling prophecy (panic): Because patient agents expect other patient agents to withdraw their funds early, they do the same. As a consequence too many funds are actually withdrawn, which otherwise would have not been the case. (Banking and Finance /Banking Crises.ppt/2008.12.03)”

The Calomiris and Kahn model basis is the Diamond and Dybvig model, but it is more complex (Charles W. Calomiris, Charles M. Kahn, “The Role of Demandable Debt in Structuring Optimal Banking Arrangements” in American Economic Review, Vol. 81, 1991). They introduced one other potential option that the banks follow a risky behavior and put their investors’ money into risky projects. Because the asymmetric information the investors don’t know about this step. Then, two possible things can happen; the project turns out well or not. If the project turns out negatively the bank starts to invest again. In the model the depositors can purchase information, but if is shows a negative indicator they withdraw their money. If there are a huge number of the depositors who want to withdraw the bank has serious liquidity problems and the bank panic starts. The only possible solution, according to this model, is to increase monitoring in the banking sector and strengthen the regulation to avoid moral hazard.

I. The Great Depression
1. The beginning of the Great Depression (1928-30)

The history of the Great Depression is important to analyze the main aspect of the crisis. From May of 1928 the stock market rise continuously and the average stock price increased because the FED raised its discount rate, and saw the stock market was booming and the stock price doubled, as excessive speculation. They tried to resolve this by increased monetary policy to raise interest rate and a new deflationary policy was introduced. As a consequence, a huge financial bubble evolved. In October 22, 1929 New York Times published an article; “Fisher Says Prices of Stocks Are Low”. (The 1929 Stock Market: Irving Fisher Was Right, Ellen R. Mc Grattan p.1) Then, two days later the stock market went crashing and the stock prices had fallen by 30 %: According to Irving Fisher the problem was that the people have been speculating on the small margins. It was not that the stock market was too high, but the people so enthusiastic to making money that they properly expected to make. It created debts because the people bought stocks on borrowed money. The politicians issued optimistic predictions to prevent the selling panic in the U.S. market (The causes of the 1929 stock market crash, Harold Bierman).The secretary of the Treasury, Andrew W. Melon stated: “There is no cause to worry. The high tide of prosperity will continue”. The stock market did come back in the middle of 1930, more than half of the stock that has been decline as been reversed. People thought it was over recession turned into something different.

The agriculture sector stocks continued to decline. This regressive tendency was intensive not only because the Great Depression. Massive overproduction started in the European agricultural production sector after the World War I to recover the lack of the agricultural goods. To increase the legislative protection of the domestic farmers the Smoot-Hawley Tariff Act of June 1930 raised U.S. import tariffs (U.S Department of State, http://future.state.gov/). The Smoot-Hawley Tariff declined the international trust and cooperation and caused some problems in international trade.

As a result of market crush bank collapsed from October 1930 until March 1933 by this time over a third of Americans bank was out of business. It continued to decline by mid 1932, the stock had declined to 10% their value in the peak 1929 and the increase in this in uncertainty from unsettled business conditions created by economic contraction made adverse selection and moral hazard problem worse in credit market. (The great crash, 1929, John Kenneth Galbraith) There was reduction in the number of intermediation due to loss of one-third of banks. This only increases adverse selection and moral hazard problem. Funds to firm with productive investment opportunities were greatly decreased due to this problem. In some sectors like manufacturing sector the production fell dramatically which was the basis of the Firm’s wage rates cuts. The level of price fell by 25% in the period of 1930-1933. Debt deflation was triggered in which net worth fell C:Documents and SettingsJudyAsztalunemployment.gifbecause of the increase burden of indebtedness borne on the firm. One sector problems affected the others. Millions of people lost their jobs. In the period of 1900-1947 two types of unemployment were made. These researches were developed the data set for the civilian labor force and for the Non-farm employees. (Historical unemployment in relation to today, A. Andrews)The employment rate declined by approximately 20% and the economic contraction and unemployment rose to 25 percent because of the decline in net worth. The result was more increase in adverse selection and moral hazard in the credit market. This was the worst ever experienced in the United States of America.

2. The FED

This system was introduced to the public as economic stabilizer in 1913 to prevent further economic crisis although Federal Reserve System was totally passive during the Great Depression. In general, the Federal Reserve controls the interest rates and the money supply (inflation).The FED is controlled by its Board members and the majority of the twelve member Constitute the Federal Open Market Committee with five Reserve Bank The Fed not only supply the money to economy, it loans the money to them at interest. Besides, it regulates the value of the currency being issued. It should have acted as the last resort to lend as that its role. For the period of 1921-1929 the FED increased the money supply by 62% .The main reasons they did nothing was they never anticipated the negative of bank failure could have on money supply and economic activity. They thought a bank failure is as a consequence of poor bank management or bad banking practice. Small banks failures were the first to be affected in the bank panics in the early stages. And since the big city bank was the most influential they saw the failure of the small banks as complacency. Some suggested that political role might have played an important role in the passivity of the Federal Reserve System at that period. The New York Federal Reserve System was the most dominant force in the 1928, and it supported the Fed in open market purchase to lend money to the banks during the bank panics. This was opposed by other powerful member in the Federal Reserve System and the New York position was out voted. There were multiple causes and many theories about the origin of the Great Depression. According the monetarist theory the Crisis is the consequence of the lack of the FED’s policy making. The level of government influence on a bank varies from one country to another let say for example, in China the government regulation is very high probably the highest in the world and in United Kingdom the government regulation is very low .It can be said that in the United Kingdom it high if we compare with the United State. So depending of which countries are comparing to another, government influence is usually different.

3. The economic decline (1930-32)

Thanks to the Tariff Act the world market suffered a huge damage but, the act was not enough to recover the U.S. economy. People starting lose their jobs, homes and their confidence to the system and they take out their money from the banks and in the end they couldn’t repay their loans. The continuous decline shows the effect in political elections in November 1930 when the representatives of the Republican Party lost their places in the Senate and their number and voting power reduced dramatically. In 1931 some new predictions appeared in the news which says that the depression would be over in the end of that year. During this year the deepening economic depression hit Europe and credit structures collapsed there. The media blamed United States for create this depression by cutting back on imports. Various conspiracy theories were voiced about the Soviet Union and some Biblical prophecy appeared too. In1932 a new presidential campaign started where Hoover and Roosevelt describe two different political aspects about the Depression. Hoover’s economic aspect based on voluntarism and individualism, but the natural economic forces and the voluntary action by business groups couldn’t work in the last 3 years. So his voters lost the trust in Hoover and he was easily beaten in the election (Burner David, Herbert Hoover: Alfred A. Knopf, New York, 1979).

4. The New Deal

Roosevelt the new president was introduced a new program called the New Deal that contained social and economic reforms in 1933. He settled up new governmental agencies with the Glass-Steagall Act. “It gave tighter regulation of national banks to the Federal Reserve System; prohibited bank sales of securities; and created the Federal Deposit Insurance Corporation (FDIC), which insures bank deposits with a pool of money appropriated from banks. (New York Times, http://topics.nytimes.com /topics/reference/ timestopics/subjects/g/glass_steagall_act_1933/index.html )“ The senate tried to restore the people’s trust in the U.S financial system with the Glass-Steagell Act .It made a clear separation between the investment and the commercial banks .To handle the banks’ poor asset management Franklin Roosevelt declared a “bank holiday “as a result of bank panic in March 1933.The” bank holiday” regulated that the banks had to be until the governmental inspector investigation. The inspector after a monitoring process judged about the banks reopening.

Another program was started namely in that time: the Agricultural Adjustment Act which helped to increase the income of the farmers. The overproduction created corps surplus and the government pay the farms, in the frame of this program, to leave the fields fallow and not to raise pigs and lambs. (Ronald Edsforth: The New Deal: America’s Response to the Great Depression, 2000) The Act aimed to raise the value of the corps, but few months later, natural disasters destroyed almost all the corps and the machinery. To help the farmers and teach them how to measure and reduce erosion the government established the Soil Conservation Service. This program stopped in 1936 when a new agricultural act had been accepted.

The new regulation provides a possibility to the farmers to get federal subsidies. Besides of this, NIRA (National Industrial Recovery Act) had been accepted by the government to generate more jobs, strengthen the right of collective bargaining. The unemployment increased since the Great Depression had started. Based on this reason, they provided jobs in government projects such as work camps. Approximately two million people participated in this program until 1934. The unskilled workers got hard work like digging and railway repairs but they earned only a little money. National Labor Relations Act introduced new fair labor practices in 1935.The New Deal program had helped the US economy but didn’t bring the end of the Great Depression. The roots of the economic problem came from the financial insecurity and the distribution of money, because the people on relief lived from one day to another (Bernardit Bellushit, The Failure of the NRA (1975)). The investors were afraid of buying stocks and lose their money. The companies’ couldn’t sell their new products because the people spent their money to food. The inventories were full and nobody wanted to produce more and that stopped the cycle of the economy.

5. The Second New Deal

President Roosevelt decided to set a group of new economic and social measures and provided some legislative initiatives. The public and political forces lead the president to make some radical steps. . In 1936 Roosevelt won the election but the Americans wanted the government to take greater responsibility for the welfare of the nation. The Second New Deal as legislative program established some government controlled agencies and projects. He allocated billions of dollars to start and give a financial budget for the Work Progress Administration (WPA).Roosevelt nominated the social worker Harry Hopkins to be the head of the WPA. In its early years it focused on the construction programs such as build schools and government buildings. Attempt to the population of the United States it found that the one of every six people was unemployed and most of them was unskilled (http://www.u-shistory .com /pages /h1599.html). Unskilled laborers the forgotten man of past generation works at decent wages. The nation was building and repairing schools, public buildings, community centers and airports to meet the changing needs of the modern world. In one project twelve hundred men were employed to improve bowling field and construct building hangers and administration buildings. In addition to the hundreds of the unskilled laborers, many skilled workers were employed in this improvement project. Hundreds of homes have been treated from bondage of property. In New York City WPA housing demolisher project was started which improved the families living conditions. In many other cities of the country old firetraps are being demolished to make way to modern buildings. Swimming pools and parks were constructed to make more public value to the community and remove the children from the streets. In many parts of the country nursery schools were established to where almost 10 thousand children got hot meals, supervised train activities. In these projects employment has been provided 600 hundred teachers nurses dieticians and cooks. More than 300 thousand adults learned to read and write first time in their life and started to learn foreign languages from native teachers. In cooperation with the national youth administration 26500 young man and women were employed as instructors’ laboratory assistants and clerical helpers.( Historical unemployment in relation to today, A. Andrews)

Clerical white -collar workers find employment at filling and checking important land records. As part of the program of rehabilitation of the conservation of human resources a number of household training school were established by WPA. In these school girls from relief families are prepared for domestic works. Health education is an important part of the WPA program in a number health centers in large cities teaches the proper care of the children and adults. In some cities sawing rooms were established to support the poor families with clothes. Another type of permanent construction was the community stadium as a representative a large group of project provides the public gatherings all over America. Hundreds of new bridges were constructed thousands of old bridges have been repaired and made safe.

In Many cities the construction was undertaken with the cooperation of the public health agencies. The rapid growth of air traffic gives the opportunity to built modern airports and gives a job to thousand s to improve and repair the existing facilities. The increased air transportation also made necessary the development of hundreds of emergency landing fields. In cooperation with the local police departments in several cities automobile inspection stations were established to reduce the unsafe vehicles on the roads. Women who had the principle to support their families are paid for the work. And the product they made was distributed free to the families on relief (John Salmond, The New Deal: The National Level (1975). pp. 188-89). Many other type of employment was provided for women and other part-time jobs were provided in kitchen and in libraries and schools. As a result of some projects thousand of books and maps were translated. This program also contained training for adults to learn tailoring. The financial support of the administration was enough to invest into more projects like Federal Writers Projects , Federal Theater Project, Federal Art Project, National youth Administration ,to generate more jobs for white-collar workers.“Because Harry Hopkins believed that the work provided by the WPA should match the skills of the unemployed, artists were employed to paint murals in public buildings, sculptors created park and battlefield monuments, and actors and musicians were paid to perform. These white-collar programs did not escape criticism and the term “boondoggling” was added to the English language to describe government projects of dubious merit.( Jim Crouch, “The Works Progress Administration” Eh. Encyclopedia(2004)). The WAP was a long program and finally was abandoned in 1943.Social security act created a new health insurance system based on employer and employee contributions, supported by taxes

6. The SWOT Analysis of the WPA

SWOT

Strengths:

Weaknesses:

Education to unskilled workers

Started project didn’t wanted

Various types of jobs

WPA as Financial “black hole”

Provide part-time jobs

Political influences

Jobs for Artist and Black people and Women

No ability to control the workers productivity

Improve the health care system

Opportunities :

Threats:

Starting more useful projects

Instable economical environment

Decreasing political aspects of the projects

Living expenses increases, because import stop

Strengthen the economy throughout projects

Potential health problems, disease could stop projects

Developing international export-import partnerships

Other political parties critics-political intervention

Support the banking act, provide more financial security

The SWOT analysis is for compute the Strength, Weaknesses, Opportunities and Threats of a sector or a company (Mehta, S. (2000) Marketing Strategy). It is used for strategic planning to create a way to the desired goal or objective. In this case it was decided to apply this technique to set a real picture about the Second New Deal through WPA. The main aim of the current analysis is not generate alternative strategies, but to summarize the situation of WPA and the critiques in 1930’s.Starting with the strength of the WPA it can be seen that the group of different types of jobs were provided to a high-scale target area. People could achieve different skills by the WPA’s trainings and educations, and they got motivation to learn and use their knowledge in long-term. There were several weaknesses of the program from the beginning. As a governmental project the WPA needed a huge financial background to work and in some cases they only waste the money. The critiques described that some part of the program was only started to get more votes. The real leaders of the WPA had no ability to control the workers’ productivity and their effectiveness. To mention some real threats the instable economic environment remained the same. The diseases could spread faster among the workers and it may stop many constructing projects and it may indicate more financial problems in the health care system. One of the most important opportunities was to prevent more political fight and decrease the obvious political aspects of the projects. It would have been useful if they could solve the import problems. The following table above contains the main strength, weaknesses, opportunities and threats.

6.1. The external factor analysis

EFAS (External Factor Analysis Summary)

External Factors:

Weight

Ratings

Weighted Score

Opportunities:

O1

Starting more projects

0,1

3

0,3

O2

Decreasing political aspects of the projects

0,2

4

0,8

O3

Strengthen the economy through projects

0,05

3

0,15

O4

Developing international export-import partnerships

0,1

2

0,2

O5

Support the banking act, provide more financial security

0,05

3

0,15

Threats:

T1

Instable economical environment

0,2

4

0,8

T2

Living expenses increases, because import stop

0,1

3

0,3

T3

Potential health problems, disease could stop projects

0,05

2

0,1

T4

Other political parties critics-political intervention

0,15

3

0,45

Total Scores:

1

1,0-5,0

3,25

The SWOT table can be used to introduce three other type of analysis the EFAS, the IFAS and the SFAS. The External factor analysis and the internal factor analysis are calculated in a same way. The external factors (opportunities, threats) are used to show the economic background of the company or the sector. The elements of the SWOT table are the main factors of these tables. Every row contains weights and the rates and the multiplied result; the weighted score. The sum of every weight has to equal by 1, and the factors’ ratings should be between 1 and 5.The total score will be the sum of the weighted scores and it shows a real picture about the company’s position. The company is in danger if the result is less 3,5 than.

6.2 The internal factor analysis

IFAS(Internal Factor Analysis Summary )

Internal Factors:

Weight

Ratings

Weighted Score

Strenghts:

Education to unskilled workers

0,15

3

0,45

Various types of jobs

0,15

4

0,6

Provide part-time jobs

0,1

3

0,3

Jobs for Artist and Black people and Women

0,2

2

0,4

Improve the health care system

0,1

3

0,3

Weaknesses:

Started project didn’t wanted

0,05

3

0,15

WPA as Financial “black hole”

0,05

2

0,1

Political influences

0,1

4

0,4

No ability to control the workers productivity

0,1

3

0,3

Total Scores:

1

1,0-5,0

3

If the result is more than 3,5, the company is in safe. The internal factors (Strengths, Weaknesses) are closely related to the object of the analysis. The internal strengths and weaknesses summarize the main topics the company has to deal with. The total score is 3 and this means that the company is not in safe and for a long -term basis the management has to handle the weaknesses to strengthen the company position in the market.

SFAS(Strategic Factor Analysis Summary )

Factors:

Weight

Ratings

Weighted Score

Duration (in terms)

S

Strenghts:

Short

Medium

Long

S1

Education to unskilled workers

0,2

3

0,6

X

S4

Jobs for Artist and Black people and Women

0,2

4

0,8

X

W

Weaknesses:

W3

Political influences

0,15

4

0,6

X

W4

No ability to control the workers productivity

0,1

2

0,2

X

O

Opportunities:

O1

Starting more projects

0,05

5

0,25

X

O2

Decreasing political aspects of the projects

0,05

1

0,05

X

T

Threats:

T1

Instable economical environment

0,2

4

0,8

X

T4

Other political parties critics-political intervention

0,05

3

0,15

X

Total Scores:

1

1,0-5,0

3,45

6.3. The Strategic Factor Analysis Summary

The Strategic Factor Analysis Summary (Business Policy and Strategy lecture SFAS power point presentation 2008.12.03) has an additional column, the duration that is separated into three different parts; long-term, medium-term, and short-term .The most important factors are listed here with weights and ratings to represent the main internal and external aspects of the WPA and to make a summary about the problems and possibilities. As a conclusion, based on the analysis listed below, the SFAS ‘s weighted score is 3,45.It means that the WPA could work in a long-term if the leadership could handle the problems. The WPA project stopped in 1944; therefore the main reasons did not connected to the internal factors, but only the externals. Some critiques had right the all the projects of WPA had only a political step to achieve more cotes in the elections.

7. The world’s reaction to the Great Depression (Theories)

The world reacted in a several way to the Great depression and created a lot of theories how to solve the situation. The most famous reaction was the communism, fascism and the Keynesian theory. The fascism took place in Germany, Italy and it represented a highly centralized economy. The public construction programs provided jobs for unskilled labourers to built roads, work camps and military facilities. It increased the demography of the population, but the system was highly dictatorial. According to the statistics the unemployment rate decreased dramatically from 6 million to 0.2 million people.The Communism, as a highly bureaucratic and centralized system, was one of response to the Great Depression. It focused to fully employ the people in a strictly regulated obligatory way. The Keynesian theory: It states that the fully employment is needed, but only the intervention of the government can create this possibility. It can be long -term purpose of the existence of the government. The Keynesian theory changed the way of the thinking about the unemployment. The idea of the welfare state was another solution of the crisis. The education, the minimal guarantee of a job to every citizen is the basis of a welfare system. It guarantees the minimum wages and the minimum social and healthcare system.

II. The Current Financial Crisis
1. The beginning of the Current Crisis

The current financial crisis started in 2007, but it was not until the last quarter of 2008 .Firstly, this part of the thesis going to show how it all started, the causes and those who were affected by the crisis and how they are trying to deal with the crisis. Most of the people are pointing directly to real estate as the major cause of the current financial crisis even financial institutions that not directly involve with real estate are affected. It can be seen how the subprime mortgages and unscrupulous lenders has caused the unsustainable real estate bubble which began to collapse in 2006.There was increase in homeownership in the United State to about 5 million in little more than six years thanks to the increase in subprime lending. Within these six years constructions of new house sing units grew more but this housing bubble could not grow forever. In this period the price of house went so high and rent price went so low. When the price of housing began to decrease in the late 2006 to early 2007, many subprime borrowers had very hard time to make their payment. The housing bubble or the excesses of the subprime mortgage market became even more evident when subprime mortgage lender filed for bankruptcy. All the sectors like households, businesses (including financial institutions), and government are the main participants in the financial market and hit by the crisis. The secondly related financial groups are the surplus units provide funds and while the other group that enter the financial market to obtain fund are the deficit units.

If market securities yield low returns why invest in it? Three factors can be seen to why it important to make investment in market securities these are, as we have said before the advantage to convert to cash rapidly so it can be substitute as cash. The second reason is that when a firm has excess cash let say for a month it can invest the excess cash in form of securities as not to hold too much cash in hand. The third reason is that when a firm know it going to pay a loan soon it gathers the money monthly to pay and this money could be invest in market securities before the loan is to be paid.

As it have seen when the financial crisis started the public could see that the financial system is in a deep trouble some even call it recession because the stock market came crashing and lost almost 42% of it original price. Before the peak of the financial crisis the total world stock market worth $62.5 trillion and now it $36.6 trillion so it lost $25.9 trillion. Let compare the stock market of leading countries of one day and another day and see how it doing.

STOCK MARKETS

May 5

prev

%chg

S&P 500

903.8

907.24

-0.38

Nasdaq Comp

1754.12

1763.56

-0.54

Dow Jones Ind

8410.65

8426.74

-0.19

FTSEurofirst 300

846.81

842.7

+0.49

DJ Euro Stoxx 50

2407.55

2419.53

-0.50

FTSE 100

4336.94

4243.22

+2.21

FTSE All-Share UK

2226.6

2174.64

+2.39

CAC 40

3225.0

3237.97

-0.40

Xetra Dax

4853.03

4902.45

-1.01

Nikkei

(c)

8977.37

Hang Seng

16430.08

16381.05

+0.30

FTSE All World $

153.46

153.19

+0.18

( source New York Times May 5 2008)

There was turmoil in the all over the international financial system due to the losses in the subprime mortgage in the mid-2007.This was wide spread global crisis even thus firm not associated with the mortgage firm. This made the financial institutions very nervous and the stock market got very weak. Between July 2007 and March 2008, there was a significantly drop in the price of shares in the large, small and investment bank. A


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