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The Maintainability of the Current Financial Market

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Any opinions, findings, conclusions or recommendations expressed in this material are those of the authors and do not necessarily reflect the views of UK Essays.

Published: Fri, 26 Jan 2018

Introduction

To argue that we are not currently in the midst of a global financial crisis is simply on maintainable, given the saturation that the issue has had in the mainstream media. There is no secret that there is a global liquidity shortage in the financial sector, mortgage assets declining in value and subsequently limiting the ability of financial institutions service their lending and interest payment requirements to investors. As a result many governments have taken proactive measures to increase liquidity in the financial sector and stave off inflation and other negative factors. It is the purpose of this paper to critically analyse the current financial crisis, in conjunction with the sub-prime mortgage issue which rose to prominence in late 2007. In light of the current economic climate this paper will discuss whether implementing a financial safety net will serve to address the pressures that are being placed on financial institutions in terms of their liquid assets and overall economic viability. It will also present the main ingredients of a sound financial safety net, and it is important to note that all of these factors must generally be present in order for a financial safety net to function effectively in correcting the economic imbalance which the global economy is currently experiencing.

The Current Financial Climate

The financial situation at present around the world is not one of economic prosperity and stability. In the last 12 months the world has had to resist the financial crisis of 2007-2008 sparked by the pressures placed on financial institutions as a result of the sub-prime mortgage crisis. Most recently, beginning in September 2008, is a global financial and liquidity crisis which has led to a number of American and European banks collapsing due to insufficient liquid assets to service its obligations to its customers. Essentially the most recent crisis began with the United States government takeover of Fannie Mae and Freddie Mac, which were to government-sponsored enterprises servicing the United States home loan industry. This, among other factors, consequently sparked a rapid decline in the value of global stock market indexes and currency indicators, such as the Dow Jones (United States), FTSE 500 (United Kingdom) and the ASX 200 (Australia) to name a few. This saw a rapid decline in the value of assets held by mortgage related entities, leaving them with significantly less equity and liquidity to service their lending and interest payment obligations.

Response to the crisis the central banks of many countries took measures to inject capital into the cash flow of the financial services industry. For example, the reserve bank of Australia injected AU$1.5 billion (approximately 3 times more than the estimated need), India’s Reserve Bank pumped in approximately US$1.32 billion and the Reserve Bank of China provided a stimulus package of approximately 4 trillion yuan (US$585 billion).[1] In the United States the Emergency Economic Stabilisation Act of 2008 was passed by Congress and gave the Bush administration the authority to purchase up to US$700 billion of unserviceable mortgage assets in an attempt to maximise liquidity.[2] In the United Kingdom, on 8 October 2008, UK government announced a £500 billion rescue package. All these measures were in an attempt to increase liquidity in the financial services industry, and were often accompanied by reductions in the national cash interest rates as determined by the central banks.

In light of the fragility of the current global economic situation, is important to consider the effect of the financial services industry safety net as a mechanism of consumer protection. As this paper will uncover in forthcoming chapters, the safety net often comprises a number of key elements in order to maximise its scope of application and effect. A number of jurisdictions have sought to implement deposit guarantees and similar protection schemes, and the effectiveness and risks associated with these schemes will be discussed more thoroughly in due course. However it is important to note in passing that the current economic crisis plays a significant role in the ability of a financial safety net to function effectively, due to the extraneous pressures which are placed on the economic system as a result of a shortage of liquidity in the global financial industry. This affects every global financial institution from major banks right down to small time debenture businesses.

An Overview of the Financial Sector Safety Net

It is difficult to confine the financial sector safety net into one concise and succinct definition. Rather one must consider the safety net in light of its many factors. As the World Bank itself points out, are significant difficulties experienced with implementing a safety net, which are appropriately defined in the following passage:

Bank safety nets are difficult to design and administer, because they have the conflicting objectives of protecting bank customers and reducing banks’ incentives to engage in risky activities. In several countries including the U.S., the financial safety net, structured to reduce the vulnerability of the financial system, appears to have had quite the opposite result. Indeed, Kane (1989) identifies the U.S. financial safety net, and notably fixed-rate deposit insurance and belated bank closures, as the single most important factor in explaining the catastrophic Savings and Loan crisis of the 1980s. Similarly, Demirguc-Kunt and Detragiache (1998) find international evidence that the existence of an explicit deposit insurance scheme has contributed to banking system fragility.

To restrain bank risk taking, financial safety nets generally rely on two mechanisms: (i) market discipline, and (ii) bank regulation. Bank creditors can exert market discipline by withdrawing their funds, or demanding higher interest rates from riskier banks. In case of publicly traded banks, equity holders can also effect discipline.[3]

The above passage demonstrates that safety nets are not effective on their own; rather they require cooperation between all the different classes of parties involved in the financial industry in order to maintain a healthy financial market. However implementing a safety net is not without its risks and, as the above passage indicates, sometimes the mechanisms employed by a safety net programme of them contribute to the fragility of the financial system is not implemented properly and in consideration of the context in which they are to apply.

In light of the above this brief has presented a basic overview of the rationale of the safety net in the financial industry and the aims it sets out to achieve. This brief will now go on to explore the fundamental elements of a safety net system, as it is important to consider the effect of each of these individual mechanisms in appropriate detail in order to draw an appropriate conclusion as to whether or not consideration should be given to a safety net scheme to be implemented in a broad manner across global jurisdictions in light of the current financial crisis.

Elements of the Safety Net

Frameworks for Liquidity Support

For most banks and financial institutions the need to maintain a certain amount of rigid liquidity to service lending and interest payment obligations is essential to ensure the long-term viability of the institution, and also to ensure that the bank or institution can continue providing a service to its customers and therefore generate further revenue. Most of these institutions have certain cash reserves available to meet these obligations in the event that the institution becomes temporarily illiquid, however it is important to consider the strength of these measures given the current economic climate and also whether other measures exist in the event that the liquidity reserves of the institution are unable to service its obligations to its customers. Therefore it is important to distinguish between the liquidity reserves which are available to financial institutions during normal operating times and those which are to be relied upon in a time of crisis, and there is a need for a financial institution to consider the efficiency of both of these measures.

A common form of day today liquidity reserves banks rely upon is the “lender of last resort” (LOLR) function, where central banks in most developed jurisdictions around the world have the authority to provide credit support in the event of a bank becoming temporarily illiquid, however still remaining solvent.[4] LOLR actions do not guarantee against banks from failing, but rather serve to protect liquidity shortages in flowing from one bank to another. As the World Bank puts it:

This kind of support can provide an important buffer against temporary disturbances in financial markets. LOLR actions may help to prevent liquidity shortage in one bank from being transmitted to other financial institutions, for example, through the payment system. LOLR actions are not intended to prevent bank failures but, rather, to prevent spillovers associated with liquidity shortages — particularly in money and interbank markets — from interrupting the normal intermediation function of financial institutions and markets.[5]

Therefore the purpose of LOLR is to ensure the overall integrity of the financial market, through containing any liquidity shortages to one bank and attempting to prevent it from reaching other institutions.

In a time of crisis a financial institution may need to seek liquidity resources from the central bank over and above those that would normally be available to them for day-to-day activities. These emergency lending procedures need to be considered in the strongest possible manner, and the International Monetary Fund has outlined a number of guidelines which should be taken into account in this regard:

  • resources should be made available only to banks that are considered solvent but are coping with liquidity problems that might endanger the entire system (e.g. ‘too big to fail’ cases);
  • lending should take place speedily;
  • lending should be short-term; even then, it should be provided conservatively because of the situation of the bank might deteriorate quickly;
  • lending should not take place at subsidised rates, but the rate should also not be penal because it might then deteriorate the bank’s position;
  • the loan should be fully collateralised, and collateral should be valued conservatively. However, at times of severe crisis, it might be necessary for the central bank to relax this criterion or to organise a government guarantees or to arrange government credit, even if the loan is executed from the central bank’s balance sheet;
  • Central bank supervisory authorities and the Ministry of Finance should be in close contact and should monitor the situation of the bank;
  • supervisory sanctions or remedial actions should be attached to the emergency lending.[6]

Therefore it is important to the above factors in emergency lending in order to ensure that the overall integrity of the financial system is not placed under threat through a central bank advancing credit to an illiquid financial institution.

Deposit Insurance or Guarantees

It is one of the simple principles of banking that, in order for a financial institution to profit from lending products, it must have the liquidity resources to advance to the borrowers. These generally come from term deposits, everyday accounts and other consumer-based banking products, not to mention larger institutional banking deposits. In order for these customers to be able to bank with confidence with a particular institution, it may be necessary for the government to introduce a type of deposit insurance which serves to protect the deposits of customers in the event of a failed investment by the bank. It could be argued that by having all deposits protected by a deposit insurance scheme, a financial institution is effectively promoting excessive risk-taking given that the particular customer may feel they have ‘nothing to lose and all to gain’ by allowing the customer to gamble with what is essentially ‘free money’. Therefore it is important to consider whether ‘large deposits’ should be protected by such a scheme as, in the event of a payout being required, the deposit insurance scheme may be unable to meet its obligations in a timely and efficient manner, which is said to be a key requirement in order for such a scheme to function effectively.[7] A fine balance therefore needs to be struck between protecting the interests of customers while also ensuring that the deposit insurance scheme is in a position to meet its obligations in the event that it is called upon, and it would therefore need to be well funded.

Investor and/or Policyholder Protection Schemes

Another key element of an appropriate financial sector safety net is the need for customers who engage in investing through that institution to be afforded some sort of insurance protection, which would otherwise be unavailable under a deposit protection scheme. These schemes would be limited in their application, as they would generally exclude losses arising from a customer’s poor investment decision-making in the like unless a causal link can be established between the decision and advice obtained from the financial institution in question. The World Bank and International Monetary Fund fully describe the function of such a scheme:

Investor compensation schemes generally cover customer accounts in which a range of investment activities — defined in the respective licensing laws and broader regulatory regimes — take place. Compensation schemes generally do not cover losses on the part of the investor as a result of poor investment advice or management by member firms, although in some schemes, compensation may be available where a causal relationship is established between the poor investment advice or management and the inability of the firm to meet claims by clients. In most jurisdictions, the compensation scheme is statutory in nature…[8]

therefore a member institution cannot simply ‘wash its hands’ purveying financial loss sustained by a customer who invest through the institution, unless it can be proven that the poor decision made by the investor was not induced (either whole or in part) by the institution itself. An investor should be afforded some protection in relation to investment, but should still be in a position to accept liability should they not heed appropriate financial advice.

Crisis Management

The final appropriate element of an effective financial sector safety net is the building of both an institution and the responsible government to manage a crisis if and when it occurs. For example, high-profile policy committees and consultants should be in place to establish the framework mentioned in the preceding three chapters of this paper, and to ensure that it is implemented in such a way that is effective in that institution’s particular context. Financial institutions also need to ensure they have the appropriate resources, both financial and in personnel, to address is particularly important area of policy especially given the current financial climate and the strange places on banks to provide some form of protection to its customers while also attempting to remain prosperous and loyal to its shareholders.

The International Experience

The financial sector safety net has been met with mixed reviews in various jurisdictions around the world in response to the current economic crisis. This is due to the fact that central banks and governments have encountered a number of problems when seeking to implement features of the financial sector safety net. For example the United States, given the current Wall Street crisis, and sought to implement a safety net measure, however Reserve Bank Chairman Alan Greenspan has stated:

The safety net, along with our improved understanding of how to use monetary and fiscal policies, has played a critical role in this country in eliminating bank runs, in assuaging financial crises, and arguably in reducing the number and amplitude of economic contractions in the past sixty years. Deposit insurance, the discount window, and access to Fedwire and daylight overdrafts provide depository institutions and financial market participants with safety, liquidity, and solvency unheard of in previous years. These benefits, however, have come with a cost: distortions in the price signals that are used to allocate resources, induced excessive risk-taking, and, to limit the resultant moral hazard, greater government supervision and regulation. Clearly, the latter carries with it attendant inefficiencies and limits on innovation.[9]

Mr Greenspan has eloquently highlighted one of the key deficiencies with the financial safety net, particularly in relation to government and regulatory supervision of banks during its operation. By increasing government supervision on the financial sector, it severely limits the ability for banks to become innovators in their field and seek to implement new ideas to better service the industry. By implementing rigid supervisory guidelines, the government would be forcing financial institutions to conform to set principles which would effectively make all institutions the same, and limit the ability of these institutions to be granted the autonomy required to be innovative in this industry. Therefore one needs to consider whether the benefits of the financial safety net outweigh the costs associated with it. Mr Greenspan also highlights the increase in costs the taxpayer in the event of the safety net taking effect:

The usual suggested premiums for deposit insurance are, of course, far from those that would fully eliminate the subsidy that insurance provides to depository institutions and their borrowers and depositors, especially at times of financial crisis. Indeed, to eliminate the subsidy in deposit insurance, the FDIC insurance premium would have to be set high enough to cover the extreme-loss tail of the distribution of possible outcomes and thus the perceived costs of systemic risk. Since so high a rate appears politically infeasible, the subsidy in deposit insurance cannot be fully eliminated. Moreover, no private insurer will be able to match the actual FDIC premium and cover its risk from the extreme-loss tail. Obviously, if premiums were fully priced, the level of insured deposits would be significantly lower.[10]

The above passage demonstrates that it is difficult to lower the deposit insurance premiums associated with a safety net programme, while also ensuring that the deposit insurance fund is still adequately funded to meet its obligations in the event is called upon. By lowering deposit insurance premiums, a financial institution would place a significant strain on itself to be able to cover potential loss associated with the ‘extreme-loss tail’ which Mr Greenspan discusses and recognises as a serious threat. American newspapers have also highlighted the risks associated with deposit insurance:

It has long been known that this feature of the safety net induces moral hazard. Because of the reality and perception that bank deposits are fully protected, banks are willing to engage in riskier activities, insured depositors are less willing and able to monitor the activities of banks, and creditors are less sensitive to the risks incurred by banks. Therefore, it is imperative to develop a system that appropriately prices this insurance and the risks associated with providing it.[11]

I fully protecting deposits, the government is inviting banks to be far less accountable for losses incurred as a result of mismanagement of depositors’ and investors’ funds, and therefore the deposit insurance scheme needs to be appropriately justified and risk assess for can have any significant practical effect in granting customers peace of mind that there investments are protected, given the current fragile economic climate.

Other countries such as Australia have moved to guarantee bank deposits in light of the current financial situation around the globe. Particularly, the Australian government has guaranteed deposits up to an amount of $20,000,[12] despite previously stating that moves by other foreign governments to guarantee deposits were “uncoordinated”.[13] Interestingly, it has been said that the legal and regulatory framework in place in Serbia and Montenegro sufficient to encourage a deposit protection insurance scheme which would serve to appropriately protect banking customers and the financial industry therein.[14] therefore the results encountered the international arena in relation to the financial safety net are mixed, with some systems acknowledging that certain reforms need to occur before the safety net will function effectively, and others seeking to implement the safety net within their jurisdiction.

Conclusion

In conclusion, and in consideration of the discussions throughout this brief, would be appropriate to conclude that a financial safety net scheme may be appropriate in certain circumstances in order to provide banking customers with peace of mind in relation to their investments. However it is important to note that a safety net scheme does not bring with it guaranteed success, and one must consider the risks associated with implementing such a scheme and their possible contribution to the dire financial situation which is currently being experienced throughout the world. While the rationale of the safety net may have good intentions, it is clear that deposit guarantees and poor crisis management can have adverse effects on the financial market and therefore affect consumers in a negative way when the intentions are all positive.

The international experience with financial safety nets is inconclusive. It is primarily due to the fact that underlying financial pressures in particular jurisdictions can have adverse effects on the effectiveness of the financial safety net, and make it difficult for the safety net to be effective in correcting these imbalances. In the case of the United States cost of deposit and investment insurance is simply too high to justify, whereas in say Australia or Japan the benefit outweighs the cost based on sound financial infrastructure and crisis management techniques. Therefore it is significantly easier to implement a safety net system in these jurisdictions, given the sturdy financial history of the Asian markets. The United States present difficult challenge, with the major financial institutions having capital tied up in high risk investment portfolios, such as what was experienced with the sub-prime mortgage crisis beginning in mid-to late 2007. In short, the question must be asked whether a safety net would increase the liquidity resources of financial institutions, which is universally accepted to be the significant cause of the current financial crisis. The short answer is yes, given that deposit and investment insurance should effectively encourage customers to invest with a particular bank given that their money is effectively insured for a certain amount. However this insurance policy is not worth the paper it’s written on the insurance fund does not itself have the liquidity service obligations should be called upon to do so. This is a problematic situation, and cannot be effectively answered in a simple form. Only time will tell whether the financial crisis eases as a result of governments purchasing bad mortgage debts from financial institutions, and whether the liquidity shortage ends as a result.

Bibliography

  • Arner, D.W., Financial Stability, Economic Growth and the Role of Law (2007), London: Cambridge
  • Australian Broadcasting Corporation, ‘Government considers upping bank deposit safety net’ (2008) <http://www.abc.net.au/news/stories/2008/10/12/2388583.htm> at 14 December 2008
  • Australian Broadcasting Corporation, ‘No need for Government guarantee on bank deposits: Rudd’ (2008) <http://www.abc.net.au/news/stories/2008/10/10/2387244.htm> at 14 December 2008
  • Demirguc-Kunt, A., and Detragiache, E., ‘The determinants of banking crises in developed and developing countries’ (1998), IMF Staff Papers 45, 81-109
  • Demirguc-Kunt, A., and Huizinga, H., ‘Market Discipline and Financial Safety Net Design’ (1999), World Bank Policy Research Paper WPS2183
  • Gerda, O., Brewer III, E., and Evanoff, D.D., ‘The Financial Safety Net: costs, benefits and implications’ (2001) The Chicago Fed Letter <http://findarticles.com/p/articles/mi_qa3631/is_200111/ai_n8986952> at 14 December 2008
  • Greenspan, A., Former Federal Reserve Chairman, ‘Speech – The Financial Safety Net’, 10 May 2001, <http://www.federalreserve.gov/Boarddocs/Speeches/2001/20010510/default.htm> at 14 December 2008
  • Herzsenhorn, D.M., ‘Administration is seeking $700 billion for Wall Street’ (2008), New York Times, 20 September 2008
  • IMF – Monetary and Financial System Department, Operational Paper OP/00/01, Emergency Liquidity Support Facilities
  • Kane, E.J., The S&L Insurance Mess: How Did it Happen? (1987), Lanham, MD: University Press of America
  • Marinkovic, S.T., ‘Designing an Incentive-Compatible Safety Net in a Financial System in Transition: The Case of Serbia’ (2004), Centre for the Study of Global Governance, Discussion Paper 35, <http://se1.isn.ch/serviceengine/FileContent?serviceID=ISN&fileid=07ECE3C0-79BF-BEF2-62FF-A5CF5F97D730&lng=en> at 14 December 2008
  • Reuters, ‘Asian central banks spend billions to prevent crash’ (2008), International Herald Tribune, 16 September 2008
  • World Bank and International Monetary Fund, Financial Sector Assessment: A Handbook (2005)

Footnotes

[1] Reuters, ‘Asian central banks spend billions to prevent crash’ (2008), International Herald Tribune, 16 September 2008.

[2] David M. Herzsenhorn, ‘Administration is seeking $700 billion for Wall Street’ (2008), New York Times, 20 September 2008.

[3] Asl Demirguc-Kunt and Harry Huizinga, ‘Market Discipline and Financial Safety Net Design’ (1999), World Bank Policy Research Paper WPS2183, 2-3; citing Asl Demirguc-Kunt, and E. Detragiache, ‘The determinants of banking crises in developed and developing countries’ (1998), IMF Staff Papers 45, 81-109 and Edward J. Kane, The S&L insurance Mess: How Did it Happen? (1987).

[4] See also Douglas W. Arner, Financial Stability, Economic Growth and the Role of Law (2007), 139-140.

[5] World Bank and International Monetary Fund, Financial Sector Assessment: A Handbook (2005), 105.

[6] Ibid, 105-6. See also IMF – Monetary and Financial System Department, Operational Paper OP/00/01, Emergency Liquidity Support Facilities.

[7] Ibid, 106.

[8] Ibid, 107.

[9] Federal Reserve Bank Chairman Alan Greenspan, ‘Speech – The Financial Safety Net’, 10 May 2001, <http://www.federalreserve.gov/Boarddocs/Speeches/2001/20010510/default.htm> at 14 December 2008.

[10] Ibid.

[11] Oscar Gerda, Elijah Brewer III, and Douglas D. Evanoff, ‘The Financial Safety Net: costs, benefits and implications’ (2001) The Chicago Fed Letter <http://findarticles.com/p/articles/mi_qa3631/is_200111/ai_n8986952> at 14 December 2008.

[12] Australian Broadcasting Corporation, ‘Government considers upping bank deposit safety net’ (2008) <http://www.abc.net.au/news/stories/2008/10/12/2388583.htm> at 14 December 2008.

[13] Australian Broadcasting Corporation, ‘No need for Government guarantee on bank deposits: Rudd’ (2008) <http://www.abc.net.au/news/stories/2008/10/10/2387244.htm> at 14 December 2008.

[14] See, generally, Srdjan T. Marinkovic, ‘Designing an Incentive-Compatible Safety Net in a Financial System in Transition: The Case of Serbia’ (2004), Centre for the Study of Global Governance, Discussion Paper 35, <http://se1.isn.ch/serviceengine/FileContent?serviceID=ISN&fileid=07ECE3C0-79BF-BEF2-62FF-A5CF5F97D730&lng=en> at 14 December 2008, 17.


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