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The world economy is now recovering step by step from the severe impact of the bank failures and financial crisis of 2007-8. Policies aiming at recue the market and stimulus the recovery of economy started to take effect, and indeed, recent published figures shows that the world economy is gradually backing to track. Yet the negative effects of the crisis might be started to fade away, the study of it has just finished its warm up.
Quite a few articles about the crisis of 2007-8 have already published; topics covered almost all the aspects, especially about the failure of the prediction of it. Actually the study of the prediction of the economic crisis has never stopped since the first crisis happened. In fact, a series of tools and methods for the prediction of the financial crisis have been developed since the previous economic crisis. But still, one of the main features of the financial crisis of 2007-8 is its unexpected characteristic.
The objective of this essay is to argue about the proposition that the bank failures and crisis of 2007-8 could have been foreseen by reviewing some of the academic papers published before 2003, and try to provided some possible answers to the question of why people, not only policy-makers but also economists and specialists failed to aware of the potential danger ahead. The following discussion is divided into four sections. Section two describes the main features of the crisis and the whole mechanism of how it became like this. Section three gives a review about some of the selected academic works published prior to 2003 to prove the proposition of the crisis could have been foreseen. Section four tries to find out the answers to the problem of people fail to predict it. Section five concludes all.
2. Financial crisis analysis
In this section, some of the causes and the relative mechanism of the financial crisis of 2007-8 will be discussed by introducing two vital features: credit derivate market mess, and the excessive liquidity.
The development of credit derivative market, which is apparently out of control without sufficient regulation, played a crucial role in accumulating the financial volatility this time as it was described by Ray Lindsley (2009). Credit derivatives were first designed for alleviating credit risks for firms and financial intermediaries and hence increase market efficiency. However, as it continued to grow and became more and more complex and popular among all types of financial institutions, credit derivatives increased the market risk rather than reduced it. The result of it was that the market became accumulate unstable, and once the market encounter a negative shock, the whole financial system might be at great risk. In fact, derivatives were not a first offender in triggering economic crisis. In the East Asian financial crisis of 1997, it was the top one criminal who should take responsibility. The only different, comparing to the financial crisis of 2007-8, is that this time more financial sectors involved and more destructive it became.
Another important feature in the financial crisis of 2007-8 is the excessive liquidity in the U.S. market, which directly caused the generation of the U.S. asset bubble. This was mainly because of three reasons: First was the expansionary monetary policy in the early 2000s. In 1998, under the consideration of the effect of the Asian crisis might slow down the economic growth in the United States, the fed began to implement expansionary monetary policy by lowering the federal funds rate and interest rate throughout the beginning of the 21st century until the mid-2003. As a result, the interest rate, in the mid-2003, was cut to 1.0%. Second was because of the former president of the U.S. Bill Clinton's "Affordable Housing" scheme, which apparently went too far and finally ended up with the sub-prime crisis. Whalen (2008) indicated that "affordable Housing" via the utilizing of "creative financing techniques" and the encouragement of the use of the over-the counter (OTC) derivatives by the fed are two of the most significant causes of the subprime crisis. The third reason, maybe not as clear as the other two, was originated from the Federal Deposit Insurance Reform Act of 2005. It, together with the help of the credit derivative instruments, stimulated the market liquidity one step further. The deposit insurance is likely to increase depositor's confidence thus the banks would have less exposure to bank run, meanwhile, it also tends to increase the incentive for banks to make more risky loans. Since the widespread of the originate-to-distribute (OTD), the new bank's business model changing from the traditional buy and hold business model, in nowadays market due to the widespread of credit derivative instruments. The market liquidity will definitely goes up.
The two characteristics which mentioned above played a key role in breeding the subprime crisis. The mechanism is quite simple and clear. The "flourishing" credit derivative market worked more like a catalyst while the macroeconomic policies have a direct effect on the market liquidity. As time goes on, the excessive liquidity and the complexity of credit derivatives made the market becoming more and more unstable. The result of this is that the asset bubble grew bigger and bigger and finally burst at a certain point.
By understanding the cause of the subprime crisis, some of the academic papers, especially those published before 2003, will be reviewed in the next section in order to try to illustrate the idea that the financial crisis of 2007-8 could have been foreseen by somehow.
3. Selected relative studies
3.1 Potential risks of credit derivatives
Rule (2001a) gave an analysis about the development of the credit derivatives market at that time. Although the content of his paper is mainly a description about how credit derivatives market works, he did mention that the credit derivatives still have a long way to go. He points out that in spite of the recently rapid growing of the credit derivatives market, the market "has not been tested during an economic slowdown". At the end of his paper, he brings forward the potential dangers that the credit derivative market might be facing some point in the future. First, the banks might become less incentive to monitor creditworthiness of a borrower's debt. Second, the creditors, regulators and the monetary authorities might encounter difficulties on assessing the "actual credit exposures of banks and of the banking system as a whole". Based on this point, the excessive use of credit derivatives might increase the risks, not individual but the systemic risks, rather than reduce it. Third, the growth of credit derivatives markets could also increase the off-balance sheet exposures amongst different financial institutions. These exposures might be magnified during economic slowdowns as the credit risk grows over time.
3.2 Systemic risk
On May 2001 the Bank of England hosted a conference on the issue of banks and systemic risk. The conference discussed the relationship between banks and systemic risk from both academic and practical point of view. One of the most important idea that had been noticed is that the supervisors might "miss the threat of systemic risk arising from a high correlation in bank exposures" if regulations focused only on individual bank.
Later on, another paper, which is also written by Rule (2001b), talked about the risk transfer between banks and insurance companies. The paper tried to raise people's attention on the notion that although the increasing interlinkages between financial institutions improve the market efficiency, the greater inter-dependence might lead to difficulties in "tracking the distribution of risks in the economy". Since the banking system changed to OTD new business model, the banks transfer credit risks to insurance companies. There might be nothing happened in a bull market, however, if the credit events have happened in a stress market condition, the whole system might be collapsed.
Wells (2002) also examined the systemic risk from the viewpoint of interlinkages between banks. He indicated that the close relationship between banks might "provide a channel through which financial difficulties in individual bank can be propagated to other banks".
By looking at the past papers, the financial crisis of 2007-8 became less surprising to us. It's no longer the problem of why people were unconscious when the shock hit, it's the problem why people ignored it. The potential danger of credit derivatives have already been points out years ago, furthermore, the Asian financial crisis of 1997 was because of derivatives. But people still neglected it. The systemic risk, which is also because of the credit derivatives from a certain point, has been foreseen as well. Credit derivatives enabled the whole financial system linked together. The market efficiency greatly increased indeed, yet it also became hard to regulate and supervise. This poses no problems during normal or positive economic condition, however, just like Rule said: the market "has not been tested during an economic slowdown". Unfortunately, no one is aware of this. People just busy chasing the profits, the high return by using the credit derivative instruments to reduce the risks, which actually have never disappeared but all went into the system. The result of this is that the whole market went out of control. Liquidity became excessive, risks became hard to track and supervise, the asset bubble appears and the financial system became accumulatively unstable. It's not hard to image that when it comes to a certain point, the whole system will collapse.
4. Reasons of ignoring
This section tries to seek the possible answers of why people ignored the potential danger after some of the researches had already warned it.
Expectation. The rapid growth of credit derivative instruments was largely because of the expansionary monetary policy in the early 2000s, when the interest rate was low and the house price was rising and thus the relative default rate was small. In fact, the return of either CDS or CDOs, both play a crucial role in the crisis, was based on the increasing house price or the anticipation of the rising house price. However, when the interest rate started to increase in the mid-2004, the situation began to change. Therefore, one possible answer is that the expansionary monetary policy concealed the potential danger of the probability of default.
Incentive. The development of credit derivative market enabled banks to change their traditional buy and hold business model to new OTD model, which is recognized as the determinant of the financial crisis of 2007-8 by Cannata and Quagliariello (2009). They argued that the OTD model decreased the bank's incentives of monitoring the credit quality of their loans. Hattori and 0hashi (2009) gave a deeper analysis of the mechanism behind this. They suggested that the "overvaluation of the low quality securitized product" is the main reason for intermediaries to conduct such behavior. In OTD model, in order to make profit, the banks would pay more attention to the question of whether they could sell it rather than how good the creditworthiness of the borrower is, which is apparently more costly to get the answer. As a result of this, the banks were busy chasing the profit in order to survive in the severe competitive market and neglect the danger behind it.
Complexity. The complexity of the financial innovations (e.g. credit derivative instruments, securitization, off-balance business, etc.) makes the regulators hard to supervise. Cannata and Quagliariello (2009) demonstrated that the shortcomings of the current regulation are one of the main causes of the financial crisis. Although the purpose of their paper was to defend for the Basel II, which they thought shouldn't be blame for but the Basel I, the conclusion is the same. The flaws of the current regulation, such as "low risk-sensitivity and the scarce adaptability to financial innovation", made the supervisors hard to detect potential risks in the market.
After went through the past papers, a conclusion could be drawn is that the financial crisis of 2007-8 could have been warned ahead. Yet people just paid little attention to it. However, it's also well recognized that the prediction of financial crisis has always been the toughest task for regulators, policy-makers and economists to tackle with. On one hand, each financial crisis has its unique feature and macroeconomic condition. Variable caused the previous crisis might means nothing this time. On the other hand, since most of the models, econometric models for example, which used to predict the crisis are set up based on the history data, the nature of it make the prediction very hard to be precise. Thus it's very important for supervisors and scholars to keep their works up with the market, to improve their models over time therefore to fit with the current economic environment.
- Cannata, F. & Quagliariello, M. (2009) The Role of Basel II in the Subprime Financial Crisis: Guilty or Not Guilty?. CAREFIN Research Paper No. 3/09. Available at SSRN: http://ssrn.com/abstract=1330417
- Dodd, R., 2000. The Role of Derivatives in the East Asian Financial Crisis. CEPA - Working Paper Series III, No. 20. Center for Economic Policy Analysis.
- Hattori, M. & Ohashi, K. (2009) Incentive to Issue Low Quality Securitized Products in the OTD Business Model. IMES Discussion Paper Series 2009-E-26, Tokyo: Bank of Japan.
- Hoggarth, G., 2001. Banks and systemic risk: conference summary. Financial Stability Review: December 2001, pp. 123-126. London: Bank of England
- Jongho, K., 2008. From Vanilla Swaps to Exotic Credit Derivatives. Fordham Journal of Corporate & Financial Law, Vol. 13, No. 5, pp. 705.
- Lindsley, R. (2009) Causes of the Financial Crisis Part 6: The Unregulated Derivatives Market [online] Available from World Wide Web: http://financialservicesissues.com/?p=151 [accessed 22 November, 2009].
- Rittenberg, L. & Tregarthen, T., 2009. Principles of Macroeconomics. New York: Flat World Knowledge
- Rule, D., 2001a. The credit derivatives market: its development and possible implications for financial stability. Financial Stability Review: June 2001, pp. 117-140. London: Bank of England
- Rule, D., 2001b. Risk transfer between banks, insurance companies and capital markets: an overview. Financial Stability Review: December 2001, pp. 137-159. London: Bank of England
- Wells, S., 2002. UK interbank exposures: systemic risk implications. Financial Stability Review: December 2002, pp. 175-182. London: Bank of England
- Whalen, R. Christopher (2008) The Subprime Crisis - Cause, Effect and Consequences. Networks Financial Institute - Policy Brief 04. Indiana State University