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The financial services industry is undoubtedly one of the most regulated in major economies across the globe. According to Llewellyn (1999) and Goodhart et al (2001), the pivotal role of banks in the economy, the necessity for depositors' protection, the control over banks' excessive risk taking behaviors and more importantly the mitigation of systemic banking risk, are the main considerations which underpins the rational for banking regulation and supervision. Accordingly, Central Bankers and Financial Regulators have been entrusted with the responsibility to maintain economic stability and preserve a sound financial system. By logical deduction, the financial cataclysm in 07/08, which led to a severe global recession, is an undeniable proof that financial regulation failed to safeguard macroeconomic and financial stability. The primary objective of this paper is to critically discuss the level of responsibility of central banks and financial regulators vis-à-vis the occurrence and severity of the recent global financial crisis. The first part of this paper will explore the multi-dimensional roots of the subprime crisis and thoroughly examine the interplay between financial innovations and the housing bubble. In the second part of this paper, we will centre our discussions on both crucial macro-policy failures and failings in financial regulation and supervision which triggered the crisis and briefly conclude with the new perspectives for regulatory reforms.
PART I: UNDERSTANDING THE MULTIDEMENSIONAL ROOTS OF THE FINANCIAL CRISIS
International macroeconomic issues which triggered the recent global financial crisis are now perfectly understood. Over the last decade, the world economy experienced a significant explosion of macroeconomic imbalances, Turner (2009), see [Appendix1]. Fast growing emerging Asian economies, such as Japan, China and Oil exploiting nations recorded huge current account surpluses, while, in contrast, the US, UK and other industrialized economies in Europe experienced large current account deficits. As savings exceeded domestic investments in surplus economies, deficit spending nations, particularly the US and the UK, became recipients of massive savings and capital inflows. For example, inflows of foreign savings in the US escalated rapidly from 1.5% to approximately 6% of national GDP between 1995 and 2006; "an amount equal to about $825 billion in today's dollars", Bernanke (2009c).
MACRO-POLICIES AND GLOBAL LIQUIDITY BUBBLE
Jacques de Larosière (2009) argued that the persistent movements of capital inflows towards the United States created an economic environment with excess liquidity and very low interest rate which stimulated rapid credit expansion and helped fueled the housing bubble. He further explained that the colossal increase in productivity of emerging markets economies helped maintain low inflation levels around the globe. As result, major Central Banks, including the Federal Reserve in the US and Bank of England "felt no need of tightening monetary policy", Larosière (2009). The lax of monetary policy led to a "global liquidity bubble" which drastically accelerated the rise in asset prices, particularly in housing, Blundell-Wignall and Atkinson (2008a), see [Figure 1&2].
Figure 1: ABS issuers, home mortgages and other loans Figure 2: Real house prices, 2000-09
Source: OECD, Datastream.
NEXUS BETEWEEN FINANCIAL INNOVATION AND THE HOUSING BUBBLE
The overflowing cosmic ocean of liquidity and low interest rate policies [2000-2004] encouraged financial institutions to embark on the pursuit of higher yields through complex securitization techniques and highly leverage structured financial products. Taking reference to the traditional approach to lending, banks would normally pool deposits and through a well-structured screening process lend out to borrowers with satisfying credit records to minimize default risk and maintain a healthy loan portfolio. Over time, banks gradually shifted away from this old process to adopt methods of securitization in which they could originate a diversified set of mortgage loans packaged together in Assets Backed Securities (ABS). ABS are then converted into bonds called Collateral Debt Obligations (CDOs), sliced into tranches and sold to investors as mean of raising finance. This business model is known as the "originate distribute model" which Dowd(2009) described as a "Giant Ponzi Scheme" because it enabled financial institutions to accumulate pyramids of short term debts and expand mortgage lending to profit, see: [Appendix 2]. Unfortunately, this new business model led to a reckless ease of credit underwriting standards, poor risk management, and inadequate incentive systems which compounded moral hazard and adverse selection problems in the financial system.
EARTH QUATE IN MORTGAGE MARKETS AND THE FINANCIAL CRISIS
Between 2005 and 2006, the Federal Reserve raised interest rates from 1% to 5.25% to calm down inflation pressures in the housing market. This sudden tightening of monetary policy resulted in huge mortgage defaults which consequently triggered serious disturbances within financial intuitions worldwide. In 2007, the bursting of the housing bubble in the US mortgage market triggered series of systemic financial shocks which rapidly engulfed the international financial system and spilled over global economy. The collapse of structured financial products was imminent and "financial institutions have seen their capital depleted by losses and write-downs and their balance sheets clogged by complex credit products and other illiquid assets of uncertain value" Bernanke (2009a). Escalating subprime mortgage defaults and significant fall in house prices led to a complete reversal of situation: from a global liquidity bubble towards a severe liquidity crisis.
The Federal Reserve, Bank of England, and the European Central Bank immediately injected massive amount of liquidity in financial system to prevent further systemic break downs and restore confidence post Lehman Brothers' bankruptcy in September 2008, see [Figure 3&4]. The economic consequences of the crisis were catastrophic and the global recession was inevitably very severe. However the unprecedented level of government intervention and bailouts during the crisis helped avoid "the worst financial and economic outcomes", Bernanke (2009b).
Figure 3 Figure 4
III. PART II: Macro-policy, Regulatory, Supervisory and Crisis Management Failures
Macro Policy Failure I: Central Banks lost control of monetary policy and the economy
The fact that Central Banks lost control of monetary policy and contributed to the global liquidity bubble is no longer a secret, Chorafas (2009). According to Blundell-Wignall, Atkinson and Lee (2008b), low interest rate policies in 02/03, (1% in the US and 0% in Japan), fixed exchange rate in China, and Sovereign Wealth Funds' accumulation of reserves, all helped to create the overflowing ocean of liquidity which "got the asset bubbles and excess leverage under way". Furthermore, the fear of a deep recession following the bursting of the dot-com bubble in 2000 and the terrorist attacks in September 2001, led the Fed's Officials and Central Banks around the world to excessively lax monetary policy and cut down interest rate to boost demand and avoid a potential deflation, Dowd (2009). Moreover, in 2002, Greenspan Doctrine that "the Fed could do nothing to stop asset bubbles from occurring, but would stand by to cushion the fall if they did occur" implicitly guaranteed partial bailout which undoubtedly compounded moral hazard during the house booming, Henderson and Hummel (2008).
There has been an enormous growing blame that Alan Greenspan's excessive quantitative easing in 2001 was the main macro-policy failure which engendered the crisis, Henderson et al (2008). It is more than obvious that the Federal Reserve failed to observe the Taylor rule and timely tight monetary policy to burst the housing bubble before it got out of control, see [Figure: 5]. Steve Hanke (2008) pointed out Greenspan's doctrine and Ben Bernanke "false deflation scare" as the "mother of all liquidity cycles and yet another massive demand bubble." However, it should be clear that the fed isn't the only one to blame. In the United Kingdom, Gordon Brown's decision to target narrowly defined Consumer Price Index which did not include housing costs led the Bank of England to neglect the consequences of the global liquidity boom channeled rapidly into house prices which sharply picked up to the highest among major countries. Allen and Carletti (2009) argued that monetary excesses, ample liquidity and rising house prices not only stimulated financial institutions' appetite for higher yields, but also led to an uncontainable explosion of highly leveraged structured financial products and credit derivatives which compounded the debt bubble, systemic risk bubble and moral hazard bubble.
[Figure 5]: illustrates the significant deviation of Fed's actual interest rate policy from the Taylor rule which has traditionally worked well since the beginning of the Great Moderation in the early 1980's. There is therefore substantial evidence that abnormal monetary excesses from 2000 to 2004 significantly contributed factor to the housing boom.
Source: The Economist, October 18, 2007
Policy Failure II: Uncontrolled Financial Innovation and Risk Management Failures
Uncontrolled Financial Innovation
The Genesis of the financial crisis goes back to the US government misguided intervention in mortgage market. The establishment of Fannie Mae in 1938 and Freddie in 1970 promoted the expansion of securitized credits. Financial innovations exploded in scale and complexity to meet "the demand for yield uplift" stimulated by mounting macroeconomic imbalances from the mid-1990s, Turner (2009). Preceding the outbreak of the credit crunch in 2007, there was a widespread opinion that securitization "enhances financial stability by dispersing credit risk", Shin (2009). IMF (2006) also shared the belief that "the dispersion of credit risk by banks to a broader and more diverse group of investors, rather than warehousing such risk on their balance sheets, has helped make the banking and overall financial system more resilient."
Nevertheless the Mortgage Meltdown marked the end of this age of ignorance and lifted the veil on the ugly truth of securitization. Mian and Sufi (2007) and Demyanyk and van Hemert (2007) provide substantial evidence that securitization led to lax credit underwriting standards. Keys et al. (2007) argued that "multi-layered agency problems" and incentives issues across the whole securitization process, particularly the triple AAA rating of CDOs' senior tranches by rating agencies, helped fuel the housing bubble. Prior to the subprime earth quake, the American dream of house ownership seemed to have made "everyone (Banks, US government and Investors) happy!" Neither financial regulators nor central banks "knew, or cared to know" the systemic risk embedded in CDOs and "how this exposure could be managed if the worst comes to the worst" Chorafas (2009, p. xii). Greater systemic exposures arose with the unregulated and unlimited trade of Credit Default Swaps (CDSs) between large insurance groups and Investment Banks such as AIG, Leham Brothers, Bear Stern and Citigroup. This toxic class of derivatives stimulated moral risk and led to excruciating bankruptcy cost; $62 trillion CDS were outstanding in 2007, Brunnermeier (2009).
Risk Management Failures
The financial crisis ounce again reminded us that identifying, calibrating and understanding risk is the pillar of the banking business. Indeed, over the past two decades, financial innovations in banking led to significant development in risk management. Scientists, mathematicians, engineers and physicists who have previously worked in astronomy, nuclear projects, and chemistry are now risk quantitative risk managers in large banks. It has been widely argued that Banks elaborated complex statistical models in risk management such as Value at Risk (VaR) based on inadequate assumptions. Dowd (2009) explained that the pitfalls of such sophisticated financial models in internal risk management are "complexity (and so greater scope for error), less transparency (making errors harder to detect), and greater dependence on assumptions (any of which could be wrong)". It is clear that investment banks were far much more in advance in quantitative finance than financial regulators and central banks were. Regulators not only over-relied on Banks' internal risk management capabilities, but also failed control excessive risk-taking in the banking system and timely address the systemic implications of a highly leveraged financial system and uncontrolled trade of CDSs. The Securities and Exchange Commission (SEC), the Financial Services Authority FSA, Fed, and other central banks "watched this happening in the false belief that markets correct their own excesses" Chorafas(2009). This extreme negligence of regulators allowed financial institutions to abuse financial innovations and do as it pleased them. The financial system became highly leveraged, moral hazard ruined corporate governance, and financial innovations exacerbated systemic and contagion risk.
Policy Failure III: Banking Regulation and Macro-prudential Supervision
It has become widely accepted that the financial crisis was mainly the result of enormous regulatory failures. Weak liquidity and capital buffers increased banks' vulnerability to the subprime meltdown. Basel lI procyclical risk-adjusted capital adequacy requirement was a massive failure in financial regulation as it enabled banks to hold less capital during the credit boom and neglected liquidity risk. Dowd (2009, p.161) explained how risk assessments and capital requirements tend to fall as the business cycle approaches its peak; stimulating a credit boom when a systemic downturn is right in the corner. As a result, Basel II was heavily criticized for exacerbating the severity of the crisis. To a great extent, financial innovations enabled banks to short-circuit the constraints of risk-based capital requirements (Basel II) by shifting risk off balance sheet and expanding mortgage lending through excessive leveraging of capital; leverage ratio up to 40:1 in some case, Blundell-Wignall et al (2008). Basel II also over relied both on credit rating agencies' risk assessments and internal risk management models of banks.
In the UK, the tripartite regulatory system created in 1997 by Gordon Brown was the biggest regulatory failure. The separation of banking regulation from monetary authorities to FSA left Bank of England "with no powers over the banks and a bank regulator with no remit to monitor the bigger picture" Osborne (2009). The Financial Services Authority failed to assess risk in banking system as a whole and prevent the excessive leveraging of capital and risk-taking within financial institutions. Macro-prudential Supervision ultimately failed as a result of asymmetric information between both regulators.
Policy failure IV: Moral Hazard, Too Big to Fail, and Crisis Management Failure
There are several historical evidences where the fear of systemic risk inclined the Federal Reserve to prevent the failure of large interconnected financial institutions at the expense of moral hazard. For example, the Fed "accepted moral hazard" to contain the systemic breakdowns of the collapse of Long Term Capital Management (LTCM) in 1998, Rosenblum et al (2008). Over the past decades, Government safety Net, particularly the too-big-to-fail policy and deposit insurance, stimulated excessive risk taking and made regulatory discipline ineffective on so called large banking groups, Cecchetti (2008). While Dr Henry Kaufman argued that "If some banks are too big to fail, then they should be very closely supervised"; on the other hand Jamie Diamond, JP Morgan CEO, contends that no bank is too big to fail, and only the financial system is too big to fail, Chorafas (2009,p. xiii).
We have reached an age where increased globalization and complex financial innovations strengthened financial linkages in the global financial system at expense of escalating systemic risk. In autumn 2008, financial contagion and systemic risk span out of control following the collapse of Lehman Brothers and mounting risk aversion dried up liquidity in financial markets. Bank of France Banking Commission (2008) deeply explains how the collapse of Lehman Brothers "has exacerbated the liquidity crisis and the international market situation, which had been unsettled for more than a year", see [Figure 6&7]. The bankruptcy of Lehman Brothers, an active player in CDSs market, triggered a widespread of counterparty risk which broke down confidence in the international inter-bank market. Lehman's failure has been regarded as the major crisis management failure with aggravated the severity of the crisis. Interestingly, even those who criticized Fed's intervention to bailout Bear Stearns "declared that moral hazard should have been disregarded in the case of Lehman" which was much more systemically important, Rosenblum et al (2008).
Figure6: Three month and interbank rate Figure7: Financial market liquidity indexes
Source: Bloomberg: (e) Lehman Brothers Bankruptcy Source: Bank of England, 2009
The financial crisis 07/08 was incontestably the most brutal financial storm the world economy has encountered since the Great Depression. Macroeconomic imbalances, unsound risk management practices created by complex financial innovation techniques, weak liquidity and capital buffers, all together combined with massive failings in monetary policy control and financial regulations are the multidimensional factors which underpin "the extraordinary complexity" of the recent global financial stress, Bernanke (2009b). Unfortunately, Central Bankers and Financial Regulators not only failed to timely react to these causal distortions, but also contributed to the severity of this global financial mess. From a global perspective, the future stability of the financial system lies in the success of international regulatory reforms underway; leading towards a robust international macro prudential regulatory framework "to gauge overall risk in the financial system and structure dynamic capital and liquidity requirements accordingly"; towards higher level of supervision to monitor excessive risk taking; towards the strengthening of risk management practices within financial institution; towards better control over leveraging of capital and off-balance sheet activities and financial innovations, and finally towards high standards of disclosure and transparency for OTC derivatives markets, Calomiris (2009). Central Bankers, Financial Regulators and Politicians all face the acute dilemma of their own wrong policy making. The crisis is now behind us, and the way forward towards a durable and sustainable global financial stability will be definitely challenging.
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