Financial Markets need to be put in their place by more regulation and higher equity capital requirements

Table of Contents

1. Introduction

2. The financial crisis of 2007/08

3. Causes

4. The role of the financial markets
4.1 Increased complexity of financial innovations – and lack of understanding
4.2 Underestimation of system-wide risks
4.3 Inadequate risk-management
4.4 Rating-failures of credit rating agencies
4.5 Selling of mortgages to mortgagors that were not fit for it
4.6 Banks’ (and households’) too small equity capital bases
4.7 Remuneration systems that spurred risk-taking

5. Changes in the financial architecture since 1970

6. Always the same goal: a safer international financial architecture

7. Possible measures to build a safer international financial architecture

8. Conclusion

References

1. Introduction

“It would be damaging for economic growth and our wealth to demonize financial innovations in general,” replied former Deutsche Bank CEO, Josef Ackermann, to the call of former head of the International Monetary Fund (IMF), Horst Köhler, for “a clear, audible mea culpa from the main actors in the international financial markets”, notably financial institutions. What Josef Ackermann is referring to by financial innovations is mainly financial derivatives, which played a major role in the financial crisis of 2007/08. The debate is about what went wrong that such a crisis was the result – and whether banks need more equity and regulation (which Köhler asked for) or not (which Ackermann and the financial world favour). An important aspect of the debate is compensation and the variable components of it.

In this assignment, the recent financial crisis of 2007/08 and the events that led up to it will be discussed, the role of the financial markets in this, the changes in the financial architecture since 1970 until the outbreak of the recent crisis and how the architecture might be adapted to prevent further crises.

2. The financial crisis of 2007/08

The recent global financial crisis broke out in 2007. “At its core, the crisis originated in credit markets in developed countries – centred particularly in the United States, the United Kingdom and Europe – but the fallout has had a significant effect on activity in every country and region” (Edey 2009, p.186). Today, in April 2013, its effects can still be felt strongly and it is not sure whether some strong aftershocks are still to come or if the worst is over for now. Particularly strongly affected by the crisis were countries with large and open financial sectors that rely heavily on exports, with a big manufacturing sector, with housing market bubbles, large debts in foreign currencies and/or large current account deficits (Snower 2009, p.2).

The immediate trigger of the crisis was the bursting of the US housing bubble (Holt 2009, p.120) which led to the collapse of the market for so-called CDOs, collateralized debt obligations, which are packages of bonds, loans and other assets (Wargo, Baglini and Nelson 2009, p.1). CDOs are derivatives that are sold on the secondary market. They consist of several tranches of securities offering various maturities and credit risk characteristics; each tranche has an own credit rating (Giesecke and Kim 2011, p.32). CDOs created more liquidity in the financial market and allowed banks and corporations to sell off their debt. Banks also sold CDOs consisting of riskier mortgages, which became famous as subprime-mortgages, and increasingly so in the years before the outbreak of the financial crisis (Holt 2009, p.121). Credit rating agencies failed to include the very high risk they incorporated accordingly; the new products were highly complex and inherently non-transparent (Crotty 2009, p.566). The deeper causes, however, are according to Crotty (2009, p.564) to be found in the “flawed institutions and practices of the current financial regime”. We will discuss this in chapter 4.

Let’s look at the most important events since the outbreak of the crisis in 2007 until the end of 2012 (IMF 2008, Edey 2009, Filardo et al. 2010, Guillen 2011 and Kingsley 2012):

- In August 2007 BNP Paribas announces that it cannot value the complex CDOs in two of their funds. It was the first time when problems in the US market for sub-prime loans became apparent. In September of the same year, a bank run on British bank Northern Rock subsequently leads to its nationalization. The bank had borrowed large sums of money to fund mortgages for customers: To pay off the debt it wanted to sell those mortgages. But its prices had fallen due to much lower demand. This led to a liquidity crisis and to fears that the bank would go bankrupt.
- In January 2008 the US Fed lowers interest rates by 0.75 per cent to 3.5 per cent: the biggest cut in 25 years. Furthermore, the largest single-year drop in US home sales in a quarter of a century is reported. Later, in March, JP Morgan buys out investment bank Bear Stearns before in September the US government bails out Fannie Mae and Freddie Mac, guarantors of thousands of sub-prime mortgages, and American investment bank Lehman Brothers – very exposed to the sub-prime mortgage market – files for bankruptcy. Still in the same month, the US banks Washington Mutual and Wachovia collapse and insurance giant AIG is nationalized. In October, then, Iceland's three biggest commercial banks go bankrupt and in America 240’000 lose their job. At the end of the year, the USA are in recession and the IMF provides 40 billion US dollars of emergency loans for Ukraine, Iceland, Pakistan and Hungary.
- In January 2009, the British Prime Minister Gordon Brown announces a new bailout for the British financial system. By March, the financial crisis had wiped out USD 50 trillion of financial assets. In April, the G20 enacts a global stimulus package worth USD 5 trillion.
- Greece is bailed out in May 2010; in November it is Ireland that has to be saved.
- In 2011, Portugal is bailed out in May before in July Greece is bailed out for the second time.
- In May of 2012 the number of unemployed in Europe reaches a new record. In July, Mario Draghi, president of the European Central Bank (ECB), announces an unlimited, open-ended ECB-programme to buy distressed government bonds.

Optimism emerged after Mario Draghi’s announcement that the worst could be over and markets reacted positively. But recent events, such as another record in unemployment figures (of 11.8%) in Europe in November 2012 and the bail-out of bankrupt Cyprus in March 2013, suggest that the worst be yet to come.

Summarizing, the consequences of the recent/current global financial crisis were/are severe: bursts of housing bubbles, bank runs, collapses of (large) financial institutions, bankruptcies of states, rising unemployment figures and as further consequences politicians and national banks and the European central bank trying to ease the severe effects of the crisis. A secondary effect was the re-emergence of protectionism in many countries (Farhad 2011, p.38).

Of further interest are the deeper causes behind the recent global financial crisis. These were debated extensively and there seems to be consensus about the most important causes. What is not so clear, however, is who can and/or should be blamed for it. Let’s look at the different causes first.

3. Causes

The global financial crisis was the result of many different factors and decisions, some of which lie many years in the past. Several of these made few individuals and (financial) institutions very rich in the short run, but ruined many others (individuals, institutions and nations) in the medium run – and sometimes the short-run winners, too.

As already mentioned, academics seem to agree largely on the different factors that caused the financial crisis. Their evaluations differ in their focal points and often also in the completeness of the factors discussed. When it comes to categorization, we note small differences, too. The differences between academics, however, seem to be limited to the naming of the same three categories (a) macroeconomic causes, (b) policy implementation and regulatory failures and (c) financial market causes (Edey 2009, Steverman and Bogoslaw 2008, Merrouche and Nier 2010, Taylor 2008 and Riksrevisionen 2010):

- Macroeconomic causes: cheap credit (which triggered excessive lending, not only in the housing market), very low interest rates that increased risk appetite to compensate for low returns, countries running large account deficits (and others – like China – large surpluses);
- Policy implementation and regulatory failures: deregulation, lack of international harmonization and coordination, the interconnectedness of banks and governmental guarantees for banks (“too big to fail”);
- Financial market causes: increased complexity of financial innovations, underestimation of system-wide risks, inadequate risk-management, rating-failures of credit rating agencies, selling of mortgages to mortgagors that were not fit for it, bank’s too small equity capital bases (and their circumvention to increase them) and remuneration systems that spurred risk-taking.

There were also secondary factors and decisions that did not cause the crisis (and will not be discussed) but worsened it and/or contributed to its prolongation, such as, first, the failure of many central banks to respond to the rapid rise in credit and asset prices, i.e. they failed to address the building-up of the housing bubble by raising the interest rate sufficiently, second, the pro-cyclicality of the relation between credit conditions and the economic cycle (i.e. in the upturn, banks offer favourable credit conditions) and, third, supervisors did not understand the risks of securitized loans for housing (Riksrevisionen 2010, p.20/25/28).

In the next chapter, we will discuss financial sector’s part in the recent financial crisis and focus on the causes identified in chapter 3.