Business

Responses to the Global Financial Crisis

Introduction
Economists have described the recent global financial crisis as the worst since The Great Depression.  It has resulted in the collapse of key businesses a drop in consumer wealth in trillions and governments had to incur numerous financial commitments. There have been many causes proposed for this crisis. Consequently, many regulatory and market-based solutions have been considered. According to the International Monetary Fund 1996 statistics, the crisis had happened in more than 130 countries since 1980. Moreover the statistics also show that in 1960s there are more than 40 countries that were still experiencing difficulties. The interdependence of economies and markets throughout the world is such that very few nations remained unaffected by the crisis.

Background and Causes of the Recent Financial Crisis
The recent crisis was triggered in 2005-2006 when there was an increase in defaulting on the adjustable rate mortgages. There had been an increase in borrowing as a result of an increase in incentives for loans. The belief was that the consumers would be able to refinance these loans later in a short time span and in favorable terms. Unfortunately, interest rates started to increase and in effect the prices of houses began to drop, making repayment of loans difficult..
 
There are financial agreements referred to as Collateralised Debt Obligations (CDO) and Mortgage Backed Securities (MBS). The value of these are determined by housing prices and mortgage payments. With the increase in credit and housing mortgages the values of these increased too. This led to worldwide investment in housing market in the US. The major global institutions that had investments in MBS incurred huge losses as the prices of houses plummeted. The fall in prices was so steep that the values of houses  reduced to amounts worth less than the mortgage,  This resulted in the foreclosures of these major global financial institutions. The crisis spread from housing to other areas of the economy resulting in increase in defaults in repayment of the loans and credit taken in other sectors of the economy.

Recently, the traditional banking system witnessed some changes, Traditionally the regular practice was to hold the loans until they were repaid. Now banks are moving to the practice of securitization. This involves pooling of loans, trenching and reselling them to other investors.

These banks and other regulated banks had failed to create adequate financial cushion for themselves as they provided loans. Consequently, when loan defaults began to occur, their ability to lend out money was impaired causing a decline in economic activity. These banks remained unregulated even as they played a critical role in a free market.   The problem is indeed very complex and needs experts and decision makers to diligently find out prudent and amicable solution. In the process, they should derive lessons learnt from the experience in the past. A brief study of the financial crisis that has occurred in the past history of the world economies would be helpful at this point.

A peep into the history
Between 1930 and 1933 US saw banking panics until when FDIC was established.  FDIC was established to maintain stability and public confidence in the US financial system.   However during this three year period, more than 11,000 banks out of 25,000 had failed. Over the period 1933 to 1979, the FDIC insurance system seemed to work well since the failures were few and the FDIC insurance fund grew in size. This did not long and one of the major banks in US, Continental Illinois faced a serious financial difficulty.
Beginning in 1980, number of bank failures increased with more than 1039, in the decade  ending in 1990 peaking at 221 in 1988. This number of failures was actually higher than that in the entire 1933-1979 period.  This saw the demise of Federal Saving and Loan Insurance Corporation (FSLIC) when  the Congress passed the Financial Institutions reforms, Recovery and Enforcement Act (FIRREA) in August 1989. This act restructured the savings association fund and transferred its management to the FDIC. It was renamed as Savings Association Insurance Funds (SAIF). The Congress also passed the FDIC Improvement Act (FDICIA) in December 1991 to restructure the bank insurance fund and to prevent its potential insolvency. The position improved significantly by late 1990s and the bank failures reduced to only a few by 2004. US economy grew stronger than ever during this period until the recent financial crisis which started brewing in 2005-2006.

Crisis struck UK virtually for the first time in early 1970. This was the severe secondary banking crisis that brought to light many supervisory and regulatory loopholes in the banking system of U.K. At that point in time, The Banking Act 1979 was enforced.  This act however did not prevent the further crisis that arose with the fall of a major bank Johnson Matthey Bankers in 1984. Following this collapse, an emergency committee consisting of officials from the Treasury, The Bank of England and an externally appointed banking expert was constituted to study the steps to be taken to correct the course of the financial system. According to the changes recommended by the committee, legislative  enactment in the form of The Banking Act 1987 was passed.

There is no denying of the fact that whenever  such crisis occurs, the government officials and politicians should take actions that protect the depositor capital as well as the banking system. The response in this case should have been to extend regulations that would cover all aspects of bank system. The banking system and role of regulations in banking system should be clearly understood in order to be in a position to give quick and correct response to a financial crisis.

What is a bank
It is important to understand the meaning of the term bank in order to get a clear idea of all the activities that banks carry on, on a day to day basis.  Banks perform the essential function of channeling funds form those with surplus funds (suppliers of funds) to those with shortage of funds (users of funds). It thus acts as an intermediary  between the savers and users of capital. Presence of such an intermediary is essential because the suppliers of funds may not be willing to give funds directly to the users of funds because of the existence of high costs of monitoring, liquidity risks, price risks, lack of adequate knowledge of and capacity to monitor the business of the user and others such reasons. The bank thus provides a facility of an intermediary and assumes all risks for the supplier of funds, and facilitates supply of money to the user of funds..
There have been several attempts to define the term Bank. The Economist have always described banks as intermediaries between savers and users of capital.

According to Heffernan, the bank is that financial firm which offers loan and deposit products to the market. He also describes the main function of banks as making their profit from the margin between the borrowing and lending rates.

What makes banks special
There is no doubt that the banks have always been treated as remarkably special.  They hold a very crucial place of importance in the economy and hence are dealt with very carefully by governments around the world. The importance of banks in the society and economy can be gauged from the following points.
Firstly, the banking system needs to be healthy and robust in order to win the trust of the general public.  Banks receive deposits from the people and lend this money to entrepreneurs who in turn invest this money into business.  At this juncture it becomes the responsibility of the incumbent government  to protect the public money as well as the economy of the nation from any possible losses.

Secondly, banks are endowed with the power of creating money through their lending policies. This is termed as credit creation.  Through credit creation banks can fuel production , consumption as well as growth in the economy.

Through lending of the funds to owners of different projects, banks help to minimise the investment risk of depositors because of diversification. It also enables all the depositors irrespective of the size of their investments, to benefit from the economies of scale. Moreover with the advancing technology, banks are able to help depositors reduce their costs of transaction. Banks eliminate the risk of mismatching of  maturities through their function as an intermediary.  Banks also help the population transfer their wealth from their youth to their old age as well as across generations. Such savings also help depositors minimise their tax burden.  

Understanding the need for Regulations
Our financial markets being near to perfect markets, has many of the characters of a perfect market such as a number of buyers and sellers, free entry and exit, perfect information, product homogeneity, and an absence of externalities.  Any perfect market, being self regulating does not need an external regulator. However it is an established fact that no such perfect markets exist. It has been severally argued that our banks failed  primarily because of two reasons Systematic failure (an externality)  and information asymmetry.

Coping with Systematic Failure (The Role of the Central Bank)
A form of moral hazard results. Regulation can be seen as playing an important role in minimising systematic risk, and the costs it involves.

The Central Bank or the Bankers Bank of any country has a very crucial role in coping with the systematic failures in the Banking system.  In some countries there is a private body which is set up by the government which handles the task of regulating the Banking system.  Such body or the Central Bank whatever the case may be, minimises the risk of  systematic failure occurring in the Banking system by exercise of a host of regulatory powers bestowed upon them by the system or the Government.  These powers include issuing of licenses and authorisations to banks to operate in their jurisdiction, setting up standards for the banks to be attained and seeing to it that the banks strictly adhere to these standards. The Central Bank also closely monitors and supervises the day to day activities of all the banks  to keep check on any irregularities such as bank lending volumes, lending rates, banks investments in the money markets and foreign exchange markets, banks control mechanisms to control money laundering and such other operational details.  

Coping with Information Asymmetry
The second economic rationale for regulation is that of information asymmetry. Davies sees two strands to this complexity of contracts and difficulties in judging the financial soundness of firms.

The population who forms the chunk of the savers in an economy are generally people not having any knowledge about the financial field and the banking industry. It is therefore hard to believe that they even a basic knowledge about the quality of the financial products being offered by a financial institution in return for their hard earned money. Almost all of such products are credence goods. Credence goods are those goods, the effects of whose use is known  only in the future and that too many years after paying for them.   To add to this, many of the products are designed to appear different  than what they actually are. They are worded or phrased in such a manner that the bare facts are clouded and the product appears much more complex than it actually is. This disallows the savers from knowing the exact nature of the product. Much has been said about the difficulties that exist in obtaining reliable information about quality, and this is particularly so in relation to financial products.

Secondly, individual savers have a limited capacity or ability to deal with the information available. That is to say that they suffer from bounded rationality. The educational background of the savers, time available with them to go into the details of the information available, and other such constraints refrain the savers from going into the details provided to them. This  means that their ability to deal with information is limited.  This is also  due to the personal interests of the individuals, and also differing psychological ability of consumers in the extent to which they can deal with information. Therefore, it will be difficult for firms to supply information which will benefit large numbers of consumers.

To add to this, the banks will always be tempted to not to supply correct or atleast accurate information to the consumers. This is because, various risk constraints posing before a bank does not allow the bank to offer an all out customer friendly  product. Putting such a not so friendly or unfavorable product for sale greatly reduces the attractiveness of the product and hence its acceptability. Some valuable information will therefore be invariably withheld. Moreover banks would tend to provide only that information and only in that manner which can be conveyed cost effectively.  The  information asymmetry as a cause of bank failure, presents  before us a very complex form of the problem. The free market economy only encourages this problem to aggravate.

From the above understanding of the two causes of bank failures, viz. systematic risk and information asymmetry, we can say that regulation and supervision in banking system is not a necessary evil but theurgent need of the hour.

What does regulation and supervision mean
As discussed earlier, banks have a special place in the economy of a nation owing to the important role of an intermediary that it plays between the supplier and user of funds. However if such an intermediary fails to perform its function and closes down after becoming insolvent, it would incur huge losses to the providers as well as users of the funds. It will also prove extremely detrimental to the health of the economy.  Banks are therefore regulated by the highest level in the government in order to protect against the disruption of such vital services and also protect from the costs incurred due to such disruption.    

It is not easy to define the meaning of regulation and supervision clearly. Hadjiemmanuil described the term Regulation as governmental interventions of a coercive character, regardless of their aims, which determine the outcome or control the operation of a private activity, restricting the free operation of markets. He defines Supervision as the associated or complementary process of monitoring the behavior of private parties, especially for the purpose of monitoring compliance with the regulatory requirements.  

By and large, the term regulation is used to refer to the different methods by which the activities of banks are monitored and observed by governments and central banks or any other body or sector that has the authority to monitor the banks.

The Role of Financial Regulations
Financial Regulations help governments to regulate the functioning of the banking system.  Regulations arm the government or the regulating authority with the following powers
It authorises the Regulator to set common rules and regulations under which banks ought to operate
Regulator has the auhority to monitor banks to ensure they abide by the regulations imposed
Regulator has not only the authority but also the responsibility to ensure safety and soundness of the banking system
Regulator posses  the authority to conduct  the examinations and inspections of member banks, bank holding companies and foreign bank offices by teams of bank examiners.

Regulations allow the Regulator to issue warnings should some banking activity by a member bank  be viewed as unsafe or unsound.

Regulations provides athority to approve various bank and bank holding company applications for expanded activities like mergers, acquisitions, expansion, diversification and the like.

Thus financial regulations play a very important role in an economy.   FSMA has set out various objectives to be achieved by banking regulations. Some of these objectives are improving transparency and accountability in the system, generating public awareness through spread of information, building confidence among the depositors with regards to the banks and the banking system.

However a degree of caution must also be applied while implementing regulations. Regulations also carry with themselves a cost. Part of these is costs is express and there might be a part of cost that is implied or hidden. Over employment of regulations having such hidden costs could result in the costs of regulations exceeding the benefits. Thus the financial regulations must pay attention to protecting the customers but  at the same time avoid imposing any stifling of competition which itself has its inherent costs.  It is important that the costs of regulation are fully weighed by Parliament and the Regulator, and a prudent decision is taken by applying cost-benefit analysis  so that there is enough assurance of costs not overtly exceeding the benefits. Indeed, the FSAs regulation is required to be proportionate to the benefits, in general terms, which are expected to result from it.

Responses to the crisis
At the time when the crisis has already struck an economy, the damage has already been done.  The damages include job losses, high inflation, foreclosures, plummeting stock market prices, general distress and others. However its never too late to act. A swift action can  help contain losses and avoid spilling over of the crisis to other sectors and other economies.  Moreover, the crisis can act as a laboratory case for economists and decision makers in the Government, which they can study and devise strategies and policies that would help them prevent occurance of similar problems in the future.  Taking a cue from those experiences, the authorities should establish a legitimate system of regulations which by and large has proven to be the best technique of minimising the risks of bank failures.  Until the recent crisis, the Central Banks have already been using other techniques such as acting as a lender of last resort by supplying money at times of crunch and developing depositor confidence through Deposit Guarantee Schemes. However these techniques are only corrective as against the reguregulations which are preventive measures to avoid the crisis to happen.

With reference to the recent financial crisis in USA which had its origins in the banking sector, it can be said that the argument in favour of need for regulations in banking sector has only strengthened.  The crisis situation led to increasing concern over the ability of financial institutions to remain stable. The Central Bank responded by providing money so that lending can continue and faith in commercial banks can be restored. The authorities also provided economic stimulus to bail out the key financial institutions affected.  It has been argued that the framework of regulations was not enough fine-tuned to keep up with the growing financial innovation, for example, the shadow banking system which had begun to gain greater importance.

Commercial banks are responsible for commercial paper (CP) markets, an integral tool of raising funds for businesses.  Off-balance sheet financing and derivatives are such other examples of innovations that were taking place in the banking sector.

Another shortcoming in the legal framework that may have allowed the crisis to occur is the changing of laws or the weakening of their enforcement in some parts of the financial system.

In consideration of the shortcomings in the legal framework in USA, the government is considering several proposals for regulation. The proposals are focused on consumer protection, financial cushions for banks, greater regulation of the shadow banking system, regulation of executive pay and greater authority of the Federal Reserve to wind down financial institutions among other things.

Few of the most common and effective measures that are being used in developed economies around the world are described below. Other nations experiencing similar crisis can stand in the face of the economic crisis by adopting these below mentioned proven solutions.

Protection to depositor
United States is one of the first countries, which have focused on the protection of consumer schemes to safeguard the money of depositors. When the Great Depression occurred at the beginning of the previous century in 1933, the United States Government set up  The Federal Deposit Insurance Corporation (FDIC),  an independent agency, to protects funds placed by depositors in banks and savings associations. FDIC insurance is backed by the full faith and credit of the United States government. Since the FDIC was established in 1933, no depositor has ever lost a single penny of FDIC-insured funds.

There were two main objectives of the establishment of such a scheme. The first objective was to protect the public money. The second objective was to induce confidence among the depositors in the banking system.
In view of the recent financial crisis, the Government raised the guarantee limit to US  250,000 per depositor for the period till 31st December 2013. From the next day onwards, the limit is proposed to go back to its 100,000 per depositor level. It is important to note that this limit is not for each account, but it is for each owner of the account. Thus the limit for an individual account will be much higher for joint accounts.

The concept of Financial Safety Net was introduced in UK.  Under this scheme, banks are provided with the emergency liquidity assistance in times of need. Moreover there is a Depositor Insurance Agency also a part of the financial Safety Net, protects the depositors money by insuring. The Financial Services Compensation Scheme (FSCS) of the UK  gives a protection limit of 35,000 pounds to each depositor for their deposits in banks. Most other European countries have depositor protection guarantee schemes although amount guaranteed are different in each case. The amounts guaranteed in some countries has been summarised in the following table

Sr. No.CountryProtection Providing Authority
or schemeLimit1.Austria20,000 euros2.BulgariaBulgarian Deposit Insurance Fund20,425 euros3.DenmarkGuarantee Fund for Depositors and Investors300,000 crowns4.FranceCash Guarantee70,000 euros5.GreeceHellenic Deposit guarantee fund (TEK)20,000 euros6.IrelandUnlimited till September 20107.ItalyInterbank Deposit Protection Fund20,000 euros8.GermanyCompensation Scheme of German Banks (EdB)20,000 euros9.NetherlandDGS40,000 euros10.PortugalDeposit Guarantee Fund25,000 euros

Bank Insolvency and Liquidation
The Government of United Kingdom has woken up to the wake-up call given by the Lehman Brothers. The Financial Services Authority has asked  banks to draw up living wills, or recovery and resolution plans. These set out a blueprint for resolution of a potential crisis and for dismembering the bank if those efforts fail. Many proposals are being considered. In one of the proposals that are coming in recently in UK, banks could be required to keep up-to-date, centralised information about their counterparties. There are proposals that would make it easier to segregate and transfer client assets in case of failures. These consultation processes on the bank insolvency package are underway and are expected to continue for further few months.  If these proposals do get accepted then, UK will the first country to set out clear road map of procedures to follow to protect client money in case there is any insolvency.

In the US, the cradle of the financial crisis, insolvency and illequidty is handled using basically two methods. FDIC is the body applying these methods. These methods are called Puchase and Assumption method (PA) and the Payout method.

Purchase and Assumption Method (PA)  In this method, all deposits with the failed bank  are assumed by an open bank. This open bank also purchases some or all of its loans.  The remaining of the bad debts are auctioned online through  The Debt Exchange  or the First Financial Network.

Payout Method  In this method all insured deposits are paid by the FDIC. FDIC recovers this amount through the sale of the immovable and other estate and assets of the failed bank. This is a straight bail out package also called as straight deposit payoff  by the FDIC and is carried out only if the FDIC does not receive any bid for a P  A  transaction. In such a straight deposit payoff, there is no purchase of any  liabilities or assets of the failed bank by any other institution. The FDIC pays the insured amount to each depositor.  The interest accrued upto the date of failure is also repayed to the depositor. Thus this method is the last resort employed by the FDIC in the event of insolvency of a bank.

The European Central Bank had responded in a manner similar to the US in handling the financial crisis. With regard to interest rates, the Governing Council of the European Central Bank lowered the interest rate, a move in line with the strategy of easing pressures from inflation. Other than this, some policy actions were taken regarding the management of liquidity. The bank like the Federal Reserve(US) temporarily  provided liquidity to the banks that needed it.  Other non-standard measures included creating a longer list of collaterals to accept more securities.  Member states of the EU also provided cash in a bid to rescue some of their financial institutions few were nationalised while others were simply allowed to perish. At that particular time, the first response in many countries was to ensure public spending by injecting money into the economies of those affected countries. It was however noted that in spite of all these crisis management measures, the crisis refused to dilute, and the Governments had to introduce regulations in the financial markets.

Other Measures taken In USA
To restore credit flow, various actions were taken. First, short-term loans were given to financial institutions. This is in line with practice of the Federal Reserve being the lender of the last resort. To underscore the commitment of lending short-term loans, the interest rates for short-term loans were lowered and the term for repayment was extended to three months. It should be noted that the short-term loans are currently being given only to healthy financial institutions. Funds were auctioned to financial institutions in order to allow the interest rates to fluctuate with the level of demand.

Target lending is another strategy currently being used by the Federal Reserve to assist in freeing up credit markets that are not within ambit of the banking system. This is happening in the commercial paper market commercial paper or CP refers to a type of debt instrument that businesses issue to get funds for their operations. Money market mutual funds are one of the investors in commercial paper. At the time when the crisis was at its peak, the people lost confidence in the mutual funds. As the public withdrew their money, the money market funds were forced to cut back on their investments leading to losses in the commercial paper market. A series of lending programs has helped to restore confidence in the commercial paper market and money market mutual fund institutions.

In addition to all these efforts, the Federal Reserve began a lending program that was aimed at providing more credit to small businesses and households. This program focused on credit such as loans guaranteed by the Small Business Administration, student loans, auto loans and credit card loans. To restore stability to the housing market, the Federal Reserve has adopted a strategy of purchasing securities in the open market. The purchase of this mortgage related securities has helped to lower the interest rates paid by consumers on mortgages. Even with this, the market for housing is still depressed, but lower interest rates and lower prices for houses have atleast made the houses more affordable.

The liquidity support provided to banks in various countries was short-term and beyond this there still remain challenges that need to be addressed in orderto promote the preservation of the financial system. To bring the financial system on a sound footing, it is important to reduce bank insolvency. Bank restructuring operations should therefore include limiting costs to creditors, depositors and taxpayers and minimizing disruption of the system. The efforts should be aimed at addressing not just the symptoms that indicate bank insolvency but the causes too.  Insolvency proceedings should be initiated for all bankrupt banks these should involve assuming direct control by a banking authority and suspending the rights of shareholders.

Any firm that is unable to meet its obligations to the market should bear the consequences of such failure. This however did not happen to those large financial institutions that received loans from the government to prevent the failure. Some people have viewed it as unfair practice. They argued that companies like AIG were saved from bankruptcy while other non-financial and smaller firms did not receive similar treatment. This view is acceptable. However, if AIG had not been saved from bankruptcy, its failure would have posed a threat to the global financial system. The threat would have been that of worsening of an already severe crisis and an economic meltdown with great losses in jobs, incomes and production. This, is due to the companys interconnectedness with large firms all over the world. A bad precedent has obviously been set in saving AIG from avoiding the discipline of the market place, but this has served as a wake-up call to ensure that changes are made to the financial rules.

Conclusion
The liquidity crisis experienced globally, was triggered by increased irregularities in issue of mortgage loans coupled with fall in the housing prices. Every financial crisis is specific in its characteristics. The present financial crisis has come very close to a classical banking crisis. The novel  characteristic of this financial crisis has been the high degree of securitization  that led to an intricate web of obligations that were interconnected. Some other factors that amplified the causes of the credit crunch have also been elaborated in this paper. These causes formed a point of start from which authorities could begin to respond to the global financial crisis. Although various nations have promptly responded, keeping the causes of the crisis in mind, yet a lot of work still remains to be done as the crisis might very well continue for another couple of years. The sign of recovery though now visible is not strong enough.

With the current global financial crisis, the ordinary depositor has borne the burden of having to bail out banks and financial institutions as well as having to face possible bankruptcy. A more solid foundation with stronger involvement of government and a focus on social interest, rather than mere economic growth is perhaps what is needed to ensure greater economic stability and efficiency, not just in one country but globally. Today, the nature of markets being globalised, highly interdependent and liberalised, certainly brings large benefits to the economy of the world. However, failure to regulate these markets can paralyse the economies. Every country has come up with proposals on how to regulate the financial markets. Most of these proposals have even been agreed upon in the recent G-20 summit. These plans should be implemented without delay in order to avoid prolonging the crisis and creating more adverse effects in the political and social spheres.