A brief background to the global financial crisis
Similar to the previous two large financial crises in modern American history – the Great Depression and the savings and loan crisis – the subprime crisis was prompted by the failure of financial intermediaries to survive considerable macroeconomic price instability. The cause of the crisis differed from one crisis to another (stock prices in the Great Depression, deposit rates in the S&L crisis and housing prices in the subprime crisis). Nevertheless, all of these crises originated from a wedge between the worth of the assets and liabilities of financial intermediaries, which made it difficult for the financial institutions to keep the inherent insurance commitments they made to their clients. The wedge was made even more lethal by high leverage and liquidity on demand, which in turn constrained the size of the buffers available against shocks. There are two major reasons which explain why managers of financial institutions continue to make such commitments but continually fail to honor them. Either the managers are aware of what goes on but fail to take measures because of personal interests. Secondly, it may be that the managers are not aware of what is going on in the financial institution.
The first scenario originates from conflicts between principals and the agent (the agency theory) whereas the second scenario originates from conflicts between the individuals and the group (the collective welfare theory). The agency paradigm asserts that managers deliberately take advantage of the less informed or farther removed. Specifically, they strive to gain the positive aspects of the institutions but leave the negative aspects to the rest (moral hazard). The collective welfare theory on the other hand asserts that managers are free agents who do not act out of ill intention but instead concentrate only on their private costs and benefits. Their inability to internalize externalities or control individual actions results in outcomes that are least favorable for the entire society. The second scenario may also originate from challenges in comprehending the internal dynamics of the financial institution and the workings of the entire system (the collective cognition paradigm). Goodhart argues that “a constantly evolving, uncertain world of rapid financial innovation leads to mood swings driven by rational but poorly informed decision making, bounded rationality or emotional decision-making.” The collective cognition paradigm is obviously related to sessions of ecstatic enthusiasm, then bouts of unexpected apprehension, dread and deep retrenchment.
The nature of the financial system
Financial transactions differ from other types of transactions because they deal with a payment today and a pledge of repayment (or risk coverage) in the future, thereby they require the signing of a contract. Such contracts are usually susceptible to two types of risk: an idiosyncratic risk, which affects the counterparties, their motives and the project they will engage in; and an aggregate risk, which affects all contracts in the entire financial system and therefore the system’s ability to keep the commitments made. In an ideal Arrow–Debreu world of perfect markets, these two types of risks can be completely and successfully captured in the contract. However, in the real world, financial contracts are normally imperfect and vulnerable to a number of frictions which include, outstandingly, the costs related to collecting information about the counterparties and their projects; implementing a contract; negotiating either bilaterally or multilaterally; and making sense of the intricacy of the system and how it changes when faced with uncertainty. These frictions produce gaps that affect the ability of an investor to handle idiosyncratic and aggregate risks. Asymmetric information and control gap results when one of the parties in the contract (the principal) has less information and therefore less control over the other (the agent). This exposes the contract to problems of strategic choice and time inconsistency. The well-known agency theory, which is entirely related to idiosyncratic risks, entails different types of market failures, categorized in accordance with the timing of the failure regarding the contract: adverse selection (before), moral hazard and shirking (during) and false reporting (after).
Liquidity and collective action gap result when investors try to minimize their susceptibility to both idiosyncratic and aggregate risks. According to the idiosyncratic risk, the principal prefers to lend less (that is, stay liquid) so as to discipline the agent by maintaining a tight leash on him, and to have an advantage over other creditors. Concerning the aggregate risk, the investor prefers to lend short so as to manage to stay ahead of the competition and quickly gain a hold of the opportunities or evade the threats that emanate from a volatile environment. Such opportunistic behavior is related to three types of collective welfare failures, categorized according to the basis of the direction of interaction between the individual and the group: externalities (the individual affects the group), free riding (the individual takes advantage of something generated by the group) and coordination failures (the inability of individuals to agree on and execute actions in a way that benefits the entire group).
The search for liquidity is important in the collective welfare theory and encompasses all three failures. It contributes to both positive and negative externalities, encourages free-riding and activates coordination failure-driven runs. However, other collective welfare failures which are not related to liquidity may also influence financial contracts. For instance, free riding by minor lenders may result in the under the generation of information and supervision. On the other hand, minor lenders can flood the market and raise the susceptibility of other lenders to default by stretching credit in times of upswings and reducing it in times of downswings. Coordination failures can also aid in explaining the unwillingness of individual lenders to halt lending during a lending boom. The systemic risk and instability gap is associated with collective risk in the system and originates from failures to cope with the insecurity and instability of financial markets and in comprehending how the resultant intricate development of the system will influence the contracts’ value. The related collective cognition paradigm leads to mood swings, which may be a sign of restricted prudence and heuristic learning, some type of illogicality of the sort highlighted in the behavioral finance studies or even full rationality in the face of ill information.
The financial system assists the investors to narrow these gaps in diverse ways and through different channels. The structure of the system is thus influenced by the comparative effectiveness with which each channel manages to deal with the inherent gaps at a specific point of time. On one hand, markets facilitate the bridging of the asymmetric information gap by giving hard public information, the liquidity gap by exchanging financial contracts swiftly in deep markets and the uncertainty gap by entering into derivative contracts. Asset managers are found in the middle. They assist fund suppliers in filling the asymmetric information gap via expert screening and monitoring (for instance, through direct participation in the board room), the liquidity gap by pooling and the uncertainty gap by expert risk management. On the other hand are financial intermediaries which take part in leverage. Conventional commercial banks narrow the asymmetric information gap through soft private information, debt contracts and capital. They assist investors to handle the uncertainty and liquidity gaps by providing them with deposits redeemable, in that order, at par and on demand, and taking responsibility for the resulting risks through capital and liquidity buffers. Therefore, for various reasons (incentive position or risk assimilation), debt and capital (and thus leverage) play an important role in the ability of commercial banks to appeal to depositors and address each of the gaps. Nevertheless, by interjecting their balance sheet between borrowers and investors, banks become vulnerable to systemic risk, rendering financial intermediation intrinsically delicate.
Regulatory framework of financial system
The present regulatory framework has been structured to aid intermediaries conquer the first two gaps. It is distinguished by three key attributes: prudential norms that strive chiefly to bring into line principal and agent motives; a safety net (deposit insurance and lender of last resort) whose aim is to attract minor depositors to the banking system and prevent infectious runs on otherwise stable institutions; and a ‘line in the sand’ which separates the world of the prudentially regulated commercial banking system from the unregulated. Consecutively, the line in the sand is warranted for three main reasons. First, regulation is expensive and can generate unnecessary changes. It can constrain intermediation, financial innovation and competition, and it should go together with good – and hence intrinsically expensive – regulation. Second, supervision on the low-priced can worsen moral hazard: it can give inadequately supervised intermediaries an unmerited ‘quality’ tag and an effortless scapegoat (if a problem arises, the regulator will be blamed). Third, investors not within the territory of the small depositor are well informed and completely accountable for their investments. Consequently, they ought to effectively supervise the unregulated financial institutions, and ensure that their capital is adequate enough to get rid of moral hazard and other agency conflicts.
In accordance with the “line-in-the-sand” argument, only the ‘systemic core’ of deposit-taking intermediaries is prudentially totally regulated and supervised. As an exchange, they have the advantage of a safety net. Other financial intermediaries lack the safety net benefit and therefore carry the burden of full-blown prudential rules. “They are therefore subjected to market discipline, aggravated by the regulation of securities market focused on transparency, authority, investor security, and market honesty.” Nevertheless, the-line-in-the-sand has become permeable and was universally violated during the climax of the subprime crisis as highly-leveraged intermediation grew outside the boundaries of conventional banking – what is now commonly referred to as the world of ‘shadow banking’ – and the safety net had to be ultimately harshly extended from the regulated to the unregulated. The unstable growth of shadow banking has been extensively recorded throughout the finance literature. By drastically increasing the edge between markets and intermediaries, the process became a breeding ground for a number of new challenges and concerns.
The interconnected nature of the financial system
One of the major reasons why regulation of financial institutions failed is because it failed to focus on the externalities that produced systemic risk. The risk incurred by individual banks was treated as an isolated case. Thus, regulators failed to take into account the fact that banks that were mandated to go into fire-sales also constrained prices for other banks or that banks which hoarded money or escaped from their commitments produced other externalities by generating uncertainty for their counterparts. What this implies is that prior to the subprime crisis very few shareholders understood that the financial system is interconnected and the dangers associated with it: “the holdings of securities issued by other parties, CDSs written by other parties, the high degree of exposure of financial institutions to each other as a result of interbank loans, and so on.” When these interconnections and related perils became apparent, confidence in the financial system fell significantly.
Unanticipated losses on subprime mortgages and mortgage-backed assets triggered overall uncertainty concerning the applicability of an entire category of assets and a universal reassessment of risk premiums. Lopez argues that, “feedback loops, loss spiral and counterparty risks suddenly became the focus of attention.” It was acknowledged that, due to the utilization of mark-to-market technique to evaluate financial statements, the fall in the prices of assets aggravated the balance sheets of other institutions also, which in turn minimized their capital ratios and raised their challenges in fund raising and developing an additional phase of asset sales. Because of the fact that financial intermediation had become an extremely intricate and unfathomable network and a key reason for uncertainty, the near-meltdown in the financial sector led to a more universal increase in uncertainty, thereby contributing to an increase in the amount of preventive savings and the delay of the execution of planned investment projects.
Interest conflicts connected with the operation of rating agencies
Another major problem surrounding regulation of the financial sector is that conflicting interests involved in rating agencies. Most rating agencies are paid by holders of securities. Thus, rating agencies have always worked in a conflict of interest environment because they had to conform partially to the wants of the security holders. Therefore, the information given by rating agencies was not always accurate. The rating agencies thus contributed significantly to the subprime crisis because regulators made use of some of the information given by the rating agencies to categorize the risk levels of the regulated financial institutions at any given time.
Proposals for regulatory reforms
The global financial crisis that resulted from the American subprime crisis made it clear that the regulation of financial institutions is wanting. Even following the crisis, it is still obvious and widely debated that the current regulation of the financial system is still rife with challenges. At the moment, several reform proposals have been made and are still being debated. It is however a consensus among financial experts and policymakers that regulation needs to be reformed in order: to get rid of regulatory “loopholes”, to closely watch the development of financial innovations, to be rendered countercyclical, and to implement a “macro-prudential” strategy which leans against credit booms and imposes capital prerequisites in addition to tax or insurance schemes. Essential to this new regulation proposal is the enhancement of tools used to detect, assess and warn against systemic risks. Such tools should consist of: macro-prudential signs which symbolize systemic risks related to debt and risk absorption; monetary and credit pointers which would signify the growth of asset price booms; early-warning models which would signify the nearness of markets to danger zones; macro stress models which would evaluate the reaction of the financial system to severe occurrences; and contagion models which would attest the interconnectedness of the financial system.
Reform of the rating agencies
Professional rating agencies have been giving essential services in the assessment of risks in the financial sectors for a long time. Rating agencies carry out data collection and analysis whose main objective is to quantify the default likelihoods of assets and institutions. The onset of the financial crisis pointed out a number of flaws inherent in the current rating system. These flaws have played a big role in determining the size of the current recent crisis. Specifically, ratings provided investors with a fake sense of security concerning the default likelihood of securitized loans and credit default swaps. The business framework of the rating agencies presently encourages the conflict of interests because these agencies not only categorize financial assets promoted by financial institutions but also provide these institutions with other different services. Rivalry among the rating agencies for corporate clients does not promote an impartial evaluation of risks as required by investors. To worsen these flaws, in the recent past rating agencies have been forced to assess novel and multifaceted financial innovations which lacked historical data and sufficient frameworks of risk analysis.
Another undermining impact of rating agencies lies in the role the Basel II accord gave to them. Based on this accord, the ratings directly influence the volume of capital held by financial institutions. The inability of these agencies to accurately estimate the risks of complex assets in the recent past has therefore played a role in the insufficient capitalization of majority of the financial institutions. It is essential to note that ratings given by the rating agencies only point out the default risks and do so without necessarily providing any sign of the exactness of this signal. The recent financial crisis was a clear indication that assets are also susceptible to price and liquidity volatility. The rational evaluation of such risks remains a major challenge to regulators. Given the inherent flaws of the rating agencies, the foremost concern therefore must be to get rid of the predisposition towards risk underestimation and the false perception of security among investors.
The realization of this proposal can only be achieved through mandatory publication of ratings by the rating agencies as well as the publication of the value of accuracy for each rating given. With enhanced transparency concerning the bandwidth of approximates, investors will be able to evaluate more cautiously new and multifaceted financial innovations. Additionally, an obligatory separation of lines of business and more rivals in the rating business would enhance the competence of services provided in the future by rating agencies. Even if the transformation of the rating agencies is not a central feature of a therapy of potential financial crises it is nonetheless essential in addressing these problems speedily. The pressure of the crisis can facilitate a solution to the inherent interests holding on to the status quo and additional developments in this area would be a much-needed contribution to restoring confidence in the financial market.
Better bank regulation
Two issues are essential in bank regulation: safeguarding of depositors and the stability of financial markets. Bank depositors are practically unable to correctly assess the risks assumed by their bank. The historical proof of this issue is somewhat vivid on this fact. Depositors are unable to methodically regulate careless financial institutions by withdrawing their funds early. Thus, deposit insurance has been initiated as major support for the safeguarding of depositors. Deposit insurance has an additional role to play in that the approach facilitates the prevention of bank runs. The inception of deposit insurance in 90 countries around the globe characterized banking anxieties that were frequent in the last three centuries have now virtually been wiped out. Nevertheless, the recent crisis is an indication that deposit insurance is not enough to reduce the threats of a universal banking crisis. Financial institutions are interconnected through the payment system and through different types of dependencies. The inability of an individually large bank to pay may therefore result in additional insolvencies and can set off a systemic crisis. So as to thwart this, financial institutions need to hold adequate capital to cater to even larger losses.
In the recent past, both bankers and regulators have worked together to minimize the size of bank capital vis-à-vis the size of bank assets. In the face of the huge systemic risks that are now obvious many of the principles put forward by the Basel II accord concerning bank capital prerequisites appear to be misguided. They bear a resemblance to measures used to improve comfort during flights in conducive weather. With regard to capital prerequisites, there is evidently a necessity to reverse the trend. Financial institutions should play a greater role in minimizing the systemic risks that are a result of their activities. Regarding the search for growth of financial institutions, policymakers should look towards regulation that minimizes the scale effects in banking. As Lopez (2008) states, “public policy cannot leave the problem of “too big to fail” unanswered. We have to devise appropriate ways to internalize the costs of this risk.” If large banks were forced to hold greater capital ratios, the competition for size would reduce. However, it would be immoral to reinforce financial stability through mere higher capital prerequisites. It is likewise vital to implement new measures that would secure the liquidity of financial institutions. Particularly financial institutions that provide financial support to long-term investments mainly through short-term funds should be required to maintain higher liquidity safeguards. Through such strategies, the financial system would have space both for regulatory reform and for improving management practices.
In conclusion, a number of theories such as the agency theory, the collective welfare theory and the collective paradigm theory help to explain the internal functioning of the financial system and its inherent flaws. Attempts at regulating the financial system have failed to cushion the system from collapse in the past. The main reason for this failure is that the regulations did not address the flaws of the financial system thereby necessitating new regulations which should focus on these flaws. In particular, there is a need to revamp the entire rating business as well as the overall banking regulation.
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