The financial crisis

The financial crisis has its origin in the US housing market, though many would argue that the house price collapse of 2007 – 2009 is a symptom of a problem running much deeper, revealing a fundamental weakness in the global financial system.

See Financial market failures

Origins

From the 1970s onwards, US and UK banks started to widen the scope of their business models by selling off their own credit risk to third parties. Increasingly they became reliant on computer-based systems for assessing that risk. Many have argued that personal judgment, perhaps the key attribute of the traditional bank manager, gave way to decision making by computer software.

(Source: Financial Times)

Relaxation of the rules regarding capital movements between countries, widespread de-regulation of financial markets during the 1980s, and a number of banking mergers also dramatically changed the global financial landscape at the end of the 20th Century.

During the 1970s and 1980s, increasingly complex financial products were developed and traded, providing a speculative income for traders and a method of spreading the risks associated with financial trades. New financial products, such as ‘derivatives’, ‘options’, and ‘swaps’, joined more traditional products, like mortgages and bank loans, in an ever-widening array of financial goods and services. In addition, this period saw the increasing securitisation of assets, most notably mortgages.

Securitisation

The increasingly complex nature of financial products did not deter banks from diversifying through increased securitisation.

Securitisation, which started in the US and spread to the UK in the late 1980s, is the creation of asset-backed debt. The assets used generate a flow of income, and the commonest asset is a mortgage, from which a regular flow of income is generated. In recent years a much wider variety of assets has been used, including income from credit cards and even from pub chains and football stadiums. (Source: HM Customs and Excise.)

One particular feature of the 2008 – 2009 financial crisis was the difficulty faced by many insurers, including the American giant, AIG. AIG, and other insurers, became heavily involved in insuring other institutions against credit defaults. Specifically, investors who wish to protect themselves against defaults on mortgage-backed securities may buy credit default swaps (CDSs). As an insurance against credit default, CDSs are bought and resold, and may end-up on the balance sheet of a wide variety of financial institutions. It has been estimated that, if one player in the market were to go bankrupt, it could take a decade to untangle the complex network or contracts between the financial institutions and intermediaries. It is primarily for this reason that the US Federal Reserve bailed out AIG and Bear Sterns.

Toxic assets

A bank or other financial institution, like all firms, must create a balance sheet which values its assets and liabilities, and from which it can calculate its net assets and its capital.

The value of a bank’s assets, that is, what it owns, is largely determined by how ‘healthy’ the debts are that borrowers must repay. A fundamental problem of the highly globalised financial markets at the time of the US housing crisis was that many of the mortgage backed debts on the balance sheets of the banks have turned out to be extremely ‘unhealthy’, referred to as toxic debts. The problem of the toxic debts, resulting from loans made to the sub-prime housing market, became more severe because banks could not quickly or accurately calculate their exposure to these debts. This was largely a result of the highly complex nature of their investments, including those related to derivatives and options.

Asymmetric information

What is clear is that financial markets failed partly because of the problem of asymmetric information.

In the context of financial markets, this means that parties to a transaction do not have access to the same quantity and quality of information. Considerable information is needed in order to assess potential risk and reward, and to make a rational decision about whether to purchase a financial product or not, and how much to pay for it.

The emergence of complex derivative products in the early 1980s, and the increased popularity of securitisation in the late 1980s, increased the inefficiency of many financial transactions. This inefficiency was the result of one party, usually the seller, possessing much better information than the other party, usually the buyer. Furthermore, with the rise in the importance of specialist third parties, like hedge fund managers, the actual buyer and seller may be unaware of the actual risks associate with a given transaction, and oblivious to the source of the investment income. Therefore, in 2007, when the mortgage market started to collapse in the USA, the scale of the problem remained largely hidden.

This failure of information could also be referred to as an example of the ‘principal-agent‘ problem, though many of the ‘agents’ involved were indeed fairly ignorant themselves!

Banking collapse

As the scale of banking losses were announced, and following the failure of leading investment banks like Lehman Brothers, growing uncertainly prevented the banks from lending to each other as they would normally do, and encouraged them to retain as much liquidity as they could. The result was that banks were failing to fulfil a key banking function, namely to make loans and ensure the adequate flow of liquidity into the economy.

Policy options

There are three fundamental issues facing policy makers:

How best to control or regulate banks
How to get liquidity into the global system
How to deal with the after-effects of the banking crisis

Nationalisation

One response to the banking crisis was to nationalise a number of key banks, including Northern Rock, and part-nationalise others, including the Lloyds Banking Group and the Royal Bank of Scotland (RBS). Many others have been heavily supported by their governments by extensive ‘re-capitalisation’.

Regulation

Since 2001, financial market regulation in the UK has been the responsibility of the Financial Services Authority (FSA).

The aim of the FSA is to ‘promote efficient, orderly and fair markets and to help retail consumers achieve a fair deal.’ (Source: FSA)

Given that asymmetric information is a serious problem in financial markets, regulatory reform will involve the promotion of a more transparent system, with financial institutions forced to provide higher quality information on risks.

Some critics of the US regulatory system allege that it is too rules-based and should move towards the European model of principles-based regulation.

With rules-based regulation, the regulators interpret the rules as laid down in law, and there is little room left for judgement or interpretation.

Under a principles-based system, as well as having extensive rules, the general principles of regulation are contained in legislation. It is argued that this gives extra powers to regulators to assess the behaviour of financial or other institutions in terms of whether the general principles are being adhered to.

The London G20 Summit, held in April 2009, recommended the establishment of a Financial Stability Board to provide an early warning system of problems in the global financial markets. It also proposed close scrutiny of the activities of hedge funds.

Monetary stimulus – quantitative easing

Quantitative easing is a process whereby the Bank of England, or another central bank, under instructions from the Treasury, buys up existing government bonds in order to add money directly into the financial system. The process of doing this is called open market operations, and it is regarded as a last resort when low interest rates fail to work.

When an economy is in recession and official interest rates are close to zero, further interest cuts are impossible. This is the situation that faced most national economies and monetary unions during 2008 and 2009. In this situation, quantitative easing may be necessary to boost liquidity and stimulate lending.

Fiscal stimulus

To help their ailing motor industries, several national governments provided special assistance, including loans and loan guarantees, and specific subsidies which enabled prospective car buyers to trade in their old cars for new ones – the so-called scrappage scheme.

One of the first measures taken by the UK government was a reduction in VAT, from 17.5% to 15%. (It was raised to 20% in 2011.)

As well as establishing a global regulatory regime, the G20 countries also agreed an extra $750 b stimulus package, in addition to the measures taken by national governments.

A Tobin Tax

A Tobin tax is a special tax on currency transactions, designed to penalise excessive short-term speculation in the currency markets. Advocates have suggested that such a tax could be imposed on a wider range of financial transactions to reduce speculation in financial markets and help restore some stability. The formal name for a Tobin tax is a securities transaction tax.

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