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GLOBAL FINANCIAL CRISIS (Case study)
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GLOBAL FINANCIAL CRISIS (Case study)
Emmanuel Kagodo
Introduction
A financial crisis is a crisis which critically affects the functioning of the financial system.
The financial system includes banks, mutual funds, investment banks etc.
During a Financial crisis there is a sharp decline in asset prices and the volume of credit,
disruption in financial intermediation, significant balance sheet problems as well as huge
government intervention. They are multi-dimensional and are preceded by assets and credit
booms which eventually turn into busts before the authorities notice or change anything to
prevent it.
Primary Causes of the Global Crisis
In 2008 the global financial crisis led to the largest and sharpest drop in global economic
activities in modern times and was believed to be triggered by the collapse of subprime
mortgage loans.
There was a high default rate in the subprime home mortgage sector and this was due to the
following reasons;
● Low interest rates for mortgages encouraged lending
● Securitization, where mortgages were grouped into a new financial instrument and
sold in the secondary markets as low risk securities (backed by credit default swaps
insurance)
● The government gave mortgage guarantees which led to many high risk loans to be
bundled and sold by the banks to investors and government agencies of which the
losses were covered by the government.
● The US federal government signed the community reinvestment act (CRA) which led
to low-income citizens (high risk borrowers) to get mortgage loans and as not a
surprise, they failed to clear them.
Several causes can be blamed for the global financial crisis. According to Miele and Sales,
2011 the other causes of the global financial crisis include:
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● The global trade imbalances
● The real estate bubble
● Household sector unsustainable debt in arm length countries
● Financial Innovation and Shadow banking system: Accounting and regulatory
arbitrage
● The overvaluation of Credit Risk Transfer (CRT) products : the reasons for mispricing
● Misaligned Incentives: Bank Managers compensation systems and rating agencies
(Miele and Sales, 2011)
Market features and conditions that constitute a financial crisis in general
The most common features that constitute a financial crisis is disruption in financial
intermediation which can be attributed to default rate and subsequent loss of confidence in
the market and sudden change in economic indicators which includes interest rates, changes
in the level of inflation, changes in the currency exchange rates, souring unemployment rates,
lower gross domestic product and trade balances.
Studies have also revealed that there was an abundant liquidity in world capital markets, fed
by large payment imbalances between the main countries and regions in the world economy,
that is, a large and persistent current account deficit in the United States financed by ample
flows of capital from emerging and oil-exporting countries. These ‘global’ imbalances
fostered an explosion of financial activity and would not have been sustainable for so long
without the development of deep global financial markets.
How the causes led to the features of a financial crisis.
The trade imbalances meant that the US Economy was in need of funds which can only be
financed by paying rising interest rates for funds from other countries. Globalisation made
way for increased cross border trade and interaction with other countries. However, the US
has also over the years benefited from currency exchange rates as the US dollar is the
dominant unit of exchange in international trade. The trade imbalances resulted in erosion of
asset value.
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Boom in the real estate industry which was characterised by increase in house prices and
household debt and specifically mortgage debt continued until it burst. During the burst,
house prices fell but mortgages remained high. Default of mortgage repayment also piled up.
The housing debt though high, the profile was different across many countries. Most
mortgages were granted to individuals and households to finance home ownership.
Immediately credit started slowing down, interest rates began rising amidst higher
unemployment rates, default of mortgage repayment also started to rise. Households found it
difficult to service mortgages.
Financial instruments revolutionised the banking industry. Securitization allowed banks to
transform and trade an otherwise illiquid asset and unprofitable asset as a set of low-risk
securities. Mark-to-market accounting practices, though not illegal, allowed institutions to
report profit on the sale of securities earlier than necessary.
The use of Special Purpose Vehicles to hold and hide losses for parent organisations allowed
the market to be deceived.
The use of derivatives encouraged a lot of risk taking amongst institutions and other market
players. Additionally some of the derivatives are traded over the counter where regulation is
not as stringent as is with formal stock exchange.
Most derivative financial instruments were overvalued before the burst coupled with the fact
that most of the transactions were done through the OTC.
The performance and compensation scheme used by Chief Executive Officers was one that
enticed risky trading for the operatives to earn more in turn.
Credit rating agencies religiously relied upon to provide credible rating of individuals was
ineffective in providing the required service.
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Response of policymakers and regulators to the global financial crisis
Regulation alone cannot explain bank resilience to the shocks of the 2007-2008 financial
crisis.
Strong regulation had a negative impact in countries with poorly developed banking sectors
and shallow banking is positively related to consistency of bank credit provision to
non-financial entities through and beyond the crisis period, suggesting that a one-size-fits all
approach to ‘good’ regulation is not viable.
Since the outbreak of the crisis governments and central banks have supported the financial
sector immensely with the aim of resolving the crisis and turning the economy around. Some
of the responses of policy makers and regulators to the global crisis in different countries
include capital injections, assets purchases, debt guarantees, liquidity and lending provisions.
In addition to the above, regulatory responses to aid financial stability aimed at influencing
regulatory capital, interconnectivity, incentives and transparency. To be effective in ensuring
financial stability, a combination of the aforementioned elements has to be applied across
countries.
Intended effects of policymakers’ and regulators’ responses
Regulatory responses are meant to change a particular behaviour in the market for the good
of all. It is expected that the right volume and size of regulation will lead to the desired
results. However either over regulation or under-regulation may pose other significant
problems. It is intended that such a calamitous economic event never repeats again in history
but over time with changing environment, technology, there may be a need to review the
regulations.
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EVALUATION OF REGULATORY RESPONSE - (THE HEDGE FUNDS)
The financial crisis of 2008 was largely the result of excessive debt and the resulting
under-pricing and mispricing of risk. It is believed that directly or indirectly hedge funds
contributed to this financial bubble and credit crunch.
Hedge funds are composed of three important components; legal structure, investment
strategy and investor pool. Some of the salient features are as follow;
● Hedge funds are legally limited partnerships
● They are unregistered companies that are not regulated by the securities and exchange
commission (SEC)
● They are users of a variety of investment strategies and products, including futures,
swaps and short selling
● Often employ leverage, in that the amount of national market exposure often exceeds
the investment capital of the fund.
● Has limited liquidity that is investors can only get into funds on certain dates and can
get their money out of funds on certain dates.
The hedge funds undergo few restrictions in their investment strategies. They are regulated
only indirectly through their prime brokers and a loose market discipline resting on the
promotion of standards of good conduct.
The crisis of structured credit has pointed out malfunctions throughout the process of
securitization and hedge funds have hidden risks that show off rarely.
Between 2000 and 2007, the number of hedge funds had increased two folds and their assets
grown to an estimated 1740 billion dollars with an annual growth rate of 20%
Given the general characteristics of the hedge funds like pool of private capital, offshore
domiciliation, opacity because of lack of regulation and bias of database, fiscal advantages,
active trading on quoted negotiable and liquid assets, high double fees, broad investment
strategies on capital markets with research for high return and weak volatility.
Despite those advantages of not regulating the hedge fund, the following were the effects of
not regulating the hedge funds; destabilization, leverage, counterparty risk, Endogeneity of
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risks and pro-cyclicity, mimetic behaviour, liquidity risk, operational risk, lack of
transparency, and systemic risk among others
Sources: European parliament report (socialist party) (2007)
Professional organisations, regulatory authorities and international institutions like the
financial service authority (FSA), the securities and exchange (SEC), alternative investment
(AIMA), Hedge fund working group (HFWG), financial forum stability (FSF), international
monetary fund (IMF), and president working group (PWG) have come up with
recommendations regarding the regulation of hedge funds but their recommendations are
only concerned with hidden risks.
The SEC in the USA proposed that funds with more than $150 million in AUM will be
registered with the federal agency and turn a battery of information, including details about
their firms, the funds they manage and the type of investors they have. It would also force
them to name the businesses that service the funds that are prime brokers, auditors and
marketers. Like it is the case in Canada where all hedge funds must be registered in order to
manage money for their respective clients and it has proved to be successful.
This would be a good move for other countries to implement since it looks out for
accountability and transparency in the funds dealings which was not the case before the
global financial crisis.
The G-20 summit held in London in April 2009, mutually agreed that a regulatory system
was needed to identify and evaluate macroeconomic risks. This system would require
registration of managers who would disclose necessary information to assess and manage
systemic risk and counterparty risk effectively. This action is meant to monitor the leverage
and limit the exposure for a single counterparty. The financial stability board (FSB) suggested
that a common platform be built to share information when hedge funds and fund managers
are also located in different jurisdictions.
In May 2011 there was creation of an alpha return named Evolved Alpha whose main
purpose was to provide transparent, liquid and secure access to a dynamic portfolio of
specialized alpha strategies. This portfolio is composed of approximately 1000 global
positions with an emphasis on liquid financial instruments, equities, futures, options and
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currencies. Evolved alpha is capable of minimising fraud risk and increasing valuation
certainty.
The Volcker rule adopted under the Dodd-Frank Act prohibits banking entities from
investing in or sponsoring private equity funds, hedge funds, and venture capital funds,
subject to certain exceptions.
This rule is a bit complex and detrimental to the free flow of capital and the growth of the
economy
One of the regulatory responses was to prohibit short selling in September 2008 by the
authorities in several countries. The purpose of this was to reduce the market volatility. Spain
has already implemented it and is thinking of extending the ban since it has proved so
positive results so far but in other countries this measure has so far failed to prevent falls in
financial stocks, which are heavily exposed to the euro zone debt crisis.
Conclusion
With the collapse of the housing market, high rates of employment, default risk became high
and credit evaporated. Businesses continue to experience the effect of the collapse till today.
Regulatory and policy responses, though slow, were provided to salvage the situation and
eventually turn it around.
The hedge fund industry size has never been a determinant of success. The survey conducted
by SEI cited that better managed firms produce better returns hence it is important to realize
that voluntary regulation is equivalent to no regulation. And for this reason, regulating hedge
funds is a good move which can stabilize the financial markets worldwide.
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References
https://www3.tcmb.gov.tr/cbr/
https://www.thebalance.com/what-caused-2008-global-financial-crisis-3306176
https://www.thebalance.com/2007-financial-crisis-overview-3306138
https://en.wikipedia.org/wiki/financial_crisis_of_2007%E2%80%932008
https://www.cairn.info/revue-recherches-economiques-de-louvain-2009-1-page-5.htm
https://www.omicsonline.org/open-access/impact-of-regulations-on-hedge-funds-and-the-pot
ential-impact-on-alphain-2012-2472-114X-S1-009.php?aid=77800
Gatauwa, J.M. 2014 ‘The 2008 Global Economic Crisis and Public Expenditure: A Critical
Review of the Literature’, vol. 4, no.2, 131-145 ISSN: 1792-7552(online) Scienpress Ltd,
2014
Miele M.G. and Sales E. 2011, ‘The financial crisis and regulation reform’ Macmillan
Publishers Ltd. 1745-6452 Journal of Banking Regulation Vol. 12, 4, 277–307
WQU Financial Markets Compiled Notes Week 3 and 4
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