Essay-G.J.Smid-IFC-UEK
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The document discusses the causes of the financial crisis and solutions to prevent future crises. It argues that the financial system is too important to leave unregulated and that mistakes were made during the crisis that went unpunished. It identifies three main challenges regulators face: 1) increasing capital requirements for financial institutions, 2) increasing regulation and transparency of credit derivative markets, and 3) regulating credit rating agencies to address conflicts of interest. Nationalizing credit rating agencies and increasing clearinghouse requirements are proposed as solutions.
Essay-G.J.Smid-IFC-UEK
- 1. Gideon Joshua Smid (198382) Int. Financial Crisis 14 november 2016, Krakow 1 息 G.J.Smid Plan of my essay The goal of this essay is to show that the financial system is too important to leave unregulated. This essay will show what, according to my belief, went wrong and led to the finanical crisis. This essay will give three challenges officials have to face in order to limit the effects of a next crisis. This essay gives accordingly solutions for these challenges. Finally, I want to state that this is a summarized view on the cause of the financial crisis and the solutions to prevent a next shock wave. But the mentioned points are according to me the most important ones and without correcting the made mistakes it will not prevent us from the same horrific domino effect of bankruptcies, unemployment levels and loss of disposable income we saw after it.
- 2. Gideon Joshua Smid (198382) Int. Financial Crisis 14 november 2016, Krakow 2 息 G.J.Smid The financial system is too important to leave in the hands of bankers During economic downturn many firms occur lack of sufficient capital to cover the obligations of the business. A firm goes bankrupt when negative cashflow erodes the available asset stocks to the point where creditors cannot longer be satisfied.1 This didnt applied for financial firms during the banking crisis. On a large scale governments around the world took emergency actions to prevent banks and other financial institutions from bankruptcy. These firms were considered too important to fail and the public had to bear the cost by governments using tax money to intervene.2 This also sent out a message to these financial firms: when you find yourself teetering on the brink of disaster, fear not. We have your back.3 Nobody was found accountable for the made mistakes that led to the bailouts, not a single executive had to face criminal charges for the fraud of creating collateralized debt obligations and other derivatives that only a mastermind understood. Also, nobody was charged guilty for inflating the house prices by giving loans to subprime lenders that in some cases didnt even had income or a job.4 Thomas Sowell once said: it might be hard to imagine a more stupid idea or dangerous way of making decisions than by putting those decisions in the hands of people who pay no price for being wrong. Nevertheless this is what happened. The banking crisis has proofed that we cannot leave the financial system unregulated. But now the question arises how it should be regulated. By the market itself, which means self- regulation by market practitioners, by the government or an autonomous agency? First, the regulators have to find a way to increase the existing capital adequacy requirements, based on an assessment of inherent risks. The required capital should increase when a financial institution witnesses above average growth of credit expansion and leverage. In general the issuance of debt should not increase faster than nominal GDP. With regulation that keeps the solvency of financial institutions at a proportionate level we prevent countries 1 Learning about failure: bankruptcy, firm age and the resource-based view, S. Thornhill & R. Amit, Vol. 14, No. 5, September-October 2003, p. 497-509 2 Too important to fail too important to ignore, House of commons: Treasury Committee, Vol. 1, 22 March 2010 3 The bank bailout cost US taxpayers nothing? Think again, M. Herbst, May 2013 4 These loans were called NINJA loans, which can be considered as a kind of speculation since the borrowers could not made the repayment when the property didnt appreciate in value
- 3. Gideon Joshua Smid (198382) Int. Financial Crisis 14 november 2016, Krakow 3 息 G.J.Smid were credit expansion happens to live beyond their means. Secondly, there should be proper regulation in place on issuing over-the-counter (OTC) credit derivatives. Strict rules on the OTC credit derivatives market should lead to more transparency and less sensitivity of these instruments to systematic risk. The main problem of these instruments was not only the opaqueess of them, a critical thinking error led to fueling of the credit bubble. Between 2000 and 2006, nominal global issuance of credit instruments rose twelvefold to $3.000 billion a year from $250 billion.5 There was a wrong assumption that the process of slicing and dicing debt with use of these instruments made the financial system more stable. But on the contrary, the spreading of credit defaults among millions of investors rather than concentrated in particular banks didnt made it easier for the system to absorb shocks at all, it caused a domino effect of defaults. Besides the massive scale, these OTC credit derivatives required in-depth knowledge of their sophisticated structure. The pay- off information was often incomprehensible and/or inaccessible to normal investors.6 This means that millions of investors were buying something they didnt understood and they therefore werent able to make a proper risk/return calculation on their investment. Regulators have to find a way to increase the clearing requirements to provide risk mitigation and price transparency. With use of a central clearing system a chain reaction of defaults should be prevented when the next crisis hits us. There should be a clearing house standing in the middle of each trade. A central counterparty to the trade can guarantee financial performance of the contract by ensuring that each clearing member has enough funds on deposit to cover their risk. A clearing system should be designed to absorbs shocks and prevent a domino effect of defaults. An intrigiung empirical fact was that the complex assets have been traded at a premium, rather than at a discount leading to the crisis. This is inconsistent with the standard asset- pricing models, such models predict that investors unable to comprehend the nature of an asset would require a discount in the price, rather than a premium.7 Pricing of these products were made according to a given rating which gives a risk indication. Rating of these derivatives brings us to the last point, regulating of the credit rating agencies. 5 How it began, G. Tett, August 2008 6 Understanding these products require wading through its prospectus and disclosure documents which are hundreds of pages long and filled with technical jargon 7 Opacity in financial markets, R. C. Small, October 2014
- 4. Gideon Joshua Smid (198382) Int. Financial Crisis 14 november 2016, Krakow 4 息 G.J.Smid Thirdly, the credit valuation should be regulated, a main disbelief during the crisis was the assumption of investors that credit rating agencies offered an easy and cost-effective compass to navigate. Investors bought complex securities they barely understood based on the ratings given by credit rating agencies. There are three reasons that make them (solely) an unreliable source of information in making investment decisions. The biggest problem might be that the private companies that evaluate large debtors and the financial instruments those debtors issue are just three big firms. Moodys, Standard & Poors and Fitch Group hold a collective global market share of 95%.8 This shows that there is not much competition in the ratings market which makes it an oligopoly. A second problem was the revenue from the ratings business is directly proportional to the amount of credit issuance. Additionally, they received pressure from banks to give a better rating since this would allow banks to sell more of this particular product.9 UBS said it would drop Fitch from deals because of its higher stress criteria as opposed to the other agencies. US investigations found that Wall Street firms such as UBS, Bear Stearns, Citigroup, Merrill Lynch, JPMorgan and Goldman Sachs persuaded rating agencies to make favourable changes to their criteria.10 The last problem is the fact that if we look back to historic ratings and their given outlooks than agencies werent able to detect near-defaults, a bankruptcy or other financial disasters. They usually downgraded the firm or financial instrument just before (or even after) a bankruptcy. Conflicts of interest, lack of transparency and lack of competition among rating agencies contributed to the overvaluation of many mortgage backed instruments prior to the credit crisis. The solution should be to nationalize the credit rating agencies to prevent conflict of interest and increase transparency in rating companies or financial products of companies that employ them. Written by Gideon Joshua Smid (198382) for the course International Financial Crisis 8 What Role Did Credit Rating Agencies Play in the Credit Crisis?, A. J. Bahena, March 2010 9 Rating agencies were pressured to give triple-A ratings since pension funds could only buy the safest securities 10 Bankers Brought Rating Agencies To Their Knees On Tobacco Bonds, C. Podkul, December 2014