This has revealed the need to rethink fundamentally how financial systems are regulated and managed. The current implicit view behind economic models is that markets and economies are inherently stable, so by design, offer no immediate handle on how to think about or deal with a major systemic crisis. This dissertation aims to explore different policies and the extent to which they can act as tools to prevent financial crises. This includes current debates revolving around financial sector reforms as well as the key areas for policy action to reduce the risk of crises and address the weaknesses in the current regulatory and policy frameworks.
Could the Financial Crisis Have Been Avoided?
Although a number of developments helped trigger the 2007 financial crash, the most prominent one was the the prospect of significant losses on residential mortgage loans to subprime borrowers that became apparent shortly after house prices began to decline. Along with the structural weaknesses in the financial system, regulation as well as supervision, these triggers help propagate and amplify the initial shocks of the 2007 financial crisis. Following the inadequate regulation of financial innovation, a shadow banking system of structured vehicles was invented. As the shadow banking system constituted of institutions that did not take deposits, they were not thought to be susceptible to a run and were not regulated as tightly as banks. This resulted in the creation of overly complex credit products like the structured investment vehicle, a legal entity created by the banks to sell loans repackaged as bonds with high credit ratings whose assets were often securitised loans that turned out to be much riskier and less valuable than expected.
In the final report by the Financial Crisis Inquiry Commission, the panel determined that the crisis could have been avoided as there had been numerous warning signs that were ignored, among them: an explosion in risky subprime mortgage lending, an unsustainable rise in housing prices, widespread reports of unscrupulous lending practices, steep increases in homeowners’ mortgage debt and a spike in Wall Street firms’ trading activities, especially in high risk financial products. The report also called out the Bush and Clinton administrations, the current and previous Federal Reserve chairmen, and Treasury Secretary Timothy Geithner for allowing the crisis to happen and criticised bankers who got rich by creating trillions of dollars in risky investments (Financial Crisis Inquiry Commission, 2011). However, the conclusion was only supported by the 6 Democrats and was dissented by 4 Republicans on the panel, suggesting that the findings may have been affected by partisan politics and hence, may not be representative of the full situation.
Policy Options to Prevent Financial Crises
According to modern economic theory, information asymmetries and financial market failures are central in explaining macroeconomic fluctuations and financial crises (Estrada, 2011). As lenders know less than borrowers about the use of their funds and cannot compel borrowers to act in the lenders’ best interests, lenders can panic and withdraw their funds when they perceive increased risks, in the absence of adequate public regulation and safeguards. That can trigger much wider financial crises, with spiraling real-sector effects. Properly regulating the financial system is not an easy mission, especially if the underlying intention is to prevent financial crises. In order to mitigate the risks of another wide financial crisis, research has led me to identify three possible options that can be used for this purpose:
The Role of Monetary Policy
Monetary policy is the policy laid down by the central bank, involving management of money supply and interest rates and is the demand side economic policy used by the government of a country to achieve macroeconomic objectives like inflation, consumption, growth and liquidity (The Economic Times, 2017). One of the main lessons of the crisis is that central banks cannot simply neglect asset price developments on the tacit understanding that no matter how large and unsustainable price trends might become, they will be able to intervene in the aftermath of a crash to sweep up the pieces. The crisis has shown how costly this understanding can be in terms of, first, distorting the incentives of asset market participants in the boom phase and, second, tolerating the build-up of financial imbalances that can grow so large that their eventual unwinding is close to impossible to tackle with the conventional tools of monetary policy after a crisis.
Before the 2008 financial crisis, the common view was that a central bank should not react to asset price movements, except to the extent that they affect forecasts for inflation and the output gap (Munoz and Schmidt-Hebbel, 2012). They would instead stand ready to respond if and when a collapse in the prices of some assets threatened its ability to meet its policy mandates. In the aftermath of the crisis, there are increasing calls for central banks to be more proactive in responding to signs that an asset bubble may have emerged. This notion is often described as an imperative to “lean against the wind”, meaning that the central bank should act to lower asset prices that, by historical standards, seem unusually high (Gourio, Kashyap and Sim, 2017).
To contribute to financial stability, the first idea is that monetary policy should attempt to directly control financial booms that may lead to a crisis. Given the relationship between relevant interest rates and asset prices, advocators of this strategy argue that central banks can raise their policy interest rate to prick asset bubbles (De Grauwe, Mayer and Lannoo, 2008). To do this, central banks need a sufficiently broad and reliable strategic framework that can analyse and detect risks to price stability in a timely fashion. This strategic framework should include indicators that can signal macroeconomic and financial imbalances when they are forming. For example, when an unsustainable asset boom is inflating, fuelled by excess credit creation, the strategic framework should encourage the central bank to “lean against the wind” of financial exuberance. By doing this, the central bank would be implementing a more restrictive monetary policy stance than one they would implement in less perturbed financial conditions.
In this respect, there is also a conviction growing within the central banking community that comprehensive monetary policy strategies that include a prominent role for money and credit considerations are better suited to “lean against the wind” (De Grauwe, Mayer and Lannoo, 2008). By giving more prominence to money and credit in their strategy, central banks can better identify the emergence of medium-term risks to macroeconomic stability that result from imbalances in both domestic and global markets. By incorporating money and credit conditions in their policy in a systematic way, central b
anks can adopt a somewhat tighter policy stance in the face of an inflating asset market than they would otherwise pursue if they had been confronted with a similar macroeconomic outlook under more normal asset market conditions. However, the current economic structure has developed and changed since the paper was published 10 years ago, so the policy of “leaning against the wind” that may have been effective in the past, may not be as effective in the present day.
Among the disadvantages of using monetary policy to control financial risk is the possibility that this attempt may easily enter into conflict with other goals already entrusted to policymakers. This is because monetary policy as a tool is too blunt to prick bubbles effectively (Evans, 2009). For example, monetary policy cannot be targeted precisely, and will affect other financial and macroeconomic variables beyond just the set of asset prices in question. This means that the interest rate increase necessary to “lean against” a bubble may be so large as to exert a negative effect on output as the general level of prices may fall drastically in the long run (Stark, 2009). The possible conflict in the pursuit of the goals, in turn, may lead to a lack of accountability, since deviations from one goal could be justified in terms of the pursuit of other goals. More importantly, perhaps, is the fact that using monetary policy to contain asset bubbles can be interpreted as a commitment to smoothing out asset price fluctuations, thereby dampening market signals and creating moral hazard. In light of the challenges involved, we can see that monetary policy may not be suited for directly abating bubbles, and should therefore be focused on the primary goal of pursuing price stability..
At the same time, central banks should not underestimate the potency of monetary policy. It is true that in most cases a small change in the policy rate may not be sufficient to slow down those asset price bubbles that develop on the false expectation of very large future capital gains. However, recent research suggests that there are other channels through which changes in interest rates can affect asset prices. The first is the profitability of financial institutions that systematically borrow short and lend long (Gourio, Kashyap and Sim, 2017). These leveraged institutions are credit companies that borrow by issuing short term liabilities and use the proceeds of their borrowing to lend over the longer term, or to purchase assets that have a longer maturity. They use their capital as a partial guarantee for their business, with a larger proportion of their lending being financed by borrowing. Confronted with even marginal increase in the short-term borrowing costs, due to the increase in the policy rate, these institutions are forced to to borrow less and pay back their previous debt because the thin margins from which they profit would become even thinner or negative (Gourio, Kashyap and Sim, 2017). In doing so, they would probably have to sell the assets that they had purchased on the expectations of future price gains. In the end, the deleveraging process triggered by the policy induced restriction would ultimately exert a dampening effect on asset price growth.
Regulation is a rule or directive made and maintained by an authority. In the financial sector, it is a truism that financial regulation usually evolves most in response to crises (Richardson, 2012). Considering credit rating agencies, which were central participants in the global financial crisis, as a first example of how regulatory actions and inaction helped trigger the crisis, mortgage companies routinely provided loans to borrowers with little ability to repay those debts because they earned fees for each loan and they could sell those loans to investment banks and other financial institutions. Investment banks and other financial institutions then gobbled up those mortgages because they earned fees for packaging the mortgages into new securities and they could sell those new mortgage-backed securities (MBSs) to other financial institutions, including banks, insurance companies, and pension funds around the world (Richardson, 2012). These other financial institutions bought the MBSs because credit rating agencies said they were safe and by fuelling the demand for MBS and related securities, credit rating agencies encouraged a broad array of financial institutions to make the poor investments that ultimately toppled the global financial system. The 2008 financial crisis had exposed the weaknesses of the archaic and fragmented financial regulatory system. Financial institutions had exploited the crevices between regulatory agencies and no agency had overall responsibility for monitoring financial stability (Wessel, 2016). For example, even when risks were noticed, inconsistent mandates interfered with effective response. Thus, a new regulatory framework has to be developed to enhance the resilience of the global financial system while at the same time not jeopardizing the financial system’s flexibility and ability to fully support innovation and growth of the world economy.
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