Literature Review The literature that will follow will include the reasons for the global financial crisis and what steps the government is taking to overcome or recover from the crisis. One of the main reasons emphasized in the following text for the crisis is lack of effective regulations. Moreover the most important financial alteration that various committee’s around the world are taking is strengthening the regulatory requirements on the financial institutions. Hereafter it could be settled that government intervention could have played a huge role in avoiding the crisis.
Many countries around the world have to decide whether to regulate or not to regulate their accounting standards. Supporters of regulation usually state that the free market notion states that accounting information is like an economic good so it is best to leave the markets to decide what and how much information is needed. This will help achieve efficient market system, however this kind of a system exists only in theory and not in reality, and so then what is the point of a free market system when it cannot be efficient? (Y. Hong, 2007)
The rewards of free market system are realized only when it is executed in isolation. But in reality, markets cannot be left completely on its own and some regulation or government intervention is required. Government intervention even at its minimum will not be able to achieve efficient markets and thus it is better to have a well regulated system. Free market system has led to market failures that have had major adverse effects globally in the past. On the contrary, planned economies have also hampered innovation and productivity like China and thus some market system should be there.
Y. Hong (2007) in the article mentions the Australian accounting regulations and describes them as very stringent resulting in negative consequences. Australian reporting entities are faced with an increasing volume and complexity of accounting and reporting regulation. This regulation is unnecessary, and accounting policy choice and the provision of information should be left to the market. It is important to have a balance in the regulatory system where the rules are not too strict as to govern every possible action resulting in inefficiency and also where there should be certain amount of regulations to discipline the financial sector of the economy.
The literature discussed above clearly mentions a brief comparison of the free market vs. planned system. Although we have seen a trend of moving towards free market system, countries have realized that even in that system the intervention of government is necessary. We will analyze further in the light of case studies why government intervention is necessary for a well-functioning economy.
The Global financial crisis of 2007, shook the world, and is being labeled as the Great Recession. The main reason for the global financial crisis to occur was due to the insolvent and illiquid United States banking system. This weak banking system resulted in the crash of major financial institutions of the economy. The consequences were enormous ranging from the bailout of banks by national governments to downturns in stock markets. These effects did not stay within the boundaries of United States; rather, in just a matter of one year, they travelled around the world, causing deep recession in various big economies. Many economists say that this was the worst financial crisis since the Great Depression of the 1930s.
One of the immediate consequences of the weak banking system resulted in Sub Prime Mortgage crisis which was the major trigger in the Global Financial Crisis. The housing sector in United States peaked in 2005-06. These high prices led to various borrowers to expect that they would easily be able to refinance. Moreover, the banking system in United States provided housing loans on favorable conditions and incentives. What happened in reality was that the interest rates began to rise and thus it caused a fall in the prices of real estate. In June 2006, sales of existing single-family homes were 9% below their year-earlier level, sales of new homes were down 15% and framing lumber prices were down 19% (Lahart, Justin, 2007). This housing bubble eventually crashed causing major difficulty in paying back loans for the borrowers and resulting in a large number of defaults.
The reasons for the housing boom was a result of low interest rates and large inflows of foreign funds creating easy credit conditions encouraging debt financed consumption. The banks made the loans very easy to obtain. This is where the financial institutions were not regulated stringently and required proper monitoring. Many derivatives deriving their value from real estate such as mortgage-backed securities (MBS) and collateralized debt obligations (CDO), increased sharply. As Jack Welch quotes “Derivatives are the weapons of mass destruction” this indeed became true in the global financial crisis. Declining housing prices took with them the value deterioration of these derivative products as well. People defaulted largely because prices of housing fell below the mortgage loans. This resulted in an epidemic where defaults and losses on other loan types also increased significantly as the crisis expanded from the housing market to other parts of the economy. (Lahart, Justin, 2007)
Apart from subprime mortgage crisis, there were other reasons for the financial crisis. The first reason was again the result of lack of stringent regulations where the financial institutions and other investors were excessively optimistic about asset prices and risk, calmed by a low interest rate environment and changes in the financial landscape that masked the extent of leverage and made these risks more opaque and interconnected. (Jaime Caruana, 2009).
The U.S. financial regulatory framework has the following unfortunate characteristics:
Highly fragmented
Ineffective
And hence due to these problems the current crisis has demonstrated that this dysfunctional system comes with a very high cost. (Committee of Capital Market regulation, 2009)
What further fuelled this weakness was the absence of market oversight and supervision or interference by regulatory authorities to curb the excessive risk taking by these institutions. They failed to realize the dependency of these activities of regulated and non-regulated institutions and markets. This was due in part to fragmented regulatory structures and legal constraints on information sharing. (Jaime Caruana, 2009)
Fixing the global financial crisis requires government intervention and support. There are various numbers of reasons which requires better enforcement of regulations. There is an urgent need for the central bank to provide or inject liquidity in to the system. It is important to understand the monetary policy mechanism and how it is transmitted into various economic indicators. In many countries, however, this liquidity may seem difficult since banks are faced with outflows of capital and exchange rate pressures. (Committee of Capital Market regulation, 2009)
Two most important things to be done:
Enhancing sound regulation by expanding the regulatory perimeter
Strengthening transparency in valuation and accounting, compensation systems and risk management.
The global financial crisis is the result of—not so much a lack of regulation as—the lack of effective regulation. Although the banks have been regulated heavily in the past, they have not been effectively regulated. There is a dire need for financial reforms and government intervention is necessary for recovery of the global recession. While more regulation is certainly needed in some areas, the goal of the regulatory authorities must be to make the present regulatory regime far more effective than it currently is. (Committee of Capital Market regulation, 2009)
The report given by the committee focuses specifically on regulatory coverage with respect to hedge funds and private equity. The proposal given for carrying our regulatory coverage is that the hedge funds and any other financial institutions that engage in hedge funds should keep regulators informed on an ongoing basis of their activities and leverage. Although the private equity funds are not a threat to financial institutions but since these firms are large, it is vital to keep them under the regulatory umbrella in order to avoid any unforeseen losses. Bringing them into the regulatory regime will require monitoring and periodic reviews of their information. The committee also highlights that ill-conceived restrictions on the ability of private equity firms to acquire banks should be removed, not just relaxed. This is an instance where regulation is preventing a solution, not offering one. (Committee of Capital Market regulation, 2009)
In addition to hedge funds and private equity, the committee also addresses the need to improve the regulation of money market mutual funds (MMMFs), which comprise approximately $3.8 trillion of the more than $9 trillion mutual fund industry. The MMMF serves as an investment as well as helps in cash management thus playing an important role in our financial system. Triggered by the “breaking of the buck” of the Reserve Primary Fund, which was largely because of the impact of the Lehman Brothers bankruptcy on MMMF holdings of that company’s commercial paper, a run ensued on MMMFs. This run had to be halted by the Fed’s injection of liquidity into the funds, e.g., by financing the purchase of MMMF sales of asset-backed commercial paper to fund redemptions, and federal guarantees of existing investments. Hence these types of investments also added to the financial crisis and require restriction to regulate the financial sector. (Committee of Capital Market regulation, 2009)
Financial reforms should be based on fundamental principles rather than political interest of the involved parties. Regulatory coverage is very important in order to have effective reform based system. It is extremely important to focus on systematic risk when overcoming the crisis. This risk results in the collapse of the entire industry or economy as it happened in the financial crisis which extended globally affecting the biggest economies of the world. When a systemically important institution is in danger of failure, and its failure could trigger a chain reaction of other failures and hence there may be no alternative other than to inject some public money into the institution.
This is how the central bank saved many large banks during the crisis. But the amount of these injections has been significantly increased by numerous weaknesses in the current regulatory system. The Federal Reserve (Fed) financed the acquisition of Bear Stearns through a $29 billion loan, and the Fed and the Treasury have financed the survival of AIG with assistance amounting to more than $180 billion, largely because of the fear of what would have happened if such institutions had gone into bankruptcy. (Committee of Capital Market regulation, 2009)
The Committee believes there is ample room for improvement in the containment of systemic risk.