EXPLAIN THE MAJOR COUSES OF FINANCIAL CRISIS (GLOBAL)

INTRODUCTION

The 2007-09 global financial crisis has been a painful reminder of the multifaceted nature of crises. They hit small and large countries as well as poor and rich ones. As fittingly described by Reinhart and Rogoff (2009a), “financial crises are an equal opportunity menace.”

They can have domestic or external origins, and stem from private or public sectors. They come in different shapes and sizes, evolve over time into different forms, and can rapidly spread across borders. They often require immediate and comprehensive policy responses, call for major changes in financial sector and fiscal policies, and can necessitate global coordination of policies.

The widespread impact of the latest global financial crisis underlines the importance of having a solid understanding of crises. As the latest episode has vividly showed, the implications of financial turmoil can be substantial and greatly affect the conduct of economic and financial policies. A thorough analysis of the consequences of and best responses to crises has become an integral part of current policy debates as the lingering effects of the latest crisis are still being felt around the world. This paper provides a selected survey of the literature on financial crises.

Crises are, at a certain level, extreme manifestations of the interactions between the financial sector and the real economy. As such, understanding financial crises requires an understanding of macro-financial linkages, a truly complex challenge in itself. The objective of this paper is more modest: it presents a focused survey considering three specific questions. First, what are the main factors explaining financial crises? Second, what are the major types of financial crises? Third, what are the real and financial sector implications of crises? The paper also briefly reviews the literature on the prediction of crises and the evolution of early warning models.

Section II reviews the main factors explaining financial crises. A financial crisis is often an amalgam of events, including substantial changes in credit volume and asset prices, severe disruptions in financial intermediation, notably the supply of external financing, large scale balance sheet problems, and the need for large scale government support.

While these events can be driven by a variety of factors, financial crises often are preceded by asset and credit booms that then turn into busts. As such, many theories focusing on the sources of financial crises have recognized the importance of sharp movements in asset and credit markets. In light of this, this section briefly reviews theoretical and empirical studies analyzing the developments in credit and asset markets around financial crises.

MAJOR COUSES OF FINANCIAL CRISIS IN THE WORLD

Mark-to-market accounting. In the early 1990s, the Securities and Exchange Commission and the Financial Accounting Standards Board started requiring public companies to value their assets at market value as opposed to historical cost a practice that had been discredited and abandoned during the Great Depression. This pushed virtually every bank in the country into insolvency from an accounting standpoint when the credit markets seized in 2008 and 2009, thereby making it impossible to value assets.

Ratings agencies. The financial crisis couldn't have happened if the three ratings agencies Standard & Poor's, Fitch, and Moody's hadn't classified subprime securities as investment grade. Part of this was incompetence. Part of it stemmed from a conflict of interest, as the ratings agencies were paid by issuers to rate the securities.

Infighting among financial regulators. Since its inception in 1934, the FDIC has been the most robust bank regulator in the country the others have, at one time or another, included the Office of the Comptroller of the Currency, the Federal Reserve, the Office of Thrift Supervision, the Securities and Exchange Commission, the Federal Savings and Loan Insurance Corporation, and an assortment of state regulatory agencies. But thanks to infighting among regulators, the FDIC was effectively excluded from examining savings and investment banks within the OTS's and SEC's primary jurisdiction between 1993 and 2004. Not coincidentally, those were the firms that ended up wreaking the most havoc.

Securitization of loans. Banks traditionally retained most of the loans that they originated. Doing so gave lenders incentive, albeit imperfectly, to underwrite loans that had only a small chance of defaulting. That approach went by the wayside, however, with the introduction and proliferation of securitization. Because the originating bank doesn't hold securitized loans, there is less incentive to closely monitor the quality of underwriting standards.

Credit default swaps. These are fancy financial instruments JPMorgan Chase developed in the 1990s that allowed banks and other institutional investors to insure against loan defaults. This situation led many people in the financial industry to proclaim an end to credit risk. The problem, of course, is that credit risk was just replaced by counterparty risk, as companies such as American International Group accumulated far more liability than they could ever hope to cover.

Economic ideology. As the 1970s and '80s progressed, a growing cohort of economists began proselytizing about the omniscience of unrestrained free markets. This talk fueled the deregulatory fervor coursing through the economy at the time, and it led to the belief that, among other things, there should be no regulatory body overseeing credit default swaps.

Greed. The desire to get rich isn't a bad thing from an economic standpoint. I'd even go so far as to say that it's necessary to fuel economic growth. But greed becomes bad when it's taken to the extreme. And that's what happened in the lead-up to the crisis. Homeowners wanted to get rich quick by flipping real estate. Mortgage originators went to great lengths, legal and otherwise, to maximize loan volumes. Home appraisers did the same. Bankers were paid absurd amounts of money to securitize toxic subprime mortgages. Rating agencies raked in profits by classifying otherwise toxic securities as investment-grade. Regulators were focused on getting a bigger paycheck in the private sector. And politicians sought to gain popularity by forcing banks to lend money to their un-creditworthy constituents.

Fraud. While very few financiers have been prosecuted for their role in the financial crisis, don't interpret that to mean that they didn't commit fraud. Indeed, the evidence is overwhelming that firms up and down Wall Street knowingly securitized and sold toxic mortgage-backed securities to institutional investors, including insurance companies, pension funds, university endowments, and sovereign wealth funds, among others.

Short-term investment horizons. In the lead-up to the crisis, analysts and investors castigated well-run firms such as JPMorgan Chase and Wells Fargo for not following their peers' lead into the riskiest types of subprime mortgages, securities, and derivatives. Meanwhile, the firms that succumbed to the siren song of a quick profit Citigroup, for instance -- were the first to fail when the house of cards came tumbling down.

Politics. Since the 1980s, bankers and politicians have formed an uneasy alliance. By conditioning the approval of bank mergers on the Community Reinvestment Act, politicians from both sides of the aisle have effectively blackmailed banks into providing loans to un-creditworthy borrowers. While banks and institutional investors absorbed the risks, politicians trumpeted their role in expanding the American dream of homeownership.

Off-balance-sheet risk. Why did investors allow financial firms to assume so much risk? The answer is that no one knew what they were up to because most of the risky assets weren't reflected on their balance sheets. They had been securitized and sold off to institutional investors, albeit with residual liability stemming from warranties that accompanied the sales, or were corralled in so-called special-purposes entities, which are independent trusts that the banks established and administered. Suffice it to say that all of the residual liability flooded back onto the banks' balance sheets only after you-know-what hit the fan.

Bad economic assumptions. As moronic as it seems in hindsight, it was generally assumed before the crisis that home prices would never decline simultaneously on a nationwide basis. This belief led underwriters of and investors in mortgage-backed securities to believe that geographically diversified pools of mortgages were essentially risk-free when they obviously were not.

High oil prices. Beginning with the twin oil embargoes of the 1970s, oil-producing countries began accumulating massive reserves of so-called petrodollars which were then recycled back into the U.S. financial system. This situation pressured banks and other types of financial firms to put the money to work in increasingly marginal ways, such as subprime mortgages.

A broken international monetary system. One of the most underappreciated causes of the financial crisis was the trade imbalance between the developing and developed worlds. By keeping their currencies artificially depressed versus the U.S. dollar -- which is done by buying dollars with newly printed native currencies -- export-oriented nations such as China accumulated massive reserves of dollars. Like the petrodollars of the 1980s and '90s, these funds were then recycled back into the U.S. financial system. To put this money to use, financial firms had little choice but to lower underwriting standards and thereby grow the pool of potential borrowers.

The rescue of Bear Stearns. In March 2008, the Federal Reserve saved Bear Stearns with a last-minute $30 billion loan supplied through JPMorgan Chase. As opposed to failing, the nation's fifth-largest investment bank at the time ended up being sold for $10 a share. The problem with the rescue, however, was that it reduced the incentive on Lehman Brothers CEO Dick Fuld to find a private-sector solution to its even bigger, and eventually fatal, problems. In hindsight, it seems relatively clear that the Fed should have either let Bear Stearns fail or, much more preferably, bailed both of them out.

Lehman Brothers' bankruptcy. Allowing Lehman Brothers to fail was a mistake of epic proportions. History clearly demonstrates that the downfall of a major money-center bank -- be it a commercial or investment bank -- almost always triggers wide-scale financial panics. In 1873, it was Jay Cooke & Company. In 1884, it was Grant & Ward. In 1907, it was the Knickerbocker Trust Company. I could go on and on with examples. The point being, despite the admittedly unsavory thought of bailing out someone as aggressively offensive as Dick Fuld, it would have been a small price to pay to avoid the subsequent economic carnage.

The "Greenspan put." For two decades following the stock market crash of 1987, the Federal Reserve, guided by then-Chairman Alan Greenspan, lowered interest rates after every major financial shock, a trend that became known as the Greenspan put. It was this strategy, intended to stop financial shocks from transforming into economic downturns, that led the central bank to drop the Fed funds rate after the 9/11 terrorist attacks. And it was this drop that provided the oxygen, if you will, to inflate the housing bubble.

Monetary policy from 2004 to 2006. Just as low interest rates led to the housing bubble, the Fed's policy of raising rates from 2004 to 2006 eventually caused it to burst.

Basel II bank capital rules. Any time an economy experiences a severe financial shock, one of the biggest problems is that undercapitalized banks will be rendered insolvent. That's true in part because of the absurd application of mark-to-market accounting during periods of acute stress in the credit markets, and in part because banks are highly leveraged, meaning that they hold only a small slice of capital relative to their assets. The so-called Basel II capital rules, which took effect in 2004, accentuated this reality. The rules allowed banks to substitute subordinated debt and convertible preferred stock in the place of tangible common equity. The net result was that tangible common equity at certain major U.S. banks declined to less than 4% on the eve of the crisis.

Fannie Mae and Freddie Mac. Much has been written about the role Fannie Mae and Freddie Mac played in the lead-up to the financial crisis, so I won't dwell on it here. In short, the problem was that these two quasi-public corporations became so focused on growth at all costs that they abandoned any semblance of prudent risk management. Doing so allowed mortgage-brokers-cum-criminal enterprises such as Countrywide Financial and Ameriquest Mortgage to stuff the government-sponsored entities to the gills with shoddily originated subprime mortgages.

The failure of IndyMac Bank. The $32 billion IndyMac Bank was the first major depository institution -- it was technically a thrift as opposed to a commercial bank -- to fail during the crisis when the Office of Thrift Supervision seized it on July 11, 2008. In a situation like this, the FDIC traditionally insures all depositors and creditors against losses, irrespective of the insurance limit. But in IndyMac's case, it didn't. The FDIC chose instead to only guarantee deposits up to $100,000. Doing so sent a shockwave of fear throughout the financial markets and played a leading role two months later in the debilitating run on Washington Mutual.

The failure of Washington Mutual. By the time Washington Mutual failed in September 2008, the FDIC had recognized its mistake in dealing with IndyMac Bank. But this time around, while the FDIC covered all deposits irrespective of the insurance limit, it allowed $20 billion of WaMu's bonds to default. After that, banks found it difficult, and in many cases impossible, to raise capital from anyone other than the U.S. government.

Pro-cyclical regulation of loan loss reserves. The more one learns about the causes of the financial crisis, the more one appreciates how incompetent the Securities and Exchange Commission is when it comes to regulating financial institutions. In 1999, the SEC brought an enforcement action against SunTrust Banks, charging it with manipulating its earnings by creating excessive loan loss reserves. At the time, default rates were extremely low, leading the SEC to conclude that SunTrust shouldn't be reserving for future losses. Banks took note and no longer set aside reserves until specific future losses are likely and can be reasonably estimated -- by which point, of course, the proverbial cat is already out of the bag.

Shadow banking. While hundreds of traditional banks failed in the wake of the financial crisis, they share little responsibility for what actually happened. That's because shadow banks -- i.e., investment banks and thrifts that didn't fall under the primary regulatory purview of the Federal Reserve, FDIC, or, to a lesser extent, the Office of the Comptroller of the Currency -- caused most of the damage. Here's Richard Kovacevich, the former chairman and CEO of Wells Fargo, addressing this point in a speech at the end of last year:

THE MAJOR COUSES OF FINANCIAL CRISIS IN NIGERIA

Nigerian financial crisis has emphasised causal factors which can be classified as remote causes, but silent on the immediate cause that triggered the crisis. Thus, the need is brought to the fore for identification of the specific causal factor that triggered commencement of events that culminated in the Nigerian financial crisis; especially, as Bris has cautioned and emphasised the need to “wonder what the cause of the next crisis will be”. This way, policy makers and the regulatory authority in Nigeria, would be placed in a position to proactively formulate necessary policies that are designed to mitigate or avert occurrence of future banking crisis.

Ø  zero equity mortgage that enabled acquisition of mortgages by low income families;

Ø  A change in the regulatory framework that gave rise to the shadow banking system;

Ø  Acceleration of banks’ off-balance sheet activities, enabled by Basel 11 accord; and

Ø  Changes in regulation that allowed investment banks to manage their risks.

Causes of the 2008/2009 Nigerian Financial Crisis

The ripple effects of the 2007 global financial crisis, on the Nigerian financial system, are specified in Soludo, in the following terms:

Ø  There was collapse in the prices of commodities, especially crude oil which is the mainstay of Nigeria’s economy; and this resulted to a contraction of revenue to the federal government.

Ø  There was decline in capital inflows to the economy, followed by de-accumulation of foreign reserves and pressure on exchange rates.

Ø  The global financial crunch impacted negatively on availability of foreign trade finances for Nigerian banks; and credit lines became unavailable.

Ø  There was a downturn in capital market operations, which witnessed divestment by foreign investors.

Ø  There was manifestation of counter party risks vis-a-vis external reserves; however, the author added that, CBN took prompt measures to safeguard the reserves; and that Nigerian banks were sufficiently robust to withstand the shocks.

It is conjectured that the trigger of the 2008/2009 financial crash in Nigeria, lies encapsulated and hidden in the statement by Sanusi thatone of the causes of Nigerian banking crisis is macro-economic instability, caused by large and sudden capital inflows. Additionally, Soludo avers that there was decline in capital inflows to the economy, followed by de-accumulation of foreign reserves and pressure on exchange rates. Thus, as macro-economic instability is inextricably intertwined with financial instability, and consequent upon the position in Mishkin that capital flows can fuel a lending boom which leads to excessive risk-taking on the part of banks; and the position in UNDP that PCF is highly volatile, capable of creating a financial shock in the event of sudden reversal or sharp decline in capital inflows, this conceptual framework is guided to a critical examination of the Nigerian banking crisis from the viewpoint of Minsky’s financial instability hypothesis (see 2.3 above); and the analysis in McCulley, on application of the Minsky Typology, is relevant. The analysis shows how Minsky’s hypothesis translates to the subprime mortgage crisis using three types of borrowing categories of the US mortgage market. The first is the hedge borrower, who has a mortgage loan and repaying both principal and interest.

References

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Financial Crises, Consequences, and Policy Responses, forthcoming.

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