Tag Archives: Financial Crisis

Economy

Is London losing its status as world’s top financial center?

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Home to about 250 foreign banks, London is the world’s biggest center for foreign-exchange trading and cross-border bank lending and trades $1.4 trillion of interest derivatives daily, according to the Bank for International Settlements. It is also ranked as the world’s number one financial center by research firm Z/Yen Group Ltd.

London now risks losing its status as the world’s top financial center as the $360 trillion interest-rate fixing probe follows a series of market abuses by banks that eroded trust in a city already shrinking faster than rivals.

JPMorgan’s trading loss of at least $2 billion, the alleged $2.3 billion fraud at UBS and the investigation of at least a dozen banks including Barclays for rigging global interest rates all happened in London in the last year. AIG, Lehman Brothers and Bear Stearns & Co. all traded swaps in London that led to their bankruptcies or bailouts.

It seems to be that every big trading disaster are now happening in London! I wish that BOE, FSA, BBA and others take necessary steps soon to  fix these aberrations.

Economy

What does society expect from the financial sector?

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In the panel discussions at BIS, Basel, Switzerland Mr. José de Gregorio, Universidad de Chile and former Governor of the Central Bank of Chile remarked on the subject on 24 June 2012. I have based this post on his remarks.

The financial system must operate in order to fulfill its goals without threatening financial stability or imposing costs at the aggregate level. What society really demands from financial systems is quite difficult to define. Society is a collection of actors, with different interests and different needs. People want access to the financial system at fair conditions. Therefore it is useful to think of society as everyone who is not related directly to the financial industry or policy making.

The society expects safer and fairer financial systems. Unfortunately, the view that financial markets were big casinos, where the betting was done with other people’s money and gamblers walked away unpunished, is quite common around the world. Undoubtedly, financial intermediation is good, and a well functioning financial system is key to prosperity. It promotes economic growth by channeling investment funds from savers to borrowers. It is central to promoting entrepreneurship and to facilitating investment, including human capital accumulation. It provides financing to households in order to smooth consumption, and provides insurance. It provides safe and cheap means of payment.

What went wrong?

First and foremost, the crisis was caused by the irresponsible behavior of the financial industry. The structure of incentives was unsuitable. It led to excessive risk-taking without proper risk management. Compensation was heavily biased towards deal-making, regardless of the quality of the deals. Commissions and fees were a very important component of the compensation scheme. In the end, all that mattered was granting credit indiscriminately, maximizing packaging and selling securities, etc. This was at the foundation of the originate-and-distribute model of financial services, and served to increase leverage to unsustainable levels. Well, linking compensation to productivity is efficient, but the devil is in the details.

There was indifference in policy circles. None of the policy makers saw it coming, at least not with the intensity with which it arrived, which still persists. Markets should provide enough discipline to balance risk and return, but that was not exactly the case. The market functioned poorly.

What else may go wrong?

Financial systems in emerging markets escaped from the crisis due to some extent to prudent regulation, built on a history of recurrent crises. But perhaps it was also due to the fact that they are somewhat slow to adapt to financial innovation. Indeed, many issues, such as the use of derivatives by the banking industry, were being discussed in emerging markets on the eve of the crisis.

Not everything is bright in emerging markets. There are many challenges. One issue that has not been a problem so far, but presents potential risks, is the role of public banks. If public banks are prudent and avoid jumping on the bandwagon of optimism during the upturn this is good – they may even soften credit constraints during the downturn. However, public banks may also be an instrument to pay back supporters of politicians, and certainly this is unfair and inefficient. Public banks may also be subject to capture by the electoral cycle, or used as an instrument to implement industrial policy.

An issue that has been on the agenda in most countries is financial consumer protection. It is important, however, for consumer protection to form an integral part of the regulatory infrastructure in order to avoid inconsistencies among agencies and risks to depositors and overall financial stability in the name of protecting consumers. Consumer protection also has a high risk of being captured by the political cycle. This could be specially damaging in the financial system – and therefore every effort should be made to make the institutions safeguarding financial consumers autonomous and technical.

Today we have the opportunity to tackle the task of building a safer and fairer financial system, but we also have to avoid shortcuts that may end up rebuilding a weaker financial system.

Economy

The global financial crisis could have been avoided

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Raghuram Rajan, an Indian born professor at the University of Chicago’s Booth Graduate School of Business, predicted the crisis in 2005. He was the “Economic Counsellor and Director of Research” (Chief Economist) at the International Monetary Fund from September 2003 until January 2007. In 2003, he was also the inaugural recipient of the Fischer Black Prize awarded by the American Finance Association for contributions to the theory and practice of finance by an economist under age 40.

It was August 2005, at an annual gathering of high-powered economists at Jackson Hole, Wyo. – and that year they were honouring Alan Greenspan. Mr. Greenspan, a giant of 20th-century economic policy, was about to retire as Federal Reserve chairman after presiding over a historic period of economic growth.

Mr. Rajan chose that moment to deliver a paper called “Has Financial Development Made the World Riskier?” His answer was – Yes. Mr. Rajan quickly came under attack as an anti-market Luddite, wistful for old days of regulation. Many of the big names in Jackson Hole weren’t ready to hear the warning. Former Treasury Secretary Lawrence Summers, famous among economists for his blistering attacks, told the audience he found “the basic, slightly lead-eyed premise of [Mr. Rajan's] paper to be misguided.” Today, however, few are dismissing his ideas.

Incentives were horribly skewed in the financial sector, with workers reaping rich rewards for making money, but being only lightly penalized for losses, Mr. Rajan argued. That encouraged financial firms to invest in complex products with potentially big payoffs, which could on occasion fail spectacularly. He pointed to “credit-default swaps,” which act as insurance against bond defaults. He said insurers and others were generating big returns selling these swaps with the appearance of taking on little risk, even though the pain could be immense if defaults actually occurred.

Mr. Rajan also argued that because banks were holding a portion of the credit securities they created on their books, if those securities ran into trouble, the banking system itself would be at risk. Banks would lose confidence in one another, he said: “The interbank market could freeze up, and one could well have a full-blown financial crisis.” Two years later, that’s essentially what happened.

The problem is that in a boom everybody thinks they’re brilliant. Central bankers think they have skilfully delivered inflation-free growth; the finance sector thinks it is brilliantly making profits; home-owners think they have shrewdly timed the market; politicians don’t like to rock the boat. Naysayers are ignored and history is repeated!