The Global Financial Crisis - An In-depth Analysis

By M. Isi Eromosele

The massive financial instability that started in 2008 was, in the main, the result of lax monetary policy. Regulations compounded this error by allowing and encouraging excessive leverage and maturity transformation by banks.

Origins Of Current Global Crisis

The origins of the current global financial crisis can be linked to a global financial regime in which there has been no obligation to correct external payment imbalances since the breakdown of the Bretton Woods fixed exchange-rate system.

The official view in the United States was, and still is, that ever-larger current external deficits were the counterpart of a global savings glut, caused by the increase in the rate of savings of Asian countries that wanted to establish large currency reserve cushions against a repetition of the financial shocks of the late 1990s.

An alternative view emphasizes the autonomous role of declining savings rates and cheap credit to households in sustaining strong consumer spending in the United States throughout the1990s and 2000s despite scant income growth.

Given the role of the dollar as the main reserve currency, US monetary policy had a dominant role in governing global liquidity. Yet the Federal Reserve’s goals are purely domestic and it paid little or no attention to international transmission chains.

Thus, aggressive monetary expansion in the early 2000s following the end of the dot-com asset price bubble was accompanied by massive foreign-exchange interventions by Asian countries to resist the depreciation of the dollar.

This in turn led to huge official reserves investments by these countries in U.S. Treasury Securities that kept interest rates low, notably on long maturities and fed complacency at the Federal Reserve.

The financial flows necessary to finance US deficits led to a growing mismatch between

asset supply and demand, which was not visible as long as the financial system was willing to take the risk inherent in intermediating funds between Asian Central Banks and U.S. households.

The second main ingredient was a speculative bubble in a credit boom that led to unsustainable leverage. In an environment of apparently ever-increasing house prices, households were encouraged by their banks to borrow up to the full value of their property and to borrow more as soon as the value went up, without any regard to their ability to service the debt.

The third main ingredient was a speculative bubble in financial innovation. In financial markets, there is a constant game whereby banks and other agents innovate to circumvent regulation and boost returns by taking greater risks. Innovation accelerates when expected gains grow larger, that is when asset prices increase more rapidly.

One main innovation was the process of securitization, which led to increasingly complex ‘securitized’ pools of loans promising high returns with low risk, thanks to complex techniques of pooling and tranching of underlying financing instruments and complacent mathematical models for their evaluation.

As such, in the United States, ballooning mortgage loans to riskier borrowers provided the basis for an ever-larger inverted pyramid of structured products.

A parallel development was the rapid diffusion of an intermediation model,’ originate to distribute’, where loans were immediately resold to other investors and monitoring of underlying credit quality was increasingly overlooked under the collective delusion that risks had been transferred elsewhere or hedged.

As it turned out, counterparty risks were in effect concentrating with a few main players. Finally, there was an explosion of derivative contracts, equally used to hedge and to take open positions through synthetic instruments.

In hindsight, these developments have highlighted massive distortions in incentives and risk management arrangements within financial organizations. The key point is that the innovations described above were instrumental in amplifying the increase in leverage: by offloading from balance sheets risks borne by the originator of loans, by reducing capital requirements with risk mitigation techniques and by embedding leverage in the equity tranches of structured products.

Starting in 2003, financial intermediation started to grow much more rapidly than underlying credit to the world economy. Banks became increasingly interconnected by an intricate web of financing, investment and hedging operations that made it all but impossible to assess attendant risks independently.

When asset prices began to fall, these complex interconnections worked in reverse, bringing financial organizations down together and spreading panic among investors worldwide. The systemic implications of reckless lending, leverage and securitization came to full light.

Aftermath Of Global Financial Crisis

Since the crisis began in the sub-prime sector of the securitized US mortgage market, the first targets for regulation in the United States were the securitization process and the ratings agencies, which failed to spot excessive risk-taking.

In Europe, governments and parliaments have been even keener to put a brake on less-regulated financial activity, such as hedge funds and private equity, despite little evidence that they added to the turmoil.

An open question is whether once the destabilizing asymmetry in U.S. monetary policy and regulatory loopholes that allowed excessive leverage are corrected, is there still a need for separate measures to address systemic instability?

This question seems to take two different dimensions. On the one hand, various public and private reports on the financial crisis have argued that in the new globalized world of finance, the emergence of large complex organizations requires a separate layer of regulation to deal specifically with systemic risks deriving from their sheer size and particular functions.

Proposals for separate rules and oversight mechanisms to preserve systemic financial stability are already under consideration in Europe and the United States.

A fundamental difficulty with designing rules to target systemically relevant institutions is how precisely to define in practice their domain of application and how to do it without creating fresh incentives for regulatory arbitrage.

The problem is aggravated by the fact that systemic relevance may often relate to certain functions performed by financial institutions for example, acting as a main counterpart for derivative contracts rather than the institutions themselves and the fact that legal structures and business functions often do not coincide, notably in large complex financial conglomerates.

Specific safeguards may indeed be needed to preserve the integrity of clearing and settlement systems for securities; by and large this is the task entrusted to clearing platforms and central depository institutions.

There may be a need here to concentrate existing institutions at EU level and to ensure greater co-ordination and interoperability between these bodies across the main financial centers.

Insurance regulators should also be held responsible for ensuring that derivative contracts resembling insurance would not be written without adequate capital reserves and externally validated models to assess risk exposure.

On the whole, a new layer of systemic regulation appears unnecessary to the extent that systemic risk is mainly due to a destabilizing monetary policy regime. It would be sufficient to strictly ensure that monetary policy takes into account the macro-prudential dimension of financial stability.

Macro-prudential oversight would basically boil down to paying sufficient attention to asset price developments in monetary policy management.

M. Isi Eromosele is the President | Chief Executive Officer | Executive Creative Director of Oseme Group - Oseme Creative | Oseme Consulting | Oseme Finance

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