Economic/Financial Crises

Economic Forces at Work... "It happens that a liquidity crisis in a unit fractional reserve banking system is precisely the kind of event that trigger- and often has triggered- a chain reaction. And economic collapse often has the character of a cumulative process. Let it go beyond a certain point, and it will tend for a time to gain strength from its own development as its effects spread and return to intensify the process of collapse"-Milton Friedman (Monetary History of the US, 1867-1960, p 419).

FINANCIAL CRISES:

The resolution of a systemic financial crisis involves many policy choices ranging from macroeconomic (including monetary and fiscal policy) to microeconomic (including recapitalization of financial institutions, closure, capital adequacy rules and corporate governance requirements), with reforms varying in depth.

These choices involve tradeoffs, including the amount of government resources needed to resolve the crisis, the speed of recovery, and the recovery’s sustainability. Despite considerable analysis, these tradeoffs are not well known—an oversight that leads to conflicting policy advice and larger than necessary economic costs. Even less is known about the political economy factors that make governments choose certain policies. Policies enacted during crises importantly shape the financial sector and have important long-term impact on financial sector development.

Chronology for the major financial crises since 1980:

• 1980s: Latin American debt crisis, beginning in Mexico
• 1989-91: United States Savings & Loan crisis
• 1990s: Collapse of the Japanese asset price bubble
• 1992-3: Speculative attacks on currencies in the European Exchange Rate Mechanism
• 1994-5: 1994 economic crisis in Mexico: speculative attack and default on Mexican debt
• 1997-8: Asian Financial Crisis: devaluations and banking crises across Asia
• 1998: 1998 Russian financial crisis: devaluation of the ruble and default on Russian debt
• 2001-2: Argentine economic crisis (1999-2002): breakdown of banking system
• 2008: USA, Europe: spread of the U.S., US Credit Crisis.

Among other scandals, the sub-prime mortgage (credit) crisis resulted from the Ponzi Finance, Ponzi Finance Schemes (PFS). Mega-Crisis: US Credit Crisis resulted from Banks' Governance Failure. "Accounts preparers, standard-setters and auditors must all learn from the past year. It is clearly unacceptable that poor quality loans can be sliced, diced and parcelled up with an AAA sticker and overvalued on banks' balance sheets as a consequence".

According to the ACCA's policy paper, the principal source of the credit crunch is a failure in corporate governance at banks, which encouraged excessive short-term thinking and a blindness to risk.

Further contributory factors (secondary factors) were:

1. Over-complexity of financial products and lack of management understanding of the associated risks –including the fact that, currently, there is no genuine market for certain asset-backed securities
2. Over-dependence on debt and an assumption of a continuing low cost of capital environment
3. Scale of issuance of securities and the interconnectedness of financial institutions, especially between retail and investment banking
4. Human weaknesses: a failure to appreciate the influence of cultural and motivational factors such as rigidity of thinking, lack of desire to change. An attitude of ‘it is not my problem’, inappropriate vision/drivers and, perhaps most importantly, human greed
5. Lack of training to enable management to understand underlying business models, leading to poor managerial supervision
6. Lack of rigorous challenge by non-executive directors possibly caused by poor understanding of the complexities of the business and
7. Bad habits and complacency after a prolonged bull market.

The report also recommends that risk management failures need to be addressed. Weaknesses in these areas meant risk management departments in banks did not have sufficient influence, status or power.

Clearer rather than heavier regulation is required. In the UK, there is confusion about what the Financial Services Authority (FSA) is trying to achieve and the extent to which it is committed to protecting the interests of customers. It is vital that the public know what they are putting their money into. Lack of training to enable management to understand complex products and the underlying business models has to be addressed.