Financial crisis is often referred to a sudden fall in asset prices due to market liquidity
evaporation. When it comes to financial crisis, there is one thing that we can be sure of: there will always be another one. Although it has been nearly 10 years since the worst of the last financial crisis, many systemic loopholes exposed seem to have not been effectively dealt with. For example, the European banks still struggle with bad loan and inadequate capital; the too big to fail US banks are even bigger; the Federal Reserve are raising interest rate while the global economy is still weak; and the governments are imposing unnecessary political risk to the financial market. The International Monetary Fund (IMF) has recently warned that the world economy is at risk of another financial meltdown.
What will cause the next financial crisis? Please choose ONE cause that are most likely to trigger the next financial crisis and discuss it with specific reference to your
knowledge of institutions in the global financial market
Financial crisis have occurred dozens of times since the seventeenth century (The Economist, Jan., 2009). “History does tell us that several mutually re-enforcing events and decisions, rather than a single catalyst, tend to contribute to major financial market crises.” (Ellert. J, 2019) While many of us would ascribe the cause of the next financial crisis to the ongoing trade war between the United States of America and China, it is submitted that the said trade war is just merely a scapegoat for the deep-rooted institutional fallacy which had not been dealt with effectively since the last financial crisis in 2008. Apparently, the direct cause of the 2008 financial crisis was the bubble burst of the sub-prime regime and Collateralized Debt Obligation (CDOs) and mortgage-backed securities (MBS) upon their securitization in the first place.
After various bail-out programs at the time under the notion of “Too-big-to-fail”, history has proven that the interest of investors could not be safeguarded, at the very least, by the “not so objective” credit rating agencies whose interest had heavily conflicted with that of the common folks. Admittedly, steps and measures were deployed by governments and central banks across the globe the stop the 2008 crisis. However, it is submitted that, despite the extraordinary steps taken, including but not limited to, Troubled Asset Relief Program and different monetary stimulus such as quantitative easing, the institutional loopholes have yet to be plugged and the people’s confidence in the system has never been restored.
DeBoer (2008) believe that such bailout programs and other supporting packages from governments is like offering protection from a negative outcome which is more appropriate to be called as “moral hazard”; this trend could increase the possibility of future bad upshots. As a result thereof, foundation has been laid for the next crisis.
The financial services industry is the most regulated sector in practically all economies. In the U.S., the Federal Reserve, the Office of the Comptroller of the Currency (OCC), the Securities and Exchange Commission (SEC), The Federal Deposit Insurance Corporation, and a number of other regulatory bodies are responsible for regulating the financial sector (Allen. F & Carletti. E, 2009). It is acknowledged that financial crisis which instigated from USA has now become a global phenomenon (Nikolson (2008)).
It is noted that the effect of Barack Obama-era regulations such as The Dodd-Frank Wall Street Reform and Protection Act which was designed to put major regulation on the financial industry to curb the kind of excessive risk-taking that contributed to the GFC has been diminished due to ever-increasing de-regulation because of pressure exerted by different sectors or parties like the traditional banks so as to increase their competitiveness against investment banks (FOCUSECONOMICS, 30th October, 2019).
About 10 years after crisis triggered by Lehman Brothers, it is submitted that financial markets have accumulated a new batch of problems. However, the old ones have not been cured as well. For a prolonged period prior to 2008, low interest rates have encouraged banks to be not afraid of lending to risky borrowers to in turn have the loans repackaged and sold to investor. At the time, the risky borrowers were “subprime” homebuyers. Nowadays, they have become the American companies which are stuck in heavy debts in the time of benchmark interest rates being close zero for most of the recent decade.
It is observed that the American companies as mentioned above have borrowed even greater amount of money to not invest in productive assets but to buy back their shares with a view to pumping up their stock prices and producing bigger bonus packages for management and executives. As a result thereof, over the last decade, the value of US corporate bonds has effectively risen by 3 time from around USD 2.5 trillion to USD7.5 trillion with 45% of them being rate as “BBB” (i.e. just one grade above the grade of junk) (Holland. T, 15th January, 2019). In addition, since the 2008 crisis, there has also been a boom in leveraged loans (loans to high-risk corporate borrowers) and its market has doubled in size from USD 550 billion to around USD 1.1 trillion.
Most of these loans have been repacked and sold as CDOs, similarly to the way how subprime mortgages were handled in the 2000s. All these happened despite regulations discouraging banks and brokers from trading bonds on their own account. In essence, market has grown in size since 2008. It seems once again it is just a matter of time before some borrowers (who have been rated BBB) being downgraded to junk status and when that really happens, ETFs and institutional investors would be desperate to sell their bonds at whatever reasonable price they are offered. As such, all these could be once again seen as the inherent fallacy of the system.
Meanwhile, many factors seem to be in play to lead to the next financial crisis, the biggest risk might in fact lie with the public balance sheet and arguable is once again part of corruption of the system as a whole. The national debts of the U.S. held by the public currently stands at around USD 16 trillion and was expected to grow by USD 779 billion on 2018. In short, the public sector is living beyond its means. The U.S. has been printing money to pay down its liabilities. Yet, the debt monetization could cause high inflation, contracting the mission of the government and continuously harming the long-term confidence of the public in the U.S. economy. It may be time for policymaker to regulate the government spending before it is too late.
Apart from the above, one should not overlook the fallacy of synchronized growth. It is observed that there is a widespread belief that monetary policy employed by the governments (or maybe, particularly the U.S. government) had been very effective and the economic growth has been satisfying. As such, people tend to turn a blind eye about debt ever-increasing. Suffice it to say, the eruption of the 2008 crisis could be imputed to the fact that back in 2005 and 2006, even the once most prudent and pragmatic investors had chased the market. Therefore, although history may not exactly repeat itself, it surely rhymes.
In the light of the recent financial crisis, Western banks have downsized their balance sheets by reducing their exposure to over-risky balance sheets and de-leveraging. In general, these developments were pushed by policymakers and regulators around the globe with a view to reinforcing the global banking system to better cushion against future or even imminent financial crisis. For the most part, these developments were mandated by policy makers and regulators worldwide to strengthen the global banking system to better withstand future financial shocks (Ellert. J, 2019).
In today’s global financial market, with low interest rates and the ever-changing process of commodity and real estate, institutional investors and global fund manager are cling to put their money on the U.S. equities which has created a 10 year “bull” market for the equity shares of the U.S. (being the second longest in the history of the U.S.). During 2019, U.S. equity share price indexes have reached all-time highs. Although profit forecasts for the U.S. companies are declining but still healthy, it is just a matter of time that this pricing “bubble” will eventually burst, thus reducing consumer wealth and buying power. As mentioned before, merely employing some “scratching the surface” measures would really cure the problem at the end of the day and it could just delay (but not for long) the coming of the next financial.
Another build-in or inherent problem under the current system would be with the rising levels of income and wealth inequalities that have surfaced over the last two decades. The levels of inequality nowadays in modern economies are practically higher than the excessive levels last reached during 1929 in the U.S.. It has been reported that the richest 1% in the United States now own more wealth than the bottom 90%. With no effective measures being put in place, the situation is not optimistic and the implication of it could even add fuel to the next global financial crisis and recession.
The financial crisis of 2007-08 has taught us that the confidence of the financial market, once shattered, can’t be quickly restored (Singh. M, 2019). Having broken down the different aspects of what could pave way to the next global financial crisis, it is submitted that there are certain measures which could be done to diminish the negative effects of the next financial crisis, if not aver it. First of all, the government of the U.S. (or for that matter governments around the world) should not resort once again to fallacious notion of “too big to fail” and without hesitation use the money of the taxpayers to bail out the banks and investment without first holding those culprits accountable to the public.
Without doubt, banks keep getting bigger and are pushing to minimize or get rid of even the regulation imposed upon them. However, the financial crisis in 2008 has proved that banks lack the means or incentive to regulate themselves and it is prominent to put in place government oversight such as the Dodd-Frank Wall Street Reform Act to prevent them from taking too much risk at the expense of the public and leading to another global crisis (Grunwald. M, 2018)
All in all, re-regulation is the only way out. Regulation has to be constantly reviewed and renewed to keep up with the pace of the development of the finance industry. While it is critical to increase the authority on the part of the regulators, others measures like ensuring that banks aren’t too big to fail and maintain sufficient cash reserves to fight off a liquidity should continue to be pursued. Additionally, broader reforms to protect consumers, investors and borrowers are also necessary to be put in place. Deregulation of the financial system must be stopped. As David Leonhardt (2010) has pointed out, “The crisis has made Wall Street much more conservative. But this will not last. It never does. Left to their own devices, financial firms will again take on big debts and big risks. They have a lot of incentive to do so.” It is indispensable to cure the underlying cause rather than the symptoms.
References
Allen. F & Carletti. E, 2009, An Overview of the Crisis: Causes, Consequences and Solutions. Available at http://apps.eui.eu/Personal/Carletti/IRF-Overview-Allen-Carletti-26Nov09-final.pdf. Accessed on 3rd December, 2019.
Ellert. J, 2019, Anticipating the Next Global Financial Crisis and Recession. Available at:https://www.iedc.si/blog/single-blog-post/iedc-wisdoms/2019/08/20/anticipating-the-next-global-financial-crisis-and-recession. Accessed on 3rd December, 2019.
Grunwald. M, 17th March, 2018, Behind the Dodd-Frank Freakout, Politico. Available at:https://www.politico.com/magazine/story/2018/03/17/behind-the-dodd-frank-freakout-217645. Accessed on 3rd December, 2019.
Holland. T, 2019, The next financial crisis will come from the US, not China. Available at:https://www.inkstonenews.com/opinion/tom-holland-next-financial-crisis-will-come-us-not-china/article/3000469. Accessed on 3rd December, 2019.
How and when will the next financial crisis happen? FOCUSECONOMICS (30th October, 2018). Available at https://www.focus-economics.com/blog/the-next-financial-crisis-how-when-it-will-happen-according-to-26-experts. Accessed on 3rd December, 2019.
Leonhardt. D, 2010. Heading Off the Next Financial Crisis, The New York Times. Available at https://www.nytimes.com/2010/03/28/magazine/28Reform-t.html. Accessed on 3rd December, 2019.
Singh. M, 2019, The 2007-08 Financial Crisis in Review, Investopedia. Available at https://www.investopedia.com/articles/economics/09/financial-crisis-review.asp. Accessed on 3rd December, 2019.
The Print Edition (Jan.17, 2009) the financial crisis, The Economist. Accessed on 3rd December, 2019.
Leave A Comment