Looking back and forward: the world’s financial system

The financial system is the nerve centre of the modern economy. Banks pool the capital of savers and lend it to companies at longer maturities, allowing them to invest in new initiatives for continuous expansion. They provide cash machines, credit cards, debit cards and so on allowing the vast majority of commercial activities to take place. The capital market allows companies to raise capital at a reduced cost, enabling risk to be effectively managed. The financial freeze starting September 2008 was accompanied with a corresponding held up in all these commercial activities, plummeting national economies and the world economy at large into the biggest recession since the end of World War II. 

Recent economic reports across the world’s heavy economies suggest the world economy is steadily responding to growth. Britain is the latest to have announced its economy is officially out of recession. German and France were first to have recorded positive growth figures. America so far has been cautious about its figures but for the first time over a year the American economy has recorded an expansion. The message coming out so far is good taking into account the fact that the world economy came to near collapse.

Notwithstanding the figures confidence still remains fragile and the devastation and hardship that this economic phenomenon brought to ordinary families across America, Britain, the Euro zone and beyond still remains.

Here in Sub-Saharan Africa people have not lost their jobs and houses in any magnitude near the experience in the west. The reason is that regions like Africa are less integrated into the world economy, the greater your stake in the world economy the hardest you were hit. Take the British economy for instance at the height of the recession 300 businesses were going bust a day and 3000 people were losing there job a day. So for us in Africa less integration in to the global economy on this occasion was good news to us. But we never escaped equally unaffected. Remittances halved leaving the finances of families that rely on such supports equally troubled as the relatives abroad.

Increased attention to the internal economic crisis meant western governments have had to cut back their overseas development aids . Italy was the first to announce a 40 percent cut in its overseas development fund. What this implies is that governments in this part of the world that rely heavily on such aids to balance their budget and development needs were left with a huge hole in their financial plan. The crisis though subtle on our side leaves us in no better position.

Like any great failures in history there has been finger pointing all over the place. Bankers have been placed for public stoning. Governments, software writers, corporate governance – the list continues – have all been accused. But in the mix of this stiff blames the fundamental question that continue to linger is why did no body spot the red flag for an early response and a possible reverse of the situation. The point is the cause of the recession as we experienced at the start of the last quarter 2008 was a structural problem that mutated over time. It goes back to a wave of thinking across the Atlantic over 2 decades from now. At the heart of this was the struggle for a perfect tune of free market enterprise that best generates national wealth and prosperity. Faced with two options, regulated market and deregulated market (raid off market regulations) model – deregulated market thinking prevailed. “Raid off market regulations” triumphed on the belief that market regulation does not only distort economic activities but more importantly inhibits innovation and competition.  With the US national reserve department as the led point, the seed for the global economic architecture pivoted on less regulation, continued innovation and competition was fast sowed.

But rolling back the rules would mean anarchy on the market. Well not quiet as far as market deregulation thinking is concern. “Raid off market regulation” operates on a higher understanding that companies – the principal agents on the market place are self sufficient and competent enough to protect their selves on the market. Companies are essentially instrument of investment designed to maximise the interest of shareholders – create wealth for the shareholders. To reach this end a company would have the capacity to protect itself against danger. It would abstain from all stuff that would put the interest of the shareholder at risk. This assumption and market deregulation was exported across all areas of the economy from manufacturing to finance leaving the magic hands of the market forces to dictate the pace of market activities.

The reasoning was a winner. Innovation led to increased competition and the cycle continues sky-rocketing consumerism setting the tone for the economic wealth and prosperity unsurpassed in history. The west became the epic centre of this new economic age. The United Kingdom’s economy under Tony Blair expanded at a staggering GDP rate of 33%. And the spill over left no region of the world unaffected. Increased consumerism means more supplies from other regions. Governments around the world took to the raid off market regulation practice.

Apparently with a perfect economic structure that kept delivering wealth the Clinton administration in partner with New Labour opted to take market deregulation to another height. This time it was market deregulation across borders with new supra state regimes and institutions - otherwise termed the globalization phenomenon. The financial industry emerged the greatest benefactors of this new wave of raid off market regulation concept setting up the foundation of the global financial architecture we know today

International investment funds evolved and expanded at a breath taking pace as a result of abolition of restrictions on capital flow, and subsequent investment opportunities created by the development of global capital markets. Often highly leveraged (borrowed) and situated in tax heavens (so escaping significant regulatory oversight) these funds allowed for active participation in global credit market . The size and volume of transaction with little or no rules means they were discernable magnitude of risk but the banking institutions adopted a causal attitude to it. Apparently it was part of financial engineering that has made way for a condition of massive liquidity serving everyone’s interest. But their opacity and unregulated nature meant they could at best be described as shadow banking.

The dilution of banks traditional way of raising funds (the saving sector) by international investment funds with little or no regulatory framework created a systemic risk for global banking.

A global market also meant more innovative product for a global access, one of many products which accounted how compact the financial system had developed is the operation of Credit Default Swap (CDS). Also known as WMDs - Weapons of Mass Destruction - CDS allows for a bank to buy an insurance cover for its investment portfolio at a premium. A bank could not only buy but could sell to other banks. In effect banks could secure each others possible debt, creating a complex credit web of all against all.

The ingenuity here is that it is possible to think that risk has effectively been eliminated clearing the way for the acquisition of multiple investment portfolio. On the down side any risk-free thinking is equivalent to life in fool’s paradise. The concept places banks in a delicate position where a fall out of one bank weighs everyone else down. The volume of credit default swap circulating in the global financial system as at September 08 amounted to $3 trillion. The greater your stake, the more you are likely to be weaken should a member bank go out of business.   

In spite of these otherwise vague question marks hanging over the financial system the growth and expansion coming out run through all parts of the world economy, and kept the global economy expanding in all directions.

So if the world had succeeded hitherto in establishing such a fantastic economic machine why would a collapse of one investment bank – Lehman - cause a global recession. In fact Lehman did not cause the recession. Lehman’s demise only provides us with a classic tool kits for analysis of the inherent defects in otherwise a brilliant piece of economic thinking.

It questioned the fundamental assumption underlining market deregulation that companies are self-sufficient to protect their own interest. Rather than an understanding that a real estate burble in the US overwhelmingly destabilized the capital market the reverse is the truth, that erosion (a break down) of discipline on the capital market destabilized the real estate markets . And Lehman - unlike others rescued – paid the ultimate prize.

The rise of asset-backed securitization allowed major investment bank to acquire large portfolios of mortgage loans in order to securitize (give it out to mortgage lenders) and sell as debt securities to investors on a global market place. In the case of Lehman Brothers, continued expansion in the housing market and the huge profit generation out there meant that diversification; a fundamental principle in prudent financial management was slaughtered at the expense of increased leverage – more borrowing. At the peak of its operation for every 1 dollar that Lehman own it borrows 40 dollars to keep expanding. But this hardly shows on the balance sheet because they kept deploying innovative ways of passing (selling) on to the debt market as asset- backed securities.

Asset-backed securitization had always operated with “due diligence” procedure but increased demand and investors rush to meet market demands caused standards to weaken, and the trend never got better until it became reckless as mortgage loan originators came to realize that they could sell virtually any mortgage loan as long as it came with a paper certificate of credit rating. With lucrative fees and competitive pressure it was possible to induce or coerce credit rating agencies to confer the appropriate investment grade rating. Having succeeded to bring the gate keepers in their arms, mortgage originators could sell mortgage loan to even the uncreditworthy borrower. On the US house market, this market base acquired the name sub-prime market. If the age of tight credit requirement for mortgage has disappeared any body can go in for a mortgage. The increased demand for mortgage by this market group kept the housing price going up and the market ever attractive for investment.

The obvious question to ask is why somebody would sell mortgages to people with weak or no credit history. The response is this loan originators make they profit out of the volume of mortgages they sell not necessarily the quality of the mortgages. All mortgage loans giving out would be pool together as securities and sold on the global financial market. In essence their business is pretty simple they access money from other sources - hedge funds or international investment funds- which are passed out as mortgages and then sold as asset-backed securities. On the day that Lehman officially ceased trading $700 billion was wiped out of the financial market creating the shock that effectively brought the world financial system to halt.

So why did no body spotted the emerging cracks: the continued performance of the world economy and the ever growing profitability of the system created what can best be described as a state of financial euphoria where market actors became increasingly and irrationally overconfident over market liquidity – that liquidity will continue indefinitely. It was more of a financial party into which every one else was making the most. The prevailing thinking was the banks were doing great and with their initiatives on the housing market; they were helping more of society’s birds to come to roots. President Bush applauded their good work and demanded more of such innovative ideas to get even more people on the housing ladder. Seven month prior to its demise Lehman had posted a recording breaking profit of 4 billion. It is hard to imagine that such a company was in fact under the threat of collapse a few months ahead.

Reading through the events, the implosion of the financial system and the subsequent economic recession was more of a disappearance of discipline on the market place as a result of a gradually deteriorating economic model founded on flawed economic thinking. It turns out that companies on their own cannot protect themselves let alone safeguard the interest of shareholders and society at large. Depending on which lenses you are looking you might as well slam the door on any thing to go with free market.

Pessimists have moaned the death of free market enterprise and all its capitalist instinct. But capitalism has a paradox. Even at the deepest point in the crisis, Citicorp announced a $10.9 billion operating profit (Feb. 2009). That leaves us with a bit more to ponder about. And there is this other version of understanding that the positives of free market enterprise and capitalism out weighs the negatives - that the flaws which caused the crisis were more of failures in the rules not the concepts per ser.

Following the massive government bail outs, the landscape of global financial relation is changing. Prior to its eruption (the financial crisis), High Street Banks were vertically integrated financial empires with head offices in the west and multiple subsidiaries located in countries around the globe that lacked controlling owners . That is no longer the order, government acquired stakes meant other than the powers of the state, governments have acquired a higher moral standing (argument) to get under the skin of the financial system.

In America banks seeking assistance received assistance on agreement to expand lending capacity; agree to more public disclosure and restrict quarterly dividends. And in the UK, bail outs were issued in return to review executive compensation and government right to confirmation of boards’ appointment. Specific aspects of the financial system with potentially systemic character such as parallel banking and capital adequacy ratio have been put up for tighter rules and more transparency. Banks incentive schemes had come under the spot light with policy options meant to cut back bonuses and force such incentive packages to be mark against actual performance spread over time. Pressure is also piling to get banks focus on core business – retail and corporate banking- with a rollback on investment banking activities.  

The emerging consensus is supervision of the financial system can no longer be based on supervision that pays attention to individual parts. What it needs is a supervision that pays attention to the system as a whole with some degree of national diversity. Individual nation-states want to define their own parameters for operating finance. Like product safety standard laws global finance would have to comply with multiple regulatory requirement that differ across borders.

Obama’s latest plan for the future of American banks gives a much clearer picture over the intensity of change the industry has got to embrace at the state level. He wants to restrict the size of high street banks and place a cap on risk investment. Too big to fail is to be too big to exist. What this mean is this: all those areas that banks had seen phenomenal profit growths over the years is going to be restricted. The idea he argued is to protect savers money and ensure that savers money is for savers benefit not the banks. Without any doubt there may be serious consequences to trying to limit banks size; most obvious is reduction on economy of scale and increased intermediary cost. The news was met with negative trading on the financial markets. The details remain to be seen. But the plan is definitely not the one anybody in finance would like and the president was quick to point out that he is out for a fight.

David Camera and his conservative party have hinted that Britain will follow the suit if they win the next election. The challenge is whether the trend may not in fact lead to financial protectionism or possibly drive financial business offshore to permissive jurisdictions.

Beyond the state level the intellectual tide had been running in favour of global institutional repair in the context of cross border burden sharing. Angela Merkel among others wants a prototype of the UN Security Council with an international financial charter to converge international financial regulation. The IMF is to keep its job of macro prudential surveillance but to work in close partnership with this new institution to develop a global financial stability early warning system and risk mapping. But this proposal raises an issue on how much member states can give away for improved supervision and management.  The approach presumes that leading countries may be readily prepared to surrender significant sovereignty to international agencies. In fact the reverse may be true, different countries may want to sit on efficient points within their frontiers.

The closest we have come so far to make the proposal happen is the establishment of the newly reconstituted Financial Security Board (FSB) with the mandate to monitor market developments and advice on best practices for regulatory standards. Membership so far is restricted to the G20. Given that it lacks universal membership thus raises questions over legitimacy only time can tell whether it has the cohesion to support global financial stability . 

The response of government across the world so far has demonstrated that finance is apparently perceived as public good and the threat would be treated that way. But Critics have whispered that littering the entire financial system with regulations is as bad as the events that brought the crisis. Besides, there are doubts over the place of governments as both regulators and shareholders - implicit and sometimes explicit- of the financial institutions they are expected to reform.

Alternative ideas want to minimise the role of government in exchange for better public information and sooner, as a way of making it impossible for financial companies to proceed down a dangerous, risky path without the whole world knowing. Bubbles are integral part of information lag and the optimism that preceded the banks breaking is partly due to practical ignorance of the problems yet to come. Experience has shown us that financial market participants run very fast whiles existing regulators struggle to stay on the pace. Get the banks to broaden information channels and liberalize capital markets for data lags to decrease. In America the lobbyists are gathering against any swiping changes. Too tough and it risk not getting it through Congress, too soft and it incurs the wrath of the tax payer.

What nobody disputes is that the financial system has to reform. It needs some values. Such a reform would have to strike a balance between its fiduciary duty and its entrepreneur drive. The rules and practices that govern the relationship between managers and shareholders as well as stakeholders like employees, customers and creditors contribute to growth and financial stability. The financial services business model must take into account not only shareholder value but that of many other groups that are affected by their activities. And unlike shareholders other stakeholders may favour less risk taking. Reforming the financial institutions to get this balance right is the next big thing insight for global financial stability. 


Credit: Enoch Addotey
(Business Performance Analyst – Banking)

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