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Global financial crisis: What happened and what happens next?
By Ingrid Goodspeed
Governor, SAIFM

he market turbulence that began in July 2007 with the sub-prime market meltdown, led to financial market panic in September 2008 with the bankruptcy of Wall Street investment bank Lehman Brothers and the bailout of insurer American International Group (AIG). Credit markets seized up and liquidity evaporated even further. Confidence in financial institutions crumbled. The economic downturn accelerated and global economic growth fell steeply together with a slowdown in worldwide trade.

In its January 2009 Global Financial Stability Market Update Report, the International Monetary Fund (IMF) stated that the global financial system is under extreme stress and that risks to financial stability have increased. This despite the provision of liquidity support to banks; the cutting of policy rates; and the injection of capital into the banking system by both private (USD450billion) and public (USD380billion) sectors.

Causes of the crisis have been mooted by the Organisation of Economic Co-operation and Development (OECD), the IMF and authorities in the European Union (EU), United States (US) and United Kingdom (UK). These are described under two main headings: global macroeconomic imbalances and the failure of market mechanisms.

Global macroeconomic imbalances
In the last decade oil-exporting countries, China, Japan and other east Asian countries (“surplus countries”) have built up large current account surpluses while vast current account deficits have accumulated in the US, UK and certain other developed economies (“deficit countries”). The key driver of these imbalances has been the high rate of savings relative to investment in surplus countries and a lack of savings relative to investment in deficit countries. Savings flowed from surplus countries to deficit countries and interest rates reached historically low levels.

The effect of low interest rates was two-fold. Firstly they led to rapid growth of credit extension and associated asset price booms in developed countries - particularly the US and the UK. Secondly they produced a relentless search for yield among investors. This in turn stimulated a wave of financial innovation that focussed on the creation of structured financial products around the securitisation of credit instruments such as residential mortgages, including sub-prime mortgages.

Failure of market mechanisms
Causes of the crisis that reflect the failure of market mechanisms and discipline include the following:

1. The risk governance and risk management process(1) of banks and other financial firms failed:

  • The complexity of structured financial products made appropriate risk identification, assessment and measurement difficult. In addition mathematical risk and valuation models underestimated exposure to shocks and extreme tail events;
  • Banks underestimated liquidity risk(2) both in terms of business as usual (borrowing short and lending long) and stressed market conditions;
  • Remuneration and incentives schemes encouraged excessive risk taking;
  • Boards and senior management did not appreciate and execute their oversight role; including understanding the banks’ risk profiles. They did not understand the characteristics nor aggregate exposure of the complex structured products their banks were dealing in;

2. Credit rating agencies underestimated the credit default risk of structured financial products. This was exacerbated by the conflict of interest inherent in the rating process – issuers simply shopped around until they achieved a AAA rating;

3. Regulatory / supervisory oversight of the financial sector was inadequate:

  • Supervisors placed too much reliance on the risk management capabilities of financial firms and banks and on the adequacy of ratings;
  • Little was known about the size or ownership of credit risk. Securitisation aimed to distribute risks across the financial system. However lack of transparency made it difficult to assess whether risk had been spread or merely concentrated in less visible sections of the financial system e.g., in the so-called shadow banking system;
  • In terms of liquidity, supervisors did not give enough consideration to the impact of financial-market developments on the markets as a whole and on contagion and systemic risk in particular. Instead they focussed on individual firms;
  • Once the situation escalated into a crisis, the authorities’ response was undermined by an inadequate crisis management infrastructure between national regulators and supervisors and between public authorities within countries namely central banks, finance ministries and bank or financial firm supervisors;

The shadow banking system –investment banks, mortgage brokers/originators, hedge funds, securitization vehicles and other private asset pools – was loosely regulated and not subject to the prudential regulation that applied to banks. This was because it was not considered systemically important. It being unregulated made it attractive for banks to evade capital requirements by transferring risk to their affiliates in the shadow banking system. By the start of the crisis the size of the shadow system had grown as large as the formal banking system, which meant that major failures here would in fact be systemic.

What happens now?
The question arises - what should be done to lift the global economy out of recession and prevent a similar crisis from happening again?

To resolve the crisis in the short-term, the IMF suggests a three-fold approach:

  • The provision of plentiful liquidity and short-term funding support from central banks;
  • Bank recapitalisation; and
  • Measures to deal with problem assets.

Suggested longer-term policy and regulatory / supervisory initiatives are shown in the table below:

Global macroeconomic imbalances
  • Better analysis and response to problems lying at the interface between macroeconomic policy and financial systems;
  • Use of both macro and structural policies impacting savings and investment;
  • Prudential measures to curb systemic risk.
Bank’s risk governance and risk management process
  • Changes to capital requirements in respect of:
    • trading book exposures, including complex and illiquid credit products;
    • complex securitisations in the banking book (e.g. collateralised debt obligations of asset-backed securities; and
    • exposures to off-balance sheet vehicles such as asset-backed commercial paper conduits;
  • Avoid procyclicality in the implementation of Basel II to decrease the extent to which lending capacity is reduced in economic downturns;
  • Improved stress testing, scenario analysis and model validation;
  • Ensure more meticulous risk management of risk concentrations, off-balance sheet exposures, securitisations and related reputation risks.
Complex structured products Securitised and derivative products should be standardised, simplified, traded on a formal exchange and cleared and settled via a resilient and central clearing house.
Remuneration and incentives schemes Remuneration systems and incentives schemes should be risk-based and linked to the strategy and risk appetite of the firm as well as its longer term interests.
Boards and senior management oversight
  • Improve board oversight of risk management;
  • Improve skill level and time commitment of non-executive directors;
  • Provide proper incentives for the board and management to pursue objectives that are in the interests of the company and its shareholders;
  • Require the board to exercise objective and independent judgment.
Credit rating agencies
  • Supervise credit rating agencies;
  • Review role of credit rating agents in financial system;
  • Improve approach to the rating of securitised products.
Regulatory / supervisory oversight
  • Ensure more effective and consolidated supervision of large and complex financial firms;
  • Recognise that the regulation of liquidity is as important as that in respect capital adequacy;
  • Bank regulation and supervision should be supported by a retail deposit insurance system;
  • A crisis management infrastructure should be set up between:
    • national regulators and supervisors; and
    • public authorities within countries namely central banks, finance ministries and bank or financial firm supervisors;
  • Undertake more rigorous supervision of risk concentrations, off-balance sheet exposures and securitisations.
Shadow banking system Regulate entities according to their activities and not their legal form.

Many of these suggestions were incorporated into the final communication from the G20 summit in London. The Leaders’ Statement of 2 April 2009 pledged to do what is necessary to “restore confidence, growth, and jobs; repair the financial system to restore lending; strengthen financial regulation to rebuild trust; fund and reform international financial institutions to overcome this crisis and prevent future ones; promote global trade and investment and reject protectionism, to underpin prosperity; and build an inclusive, green, and sustainable recovery”.

In 2003 Christopher Fildes, journalist at the Telegraph wrote: “My law of the financial cycle says that things go wrong when the last man who can remember what happened last time has retired”. Unfortunately history teaches that few generations have avoided repeating earlier financial crises.

(1)The risk management process includes the identification, assessment and measurement, management and control, reporting and monitoring of risk

(2) There are two types of liquidity risk: market liquidity risk and funding liquidity risk. Market liquidity risk is the risk that the bank cannot easily offset or eliminate a market position without significantly affecting the market price because of inadequate market depth or market disruption. Funding liquidity risk is the risk that the bank will not be able to efficiently meet both expected and unexpected current and future cash flow and collateral needs without affecting either daily operations or the financial condition of the bank.

  • IMF. January 2009. Global financial stability report: market update.
  • IMF. February 2009. Initial lessons of the crisis. http://www.imf.org/external/np/pp/eng/2009/020609.pdf
  • European Commission. February 2009. The high-level group on financial supervision in the EU. http://ec.europa.eu/commission_barroso/president/pdf/statement_20090225_en.pdf.
  • Financial Services Authority. March 2009. The Turner review: A regulatory response to the global banking crisis.
  • Bernanke, B.S. March 2009. Speech titled Financial reform to address systemic risk. http://www.bis.org/review/r090313a.pdf
  • King, M. March 2009. Speech titled Finance- a return from risk. http://www.bis.org/review/r090319a.pdf
  • G20, April 2009. London Summit – Leaders’ Statement. www.g20.org
  • www.bis.org
  • www.economist.com
  • www.imf.org
  • www.oecd.org
  • www.worldbank.org

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