The US financial market had hit rock bottom. The current turmoil has not only been at an unprecedented level in Wall Street history, but the complexity of its impact is unknown. Consequently, the financial meltdown raises concerns over how financial markets are structured. But to me, there is an even bigger issue that requires an immediate attention. For years, the ideology of laissez faire, where market clearing occurs without interventions, has been the motivation in US capitalist society. Such paradigm has reduced the role of government in regulating and provisioning esoteric activities in the financial market. If we can learn something from this experience, I hope that lesson is to realize the need to implement better and effective regulations.
Since, much ink has been spilled in the past months about the current economic meltdown, I intend to share some facts that I find rather shocking.
It is surprising that all you need is a small trigger to upset the whole financial system. The crisis began with Sub-prime related mortgages that defaulted last year. These Sub-prime mortgages are packaged into a group of securities and it only accounts about 30% out of the whole package.
The financial breakdown is certainly a structural problem. The breakdown is linked with the failure to regulate the largest and the most complex institutions that are, at the same time, the primary traders of derivatives.
Last year, when the Sub-prime mortgage fired, the media and investors immediately pointed their fingers directly towards rating agencies, such as Moody’s and Fitch Ratings, among the few, who failed to spot loopholes of these financial products. We began to question the models used by these agencies when rating such products. They paid the price, consequently. Their stock value fell tremendously and jobs were lost. The worst damage of course, is the tainted reputation of their business model. One interesting fact is that ratings agencies assess credit risk. They, however, do not put into consideration the liquidity risk that may be caused when financial products fail (in large sums), which may result in a deadlock between buyers and sellers’ confidence to transact openly in the market. This, perhaps, can be the missing variable that could be added in to their model.
After reading some policy recommendations published by the European Parliament on Economic and Monetary Affairs (Kern Alexander, John Eatwell), it became clear on how such a crisis could cause such a devastating shock globally. Mr. Alexander and Lord Eatwell theorized the danger of homogeneity. We know that information is asymmetric. Such imbalance is the primary reason why some reaps more economic gain than others. However, in banking, not all information is asymmetric; large chunks of their information that are used for developing their models are equally shared. Banks all have access information on available liquidity. They use also the same historical data and utilize the same conventional models. Now, during economic booms, such information will work on everyone’s favor, but observe what happens when the market is illiquid or lacking in money stock? Banks and other financial institutions will behave homogenously, that is abruptly selling securities in the market that may lead to a massive unwillingness to lend money on the inter-bank overnight market, especially at a panic financial moments. When there is a panic, everyone follows. A healthy liquid market is when there exists differing business interest where there is a buyer in one end and a seller on the other. Hence, activities in the financial market must be heterogeneous.
The current financial crisis, which has been dubbed frequently as the worst financial crisis after the Great Depression of the 1930s, will scrutinize components of the Basel II agreements. The Basel II consists of 3 pillars, which discussed holding adequate capital guarantee in case there is an adverse financial shock; the second is more banking transparency; and thirdly, a better supervision. These all look like a promising start, except for the consequences of transparency. I don’t deny the importance of lucid information by disclosing how banks manage their daily risk; the problem is how rating agencies would react to such available information. Disclosing banking models allow rating agencies to adjust their ratings in order to satisfy the conventional structure that could already be in danger in the first place.
Aside from the policy changes stated above, there are some recommendations that seriously need to be implemented. One choice that many of the European economists have put forth is the contra-cyclical provision for bank’s reserve requirements. Banks should hold required to hold greater reserve requirement during booming periods and less during illiquid market. Doing so would enable banks to have enough resources to protect themselves when money is most needed; it’s sort of like keeping money in a lock box.
The other alternative is to have a contingency plan, accompanied with a stress test that detects market liquidity. Such a test is already an existence in many parts of the world, but a consistent testing of bank’s stress level in acquiring inter-bank funds can be helpful in anticipating future shocks.
Financial meltdowns are not an alien phenomenon. The US has had a few of such event in their past. You don’t need a complex financial market for a destruction of such magnitude to occur, a simple banking stage where banks are simply intermediaries can already have such a consequence. Citizens need to understand that, yes, regulation is a key component, but they too need to realize that regulation cannot oscillate. The US is obsessed with getting governments off their backs. I think what people should start believing is, getting governments on the right side of your back.