Before we assess whether the financial crisis was avoidable, it would be a good starting point to discuss the actual causes of the crisis in the first place. In my opinion, it would be fair to say that there is no simple answer to this, with the crisis more than likely being a result of a number of factors and failures within the financial industry. Barack Obama claimed that a ‘culture of irresponsibility’ was responsible for the crisis. This is probably true in most places with excessive borrowing due to factors such as a lack of corporate governance and dysfunctional incentive systems causing firms to collapse. As discussed through a number of my blogs, with greater risk, comes the potential for greater reward, however in the case of the financial crisis in 2007, firms took on too greater risk which did not pay off.
One of the key factors linked blamed for the crisis was the sub-prime lending business, whereby financial institutions offered mortgages to individuals with poor credit histories, packaged these as mortgaged backed securities in the form of collateralised debt obligations and sold them on globally to investors. As interest rates rose, homeowners could not afford the repayments and defaulted on their debt in large numbers, affecting bank’s liquidity and therefore ability to repay investors. The existence of an off balance sheet and almost unregulated ‘shadow banking system’ made up of investment banks and hedge funds, allowed institutions to leverage themselves so highly, that they were essentially loaning out money which they could not support through capital in the event of credit defaults. The lack of legislation and regulation in such shadow industry allowed firms to act upon their own accords. This combined with dysfunctional remuneration packages, in that employees were rewarded for short term success and therefore taking risks, encouraged employees to increase their firm’s leverage and therefore issue increased mortgages and loans. Eventually the whole system failed, as financial institutions had too much debt and not enough capital to support this debt, which combined with vast credit defaults, lead to illiquidity of banks, resulting in a number of collapses and government bail outs to resolve the situation.
Essentially Barack Obama’s simple claim regarding a ‘culture of irresponsibility’ was correct, as responsibility on a number of levels arguably could have prevented the crisis. Firstly corporate governance needs to be applied internally by firms. The most widely used definition of corporate governance is "the system by which companies are directed and controlled" (Cadbury, 1992), therefore explaining how firms need to conduct themselves in the correct way to ensure their success. Clearly this was not the case as corporate governance surrounding leverage limits along with dysfunctional behaviour was not in place, leading to financial institutions making huge losses. Such corporate governance was highlighted to myself first hand whilst on placement at UBS in 2011, whereby rogue trader, Kweku Adoboli was allowed to incur losses of around $2 billion due to a lack of corporate governance controls in place and remuneration packages encouraging such risk raking. In the weeks after this event, corporate governance controls were noticeable tightened as all staff were made to complete rigorous training exercises and compliance's role became more apparent in the day to day running of the organisation. Another example of irresponsibility could be through the lack of legislation by governments. If governments had stronger legislation upon the shadow banking industry or minimum levels of capital firms had to hold for example, then firms would have been less likely to have been able to get into the situation they did. Such regulation has now been put into place, such as the recent Basel III regulation which encourages financial institutions to increase liquidity and reduce leverage through strengthened capital requirements. Finally along with financial institutions and governments, I believe consumers and individuals themselves are partly to blame for the irresponsibility leading to the financial crisis. Individuals should be responsible for the levels of debt they take on and take responsibility for repayment of this debt. As individuals took on too much debt, mainly in the form of mortgages it led to the crisis. In order to prevent this there may be a strong argument for more stringent credit rating controls imposed by rating agencies as individuals tend to be optimistic when it comes to accumulating debt.
Phil Angelides, chairman of the Financial Crisis Inquiry Commission conceded in his final report on the causes of the crisis, “we conclude first and foremost that this crisis was avoidable." (cited by Rooney, 2011). After briefly assessing the causes of the crisis in this blog, I would agree that the financial crisis could have been avoided, or at least its consequences could have been reduced. I believe firms could have imposed more stringent corporate governance controls to control their policies along with ensuring leverage and liquidity levels remained reasonable. I believe this could have also been supported by stricter legislation imposed on financial institutions by governments, mainly in the ‘shadow industry’ of investment banks and hedge funds. I believe firms could have incentivised and remunerated staff in different ways, to encourage them to focus on longer term wealth maximisation aims in line with shareholders rather than a short term risk taking approach. Finally I believe the credit rating agencies could have imposed more stringent controls on individuals to ensure that credit defaults are minimalized. I also believe that consumers could have taken more responsibility in terms of the amount of debt they took on to ensure that they were in satisfactory positions to repay debts, which also would have been aided by stronger credit controls. I believe that if all parties took such steps, the financial crisis would not have been able to reach the severity level it did, and therefore financial institutions, individuals and the government should consider such steps in the future to prevent a similar worldwide crisis.
References in this blog
Cadbury, A. (1992) The Report of the Committee on the Financial Aspects of Corporate Governance. London: Gee.
Rooney, B. (2011) “Financial Crisis Was Avoidable: FCIC.” Retrieved from: http://money.cnn.com/2011/01/27/news/economy/fcic_crisis_avoidable/index.htm (Accessed 16/03/2013)
No comments:
Post a Comment