Financial downturn in 2007 - Case Study Example

Risks and the 2007 Financial Crisis By the time the year 2007 began, the world was speedily heading toward a financial downturn. It originated in theUnited States due to the subprime mortgage crisis. The crisis spilled over to other countries and assumed global proportions in just a span of 18 months. The series of financial collapse led by the Lehman Brothers caused credit markets to cease functioning while capital flows effectively ground to a halt. A year later, the majority of world economies would be in recession and the global growth was collectively stunted, continuing way until. There are several reasons for the crisis. But they can collectively be classified as those about the taking of systematic risks in the financial system. An effective approach to explain the causes of the 2007-2009 financial crisis is to outline the three main solutions developed in Britain to address the problem. FRC Update The Financial Reporting Council (FRC) is one of the primary agencies mandated with overseeing and development of the standards in corporate governance in the United Kingdom. Every other year, it reviews the UK Corporate Governance Code, which is a combination of principles set in reports and codes of good corporate governance required for the organizations that are listed in the London Stock Exchange. In 2009, after the financial crisis, FRC reviewed and updated the Code so that it better addressed the variables that have led to the financial crisis. Stricter regulations has been proposed and seriously considered as corporate managements were found to have taken extreme risks by making bad operating, investing and financing decisions. (Saunders and Allen 2010, p. 21) Particularly, the on-going development initiated by FRC since 2009 has focused on the need for disclosure, the increase in overall level of prescription and the emphasis on independent and authoritative for the chief risk officers and group risk management departments. (Picket and Pickett 2010, p. 148) The on-going update and developments within- and those initiative by the FRC underscored the fact that British policymakers saw the need to examine and update its corporate governance codes and requirements because it was identified as a major precursor of credit crunch. For instance, before 2007, the financial system has been undertaking systematic risks because of the so-called shift in the banking model from "originate and hold" to "originate and distribute". (Saunders and Allen, p. 21) This change supposedly exposed the financial system to risks because it led to the deterioration of the credit quality and the rapid increase in consumer and corporate leverage. (p. 21) FRC’s focus on corporate responsibility, accountability, transparency, regulation and prescription were all reflective of the need to address systematic risks. Introduction of ICB The establishment of the UK Independent Commission on Banking (ICB) also served to highlight the systematic risks responsible for the financial crisis that are sought to be avoided in the future. It was created in June 2010 and was mandated with the following purposes: reduce the systematic risk in the banking sector and explore the risk posed by banks of different size, scale and function; mitigate moral hazard in the banking system; reduce the likelihood and impact of firm failure; and, promote competition in both retail and investment banking with a view to ensure the needs of banks’ customers and clients are efficiently served. (UK Parliament 2011, p. 95) The objectives clearly reinforce the updates undertaken by the FRC by emphasizing the need to reduce risk-taking in both the financial and corporate sectors. By September 2011, ICB is expected to come up with a report containing the recommendations in regard to how to ensure financial stability and competition in the British industry. The ICB also underscored the role of regulation by states because prior to 2007, the policy that have permeated allowed for the ratio of banks assets to their capital base to grow far too high and that they could not access market funding when they needed it. (Financial Regulation Forum 2011) Upgrade to Basel III September 2010 also saw another development in risk mitigation efforts with the creation of Basel III, a new regulatory standards adopted by members of the Basel Committee on Banking supervision to be implemented worldwide. The new accord raised the minimum capital ratios for common equity and aggregate capital between 2011 and 2015 and involved other requirements such as those concerning liquidity. (OECD 2010, p. 61) Following multiyear phase-in periods, a new leverage ratio and a new global liquidity standard with a liquidity coverage ratio designed to ensure sufficient liquidity during “stress situations” are being implemented. (Russo and Katzel 2010, p. 40) The new standards and stricter requirements identify the raising of discretionary capital buffers among other precautionary measures based on the experiences from 2007 to 2009. Basel III specifically highlighted how the crisis demonstrated how regulatory policies failed to restrict excessive leverage, which, for its part, emerged as a consequence of long periods of low interest rates and high growth. Spence and Leipziger (2010) explained that since the financial regulators could not agree on simple measure of overall leverage, they allowed banks to use internally rated models to measure their own risks and capital needs, which resulted to the sharp increase of embedded leverage. (p. 85) Basel III aims to address future financial crises by mitigating risks through reforms in regulatory policies and architectures. The succession of measures undertaken in the UK and elsewhere around the world demonstrated one important point – that the 2007-2009 financial crisis has been fundamentally driven by the excessive taking of risks in the financial system. FRC highlighted the culpability of corporations in their greed for profit. ICB emphasized the vulnerabilities of the financial system while Basel III underscored weak regulatory infrastructure that became conducive to risk-taking. These measures were all about reforms that emphasize stricter supervisory techniques at least within the next 4 to 5 years. Certainly, because these days are the bad times, the risks that have characterized the good period are rejected in favor of excessive caution. For the UK, the ICB and the FRC are particularly important mechanisms to achieve this end. In the absence of a global regulatory authority, it is up to the British government to establish its own regulatory agencies to make sure corporations and the financial sector are following the principles of corporate responsibility. References OECD. (2010). OECD Economic Outlook, Volume 2010, Issue 2. Paris: OECD Publishing. Picket, S. and Pickett, J. (2010). The Internal Auditing Handbook. Chicester: John Wiley and Sons. "UK Independent Commission on Banking Interim Report". (2011). Financial Regulation Forum. Retrieved 19 April 2011, from Russo, T. and Katzel, A. (2010). "The 2008 Financial Crisis and its Aftermath: Confronting the Next Debt Challenge." Google. Retrieved 19 April 2011, from http://books.google.com/books?id=u515NZjrFuMC&printsec=frontcover&source=gbs_ge_summary_r&cad=0#v=onepage&q&f=false Saunders, A. and Allen, L. (2010). Credit risk measurement in and out of the financial crisis: new approaches to value at risk and other paradigms. Hoboken: John Wiley and Sons. Spence, M. and Leipziger, D. (2010). Globalization and growth implications for a post-crisis world. Washington, DC: World Bank Publications. UK Parliament: House of Commons. (2011). Government Assistance to Industry: Report, Together with Formal Minutes, Oral and Written Evidence. London: The Stationery Office. Read More