Financial Crisis of The Future - Essay Example

Will there be another financial crisis in the future? Factors that drive globalization of the international financial markets Global financial market involves transactions and financial flow within equity, bond, derivatives, exchange rate and banking market around the world (Schultz, 2005). One of the major factors that are known to drive globalization of financial markets is exploration for economic profits. It is argued in economics that economic profits become smaller as one gets closer to a perfectly competitive market (Alasrag, 2010). Due to increased competition and saturation in industrialized countries financial markets investors were in need of markets, which could offer them increased returns on their investment (Kramp, 2010). The downward trends in the interest rates in 1990s in industrialized countries provided impetus for private investors to direct their investments into developing countries. Globalization of financial markets was also influenced by the avoidance of excessive taxation and regulation in some countries (Schultz, 2005). For instance, the US controlled its interest rates in 1960s and this saw many Americans move their assets into Eurodollar deposits (United Nations, 2009). This has resulted into exponential growth of this market into the greatest floating capital pool in the world history. Early financial market globalization was also influenced by prudent macroeconomic management and economic growth. During early 1990s, East Asia experienced consistent policies and growth. This prevailing stable financial environment convinced many investors that this was the best place to invest. Adjustment of economic policies by many countries has also contributed to rapid increase in globalization of financial markets (United Nations, 2009). Most developing countries, which have been traditionally under the influence of World Bank and the International Monetary Fund (IMF), have adjusted their economic policies to attract free capital movement across borders. Another factor that has been instrumental in globalization of international financial market is the deregulation of financial markets in developing countries (Schultz, 2005). This deregulation resulted in increased foreign capital flows to developing countries (United Nations, 2009). The deregulation involved allowing of Eurocurrency deposits, abolishment of credit and interest limits from financial intermediaries and allowing unrestricted ownership of local assets by foreign investors. Most developing countries have abolished floating exchange and exchange control and thus all foreign exchange transactions go through the central bank. This has also contributed to integration of global financial market (Alasrag, 2010). This freeing up of the system has made international money transfers to be easier and quicker (Kramp, 2010). Nevertheless, this has opened avenues for greater foreign currencies speculations in some countries. The privatization of state enterprises in both developed and developing nations provided international investors additional chance to diversify their portfolio and increase their profits. Thus, privatization of state parastatals is a factor that promotes globalization of financial markets (Kramp, 2010). Financial innovations have drastically reduced the cost differential between the rate of return paid to the investor and the cost of capital paid by the ultimate borrower. Recent innovations in financial markets include Eurobond financing, derivatives and hedge funds. These innovations have been integral in the globalization of financial markets. Technological advancement has resulted in reduced costs of data transmission and transportation costs, which have been critical in the process of globalization. This advancement has seen stability in stock and foreign exchange markets in developed economies. Thus, it is rare occurrence to see such markets in developed countries move in opposing directions today. The final factor that has been instrumental in globalization of financial markets is political factors (Schultz, 2005). For instance, the fall of Berlin wall and the collapse of the Soviet Union had an impact on international financial market (Honohan and Laeven, 2005). This resulted in an ideological shift by developing countries away from reliance on non-market forces resulting in improvement in the general climate for investment. Policies that create conducive environment to an evolving financial crisis Central bank policy can propagate financial crisis (Alasrag, 2010). In case central bank adopts a policy, which provides the economy with large amounts of liquidities, speculation and housing bubbles are boosted hence creating conducive environment for occurrence of financial crisis. Global imbalances also create conducive environment for emergence of financial crisis. This policy favours constant deficit of trade balance (United Nations, 2009). This results in increase in interest rates and reduced consumption. This attracts more foreign investors and hence citizens of such a country live beyond their means because of reduced cost of borrowing (Honohan and Laeven, 2005). The consequence of this is inability to pay debts, which culminates in financial crisis. Other policies that may promote development of financial crisis include internationalization of production without globalization of regulation and oversight (Schultz, 2005). In addition, policies that lead to state withdrawal, deregulation and liberalization of economy tend to promote evolution of financial crisis (Honohan and Laeven, 2005). Decrease in labour share and increased inequality in wage income is a factor that can lead to financial crisis. Structural and management issues, which create conducive environment to an evolving financial crisis Economic integration, advances in technologies and deregulation have dramatically changed the nature and structure of financial services. The central banks and other monetary authorities are finding it hard to play their basic of role of stabilizing financial markets and prices within their domestic economy (Alasrag, 2010). The increased volatility of exchange rates and financial flows, the complexity of financial transactions, the increased uncertainty and the instability in the global financial markets, which are a result of globalization of financial markets, are challenging to both central banks and the international financial authorities (United Nations, 2009). This environment is created by weak financial and macroeconomic policies, development of off-balance sheet transactions, domestic policies inconsistencies and over the counter transactions in swaps, options and other financial derivatives and vulnerability to external shocks by national economies. Furthermore, capital market reforms often generate internationalization, which presents a challenge to policy makers (Honohan and Laeven, 2005). This is because their efforts to enhance domestic market development result in more internationalization with potential negative spill over effects on domestic markets. Securitization as a means of managing risk exposes many countries to financial crisis (Alasrag, 2010). Under securitization, banks come together and pool their various loans into sellable assets. This saw many financial institutions borrow large amounts of funds to lend. This exposes banks and other financial firms to great risk that may quickly result to their collapse and hence leading to financial crisis. Causes of the Failure of Barings Bank One of the causes of Barings bank failure is the failure by its management to institute a proper financial, managerial and operational control system (Schultz, 2005). This poor management resulted in the ability of the management to manage derivative trading (McQueen, 2009). As a result, Leeson who was involved in derivatives trading took advantage of this and engaged in dubious trading, accounting and reporting practices, which concealed the losses that he was incurring (United Nations, 2009). He took speculative unauthorized positions in Futures and options on the Nikkei. He managed to hide his trading in an unused BSF error account. Even though the firm was making losses, the concealed loses were reported as profits and hence the profits which were reported were not correct (Kolb, 2010). The management allowed Leeson to be in charge of both the dealing desk and control over the back office operations that enabled him to manipulate the accounts of the bank. Therefore, the bank lacked segregation of duties, which is critical to ensuring the accuracy and integrity of information (Kramp, 2010). Thus, the risk for irregularities was heightened failure by the Barings Bank management to institutionalize time-tested fundamentals necessary for effective internal controls. Causes of the Asian Financial Crisis Financial crisis took place in late 1990s (Schultz, 2005). the major causes of this crisis is attributed to domestic currencies real appreciation, deterioration in the position of current account positions, excessive external borrowings by banks, currency mismatches in bank balance sheets, excessive growth of domestic credit, the burst of asset price bubbles and economic slowdown (Kolb, 2010). Structural and policy distortions are also seen as key cause of financial crisis in Asian countries. Under this view, fundamental imbalances triggered the crisis. The overreaction of the market led to fall in asset prices, exchange rates and economic activities. Causes of the Global Financial Crisis There are three main shocks, which led to global financial crisis. First was the burst of the housing bubble (Kolb, 2010). This caused reallocation of capital and loss of household wealth and reduced consumption (Von Mises, 2006). Second was the sharp rise in the equity risk premium. This caused a rise in the capital cost, fall in private investment and collapse of demand for durable goods. The last shock was the reappraisal of risk by households (United Nations, 2009). This led to discounting of future labour income and increased savings while decreasing household consumption (McQueen, 2009). The global financial crisis is also attributed to structural causes. This included deeply flawed institutions and practices that are often referred to as new financial architecture. This architecture had a globally integrated system of giant banks and shadow banking system of hedge funds, bank created special investment vehicles and investment banks (Schultz, 2005). It is argued that these institutions had poor regulatory systems in place. The effects and consequences of a financial crisis on financial system and economy Following a financial crisis, many financial institutions lose lots of money in form of bad loans and toxic assets. This often leads to investor panic and bank run (McQueen, 2009). Major companies involved in constructions also suffer a set back due to inability to obtain financing through the credit markets (United Nations, 2009). In addition, most mortgage lenders become bankrupt (Kolb, 2010). Many mutual funds also withdraw their money from money markets, which interrupts the ability of corporations to rollover their short-term debt. Global financial crisis results in collapse of shadow banking system, which reduces funds available for lending. Will there be another financial crisis in the future? There is likelihood that financial crisis could occur in future. Given the globalization of the financial markets and the innovations in financial institutions that make it hard for financial institutions to control them, another financial crisis could occur in future (Kramp, 2010). From the analysis of the three financial crises, it is apparent that poor control or structural systems promote the likelihood of financial crisis to occur (McQueen, 2009). In case financial institutions will not be more resilient to accommodate innovations in form of financial products such products may still cause a financial crisis (Schultz, 2005). Even though globalization may result in creation of very big firms or interconnected firms, this does not eliminate chances that such firms may be liquidated or allowed to fail. Many financial institutions in different countries still have low capital requirements. This low capital does not provide adequate risk based capital and liquidity for such firms and hence is likely to fail culminating in another global crisis since most of them operate in global arena (Alasrag, 2010). As noted in the causes of the three financial crisis deregulation was one of their major causes and given that developing countries still need to access funding such deregulation will continue being experienced. As a result, if proper policies are not put in place, this will see many of such countries assume stable economy and growth in short run attracting more investors to a state where indebtedness increases beyond control. Such occurrence may result in a crisis like the one that hit the Asian countries. To avoid this, major economies need to put in place mechanisms of ensuring the economic imbalances do not persists or else we are likely to experience another crisis in the near future. References Alasrag, H. 2010. The effects of the global economic crisis on the Arab Economy. London: Lap Lambert Academic Publishing Honohan, P. and Laeven, L. 2005. Systemic financial crises: containment and resolution. London: Cambridge University Press. Kolb, R. 2010. Lessons from the Financial Crisis: Causes, Consequences, and Our Economic Future. London: John Wiley and Sons. Kramp, R. 2010. The Great Depression: It's impact on forty-six large American Public Libraries, an inquiry based on a content analysis of published writings of their directors. London: Library Juice Press, LLC. McQueen, R. 2009. A social history of company law: Great Britain and the Australian colonies 1854-1920. New York: Ashgate Publishing, Ltd. Schultz, S. 2005. The Great Depression: A primary source history. London: Gareth Stevens. United Nations. 2009. The global economic and financial crisis: regional impacts, responses and solutions. New York: United Nations Publications. Von Mises, L. 2006. The causes of the economic crisis: and other essays before and after the Great Depression. Berlin: Ludwig von Mises Institute Read More