THE ROLE OF FINANCIAL INSTITUTIONS IN THE FINANCIAL CRISIS
The Role of Financial Institutions
One of the reasons why the recession, which started only in one country, spread rapidly around the world is the rapid globalization that has taken place in modern times. Due to this fact, financial institutions across the world are threaded together into a mesh of complementary financial partners. This makes it possible for various financial institutions to trade with each other, and influences the global financial outcome. This means that the success of one influences the other, and vice versa. At the same time, a great majority of the large financial institutions are established internationally. Although this is a good thing, a down turn may not allow for any salvation because wherever they are, regulatory practices and rules apply. It would be almost impossible for instance, to bail out a company with over one hundred subsidiaries across the globe. It was reported that some of the institutions pressured the Securities and Exchange Commission to change some of the rules that it in place in order to facilitate easier trading. What this did in effect was to create gaps that made it possible for these financial institutions to deal unscrupulously (Gillian 60). In the United States in particular, the financial institutions got deeply involved in housing business in an attempt to take advantage of the low rates that were offered by the Federal Reserve. As the Credit Default Swaps (CDS) grew, the major financial institutions took some huge risks without properly assessing their exact nature (Gillian 71). All of this time, the regulators in the industry did not offer the right advise to these institutions. As a matter of fact, the rating that was offered to insurance companies respecting CDS indicated that it was the way to go. This was the case, for instance, with AIG. Due to the wonderful ratings, the company did not post security when it made decision to insure debt securities. The fact that most of the institutions involved were huge gave assurance to investors. This confidence was perhaps an extra reason, why people went on with investments because the situation was that there was no regulatory body observing and all of this time the rating agencies were indicating that it was an all time high. Obviously the mistake that institutions made was to assume that the way insurance operated could be applied in the securities market (Gillian 68). In other words, if a house is broken into, it is not the case that other houses would experience the same eventuality. However, things are different with the bonds market, because there is a certain correlation. Defaults cause further defaults. Thus when Lehman Brothers failed, for instance, a chain of other institutions were at great risk of failure. In particular AIG, the main insurer of Lehman Brothers was greatly compromised by this down turn of events.
The Federal Reserve and Bank Policies
When the Federal Reserve made the decision to bring down its rates to 1.0 percent from 6.5 percent between 2000 and 2003, it encouraged a lot of borrowing, because people wanted to benefit from the favorable environment. The reason that was offered for this measure was that people really needed a break from the harsh effects of the terror attacks the dot com bubble collapse, as well as need to prepare to handle the deflation that had been perceived (Gillian 69). At the same time, it became clear that the countrys current account deficit was on the rise. This meant government borrowing heavily from abroad, which already encouraged further spending. Financial assets, as well as mortgage backed securities, became the preferred investments. Unfortunately, it meant a further reduction of interest rates. When the Federal Reserve raised its rates later on, the interest rates went up across the divide. This meant that the choice investment areas were no longer attractive. Mortgage backed securities as well as financial assets were now suffering a major set back.
On the other hand, the biggest investment banks were taking steps to increase leverage. This obviously meant that incase of a down turn they had no cushion against the financial shock. In 2007, only five of these institutions had over 4.1 trillion dollars in debts. This also came along with the fall of huge financial institutions as the Lehman Brothers, the sale of Merrill Lynch, and Bears and Stearns (Gillian 54). It was also the time that Morgan Stanley and Goldman Sachs were converted into commercial banks.
At the same time, Freddie Mac and Fannie Mae had been encouraged by the government to expand in mortgage lending. Over five trillion dollars were already lost in 2008 when the government placed them into conservatorship (Gillian 57). These two corporations, as well as the five investment banks had over nine trillion dollars in debts, while they enjoyed privileges that depository banks did not.
The SEC and the Financial Crisis
The Securities and Exchange Commission has terribly failed in its role as the protector of investors. The chairman was quoted saying that the commission did everything in its power to avert the financial crisis (The Wisconsin-Madison University 1). This statement by the commission pointed to a serious neglect of its responsibility. If it did all it could, which did not cushion the investors, and indeed the world, from massive financial losses, then it means it is incompetent. The absence of the chairman of the commission in the meetings held by the directors of the various corporations and the regulatory agencies, in which discussions were held on how to save the situation, was very conspicuous. In September last year but one, the chairman was quoted saying that the problem of short selling, and the manipulation of the market was taken care of. Allegedly there have been several cases of what is referred to as naked shorting. Brokers have the tendency of borrowing shares, and selling them at a high price, then when prices come down they buy shares to replace the ones they had already borrowed. Sometimes, these people do buy the shares, but they delay the delivery, creating a possible manipulation of prices, in order to benefit from this situation, by selling non existent securities. There is high possibility that this is exactly what happened in the current financial crisis. But it is not enough for the commission to come in after the worst has already happened. Its role is to ensure that the investors are warned, or informed of possible crisis. This is not what the commission did in this crisis. Those on the commissions side argue, however, that there isnt much it can do in terms of helping out the falling companies, especially companies whose policies are formulated by parent companies elsewhere. Some have even blamed the Congress, arguing that they set stage for the crisis in the 90s when they took away the tools necessary to offer directions to emerging markets and securities. The chairman, when summoned by a committee of the Congress said that the commission didnt have the powers to control the kind of risks that these corporations took. They argued that rules that were two centuries old, were expected to regulate modern markets all this in an attempt to absolve the commission from blame.
The commission is supposed to check on all the securities firms and all the brokers as well in order to ensure that those that are experiencing difficulties in performance can be highlighted for the public (Securities and Exchange Commission 1). This would go along way in ensuring that the public knows exactly what is going on. Unfortunately, the commission in several instances didnt even seem to know what was going on in these companies. This is evidenced by the fact that so many companies that are in serious financial mess have come into public eye in the last one year. It is a fact now, that there is increased leverage in the U.S., but sadly, there are no rules or even acknowledgement of this fact. As earlier mentioned, the commission said that it had control only over the subsidiaries, rather than over the parent companies (The Wisconsin-Madison University 1). This however is not entirely true. In 2004, an arrangement was made to have to have the commission access information regarding a companys stability from companies that function from any of the European countries. This effectively places the commission at a position where it can monitor the performance of the parent companies. This means that if the subsidiary does not have the ability to stand financially, the commission is already aware, and thus raises the alarm to the potential and already existing investors. This they didnt do either before, or at the beginning of the crisis. The collapse of so many huge institutions means that there is a lot that wasnt done, and instead of the commission setting up conferences to tell us that they had done all in their power, they should have come clean, and apologized to the public for a neglect of their important duty as guardians of the investors (Southern California Public Radio, 2009). What did they tell us regarding the over sixty percent of banks that vanished out of the horizon Absolutely nothing
The commission has all the powers needed to demand of a company that it furnishes the public with additional financial information, yet to date few have the knowledge of the height of leverage in their choice investment companies. The Commission may investigate any firm if it feels that that firm submitted in accurate information, or left out some information regarding its performance. It also has the duty of investigating any broker if it feels they were unfair in their dealing with the customer. It is worth noting that the commission was created after investors suffered great losses from the Great Depression of 1929 in order to ensure that they do not suffer similar losses in the future out of careless securities firms (Financial Industry Regulatory Authority 1). This is the prime role this commission failed in. Since the securities markets are so significant for prosperity, the Securities and Exchange Commission must be guided by integrity and the awareness that they are not only controlling business investments but the lives of all the citizens of the United States of America, and by extension of all citizens of the world.
Various financial institutions enjoy an interconnectedness which makes it possible for them to expand rapidly. However, financial institutions played a huge role in the development of the crisis. Most institutions pushed for a relaxation of rules, which made it possible for them to take advantage of gaps that were in existence. Consequently, institutions were able to take on huge amounts of debts, due to the low interest rates. All this coupled with the laxity of the Securities and Exchange Commission precipitated what is currently a global concern, namely the global financial crisis. The entire life of the globe seems to hang on the threads of financial stability. If one thread comes loose, the entire network is threatened. As already mentioned, the Securities and Exchange Commission has a role of protecting the investors against possible fraud. This was the role that was placed on it after the depression of 1929. However, the commission did not take its role very seriously, a fact that is attested by the fall of great giants in the financial industry, such as the Lehman Brothers. The financial institutions, the regulators as well as the agencies charged with the responsibility of rating performances should have done a lot more to ensure that what the world is going through right now was avoided. It would only be fair that they own up to their mistakes and do something more to reverse the situation now.