Source: http://global2015.net/challenges/finance.html?;black;expandedmenue
Timestamp: 2019-04-19 02:19:41+00:00

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Affected people and foundations of life: Debt problems and other poorly secured financial transactions induced the Asia crisis, the Argentina crisis, the dying of dot-coms, the US (United States [of America]) subprime crisis and its global consequences, etc. The financial system entails a higher risk than other parts of the economy, because the consequences of market failure are not restricted to the market in question; instead, the collapse of just one financial institution might trigger the implosion of the entire financial system (systemic risk) and would also drag down the real economy (SRW [Sachverständigenrat zur Begutachtung der gesamtwirtschaftlichen Entwicklung (The German Council of Economic Experts)] 2008, 4). The financial system has a tendency to be procyclical, overexpanding in good times and retrenching sharply in bad times, exacerbating the likelihood of financial instability and amplifying undesirable macroeconomic feedbacks (BoE [Bank of England] 2008, 44). In 2005 the Counterparty Risk Management Policy Group (CRMPG) in its "Corrigan report", that was prepared by senior officials from a number of private financial institutions, came to the conclusion, that since the Asia crisis the statistical probabilities of the occurrence of major systemic financial shocks have decreased. But the damage caused by such a shock would be greater because of the enormous rise in speed and complexity and the tightening of linkages in the global financial system. In addition to that CRMPG concluded, that the financial world's capacity to anticipate systemic shocks is nil. (CRMPG 2005.) Now the risk event has occured.
Over the period 1970 to 2007, there emerged 124 banking crises, 208 currency crises, and 63 sovereign debt crises at national level (including 42 twin crises and 10 triple crises; Laeven/Valencia [IMF (International Monetary Fund)] 2008, 7 and 56). Fiscal costs of financial crises in emerging markets in the 1980s and 1990s topped US$ (United States dollar)1 trillion (WB [World Bank] 2006). There were common denominators across all post-1980 financial crises: credit concentrations (in specific borrowers), broad-based maturity mismatches, excessive leverage, the illusion of market liquidity – or the belief that such liquidity will always be present –, and macroeconomic imbalances, including such forces as inflation, recession, budget deficits, and large external account imbalances (CRMPG 2008, 6).
The decline in lending and due diligence standards in the US mortgage and related securities markets undermined market confidence (IIF 2008, 15).
Certain countries incurred large deficits in international trade and current accounts (particularly the United States), while other countries accumulated large reserves of foreign exchange by running surpluses in those accounts (CRS 2008, 12). These macroeconomic imbalances have long been recognized as potential sources of instability (CRMPG 2008, 3, 6; UN 2005, 165f. [and following page]; ECB [European Central Bank] 2008, 17f.).
Investors deployed 'hot money' in world markets seeking higher rates of return. These were joined by a huge run up in the price of commodities, rising interest rates to combat the threat of inflation, and a cyclical slowdown in world economic growth rates (CRS 2008, 12). The implications of building asset price bubbles were not recognized even in the advanced stages of their development (CRMPG 2008, 133; with the exception of warnings like UN 2006, 23-24).
Banks, market participants and the authorities have all underestimated the risks to which many banks and other financial institutions have been exposed (BoE 2008, 42). There has been a general underpricing of credit risk (G-20 SG [Study Group] 2008, 3). Failures in risk management policies, procedures, and techniques were evident at a number of firms (IIF 2008, 9). Other firms had exercised better practices (SSG [Senior Supervisors Group] 2008). However, risks that had been expected to be broadly dispersed turned out to have been concentrated in entities unable to bear them (FSF 2008, 9).
Banks, investment houses, and consumers carried large amounts of leveraged debt (a high proportion of debt or assets to equity; CRS 12). High leverage has been a significant factor amplifying losses and leading to some financial institutions needing to sell securities into falling markets (G-20 SG 2008, 22). The current turmoil has made clear to what kind of result a high leverage can lead: Losses being low compared with bank assets can exhaust a large portion of equity capital (SNB [Schweizerische Nationalbank (Swiss National Bank)] 2008, 6).
The originate-to-distribute model of these vehicles increased risk in financial markets: The originator of credits or mortgages passed them on to the provider of funds or to a bundler who then securitized them and sold the collateralized debt obligation (CDO) to investors (CRS 2008, 11). Risks were being transferred to the unregulated segment of the market (Laeven/Valencia [IMF] 2008, 26). There also was a lack of transparency about the risks underlying securitised products, in particular including the quality and potential correlations of the underlying assets (FSF 2008, 9f.).
Credit rating agencies have not conveyed the full array of risks embedded in structured products (IIF 2008, 15). Risk assessments by rating agencies tend to be highly pro-cyclical as they react to the materialization of risks rather than to their build-up (UN 2008b, 29). Moreover, risk was also increased by a rise of perverse incentives and complexity for credit rating agencies. Credit rating firms received fees to rate securities based on information provided by the issuing firm using their models for determining risk. (CRS 2008, 11.) Some institutional investors have relied too heavily on ratings in their investment guidelines and choices, in some cases fully substituting ratings for independent risk assessment and due diligence (FSF 2008, 37; IIF 2008, 16).
Public disclosures that were required of financial institutions did not always make clear the type and magnitude of risks associated with their on- and off-balance sheet exposures (FSF 2008, 8).
Limitations in regulatory arrangements, such as those related to the pre-Basel II (roman 2) framework, contributed to the growth of unregulated exposures, excessive risk-taking and weak liquidity risk management (FSF 2008, 9). The fundamental pro-cyclicality of the financial system has even been raised in the last years through regulation, by valuation of assets according to market prices (fair value), by risk-weighting of assets introduced by Basel II, and models of risk assessment used for that purpose (SRW 2008, § 266).
Total mark-to-market losses on securitized credit instruments and corporate bonds across the USA (United States of America), the Euro area and the UK (United Kingdom) have risen to around US$ 2.8 trillion (losses until 20 Oct 2008 compared to Jan 2007; a further increase is expected; BoE 2008, 12 and 14). This is equivalent to 5.1% of the global GDP (gross domestic product) (IMF 2008b, 259, and by own calculation).
Governments of twenty industrialized countries supported their banking systems by guarantees of US$ 5 269 billion (including some guarantees of bank's wholesale debt or nationalizations of banks), capital injections of US$ 711 billion, purchases of assets of US$ 659 billion, and other supports of US$ 1 413 billion (announcements until 24 Oct 2008; BoE 2008, 33; CRS 2008, 15; dollar values in column 3 and 4 corrected according to column 1 and 2 by own calculation). Most of these support packages consist of credits yielding interest, shares in banks, guarantees against fee, or swaps of securities (so there are options for a return of money).
Financial crises: to ensure that a global crisis, such as this one, does not happen again (G-20 summit declaration: G-20 2008, § 2).
Debt of poor countries: a debt relief for heavily indebted poor countries, and a cancellation of all bilateral debts (goal of Millennium Summit: UN 2000, § 15.2).
Financial crises: − Since 1970 the number of systemic banking crises has increased (Caprio/Klingebiel [WB] 2003; Laeven/Valencia [IMF] 2008, 56), and in 2007/08 the worst financial crisis since 1929 has emerged.
Debt of poor countries: + In 2007 there was a cumulative debt relief of US$ 69 billion (regarding the Highly Indebted Poor Country Initiative and the Multilateral Debt Relief Initiative; UN 2008b, indicator 8.11).
Developing recommendations to mitigate pro-cyclicality, including the review of how valuation and leverage, bank capital, executive compensation, and provisioning practices may exacerbate cyclical trends. (G-20 2008, action plan p. 2.) The basic objective of prudential regulation and supervision should be to introduce strong counter-cyclical rules (UN 2008b, 30).
Strengthening capital requirements: Authorities should ensure that financial institutions maintain adequate capital in amounts necessary to sustain confidence. International standard setters should set out strengthened capital requirements for banks' structured credit and securitization activities. (G-20 2008, action plan p. 2.) Supervisors must set capital and liquidity buffers at levels that take account of the potential for risk management failures to occur and that limit damage to markets and the financial system when they occur (FSF 2008, 10; EK [Enquete-Kommission "Globalisierung der Weltwirtschaft – Herausforderungen und Antworten"] 2002, 115f.). This includes further improvements to the Basel II capital framework (FSF 2008, 12; BoE 2008, 42).
To mitigate pro-cyclicality, it is considered to allow capital requirements to be flexible or varying, corresponding to indicators such as balance sheet total, growth, and inflation (SRW 2008, §§ 290-292; BoE 2008, 42).
Strengthening liquidity standards: Supervisors and central banks should develop robust and internationally consistent approaches for liquidity supervision of cross-border banks (G-20 2008, action plan p. 3). Most of the current defences in the supervisory framework are presumably designed to handle idiosyncratic risks to liquidity, rather than the more challenging case of a systemic problem, where everyone is scrambling for liquidity (G-20 SG 2008, 35). Liquidity standards should be strengthened to ensure that firms are sufficiently resilient to a range of shocks (BoE 2008, 41, table 6.A, and 43; FSF 2008, 12).
Enhancing risk management: Supervisors should ensure that financial firms develop processes that provide for timely and comprehensive measurement of risk concentrations and large counterparty risk positions across products and geographies (G-20 2008, action plan p. 3). Supervisors will strengthen banks' risk management practices, to sharpen banks' control of tail risks (events in the adverse tail of risk distributions) and mitigate the build-up of excessive exposures and risk concentrations, including off-balance sheet activities (FSF 2008, 17 and 19). Banks even have to consider those kind of shocks, which occur rarely, but show a high potential of damage (tail events; SNB 2008, 10).
Action needs to be taken, through voluntary effort or regulatory action, to avoid compensation schemes which reward excessive short-term returns or risk taking (G-20 2008, action plan p. 3). The financial industry should align compensation models with long-term, firm-wide profitability (FSF 2008, 20; SRW 2008, § 262). This should also be the focus of promotions and awarding job titles in senior and executive management. Additionally, compensation practices should be heavily stock-based with such stock-based compensation vesting over an extended period of time (CRMPG 2008, 5).
Supervisors and regulators should speed efforts to reduce the systemic risks of CDS and over-the-counter (OTC) derivatives transactions (G-20 2008, action plan p. 3). Market participants should ensure that the settlement, legal and operational infrastructure underlying OTC derivatives markets is sound (FSF 2008, 20). The financial industry should create a clearinghouse for outstanding OTC derivatives, starting with CDS (CRMPG 2008, 1).
Risky volumes of derivatives could be limited by a tax on foreign exchange transactions (Tobin tax; EK 2002, 115f.).
Central banks are challenged to consider in their monetary policy not only the stability of money value, but more than up to now the stability of the financial system (SRW 2008, § 261).
Supervision of credit rating agencies: G-20 members will exercise strong oversight over credit rating agencies. Rating agencies that provide public ratings should be registered. (G-20 2008, § 9, and action plan p. 3). An external review of the rating process should be established (IIF 2008, 16). Credit ratings agencies should review the quality of the data input and the due diligence performed by originators, arrangers and issuers. They should expand information on structured products. (FSF 2008, 58.) Rating agencies should develop a different or additional scale (and/or system of symbols) for rating structured products – which in stressed market conditions can have much higher rating and price volatility than, for example, corporate bonds (IIF 2008, 16; FSF 2008, 58).
National and regional authorities should implement national and international measures that protect the global financial system from uncooperative and non-transparent jurisdictions that pose risks of illicit financial activity (G-20 2008, action plan p. 4, and § 9). This may include a special jurisdiction regarding offshore finance centres, and regulations on transactions with them (EK 2002, 115f.).
Regulators should take all steps necessary to strengthen cross-border crisis management arrangements, including on cooperation and communication with each other and with appropriate authorities (G-20 2008, action plan p. 4, and § 9).
A global early warning system should be established, with the IMF and FSF working closely together to analyse the risks to global financial stability, and the links between macroeconomic events and prudential regulation (HMT [Her Majesty's Treasury] 2008, 15). An international system for recognizing risks and early warning should have access not only to macroeconomic information but also to microprudential data on individual large financial institutions (SRW 2008, § 6, and p. 6). The finance industry establishes a Market Monitoring Group to provide ongoing assessment of global financial market developments for future vulnerabilities (IIF 2008, 23).
G-20 members agreed to reject protectionism and to refrain, within the next 12 months, from raising new barriers to investment or to trade in goods and services.
With regard to the impact of the current crisis on developing countries, particularly the most vulnerable, G-20 members reaffirm the importance of the Millennium Development Goals and the development assistance commitments they made.
To mitigate the risk of a disorderly adjustment in the global imbalances, the major economies should coordinate their macroeconomic policies over the medium run (UN 2006, viii [roman 8]). IMF analysis suggests that the financial turmoil has made joint action to curb the imbalances more relevant (IMF 2008a). A multilaterally agreed strategy on global imbalances called for: steps to boost national saving in the United States, including fiscal consolidation; further progress on growth-enhancing reforms in Europe; further structural reforms, including fiscal consolidation, in Japan; reforms to boost domestic demand in emerging Asia, together with greater exchange rate flexibility in a number of surplus countries; and increased spending consistent with absorptive capacity and macroeconomic stability in oil-producing countries (IMF 2007). More far-reaching recommendations include import certificates, an International Clearing Union, or a reform of the present international reserve system, away from the almost exclusive reliance on the United States dollar and towards a multilaterally backed multi-currency system which, perhaps, over time could evolve into a single, world currency-backed system (UN 2008b, 33).
All measures should be part of a framework guaranteeing that default risks will be considered in booms ahead – even despite of several years of perceived stability, high yields and high competition, as seen in the period up to mid-2007.
Debt of poor countries: Initiatives for debt relief for poorer countries amounting to US$ 59 and 50 billion were started in 1996 and 2005, which should reduce the annual debt payments by about US$ 1 billion each (Highly Indebted Poor Country Initiative and Multilateral Debt Relief Initiative, UN 2006a, 23).
BoE 2008 – Bank of England: Financial Stability Report. October 2008 (Issue No. 24).
Caprio/Klingebiel (WB) 2003 – Gerard Caprio and Daniela Klingebiel: Episodes of Systemic and Borderline Financial Crises. . World Bank, Washington, January 2003.
CIA 2006 – Central Intelligence Agency: The World Factbook 2005. Debt – external.
CRMPG 2005 – Counterparty Risk Management Policy Group II: Toward Greater Financial Stability: A Private Sector Perspective.
CRMPG 2008 – Counterparty Risk Management Policy Group III: Containing Systemic Risk: The Road to Reform; The Report of the CRMPG III. August 6, 2008.
CRS 2008 – Congressional Research Service: The U. S. Financial Crisis: The Global Dimension with Implications for U. S. Policy. (CRS Report for Congress, Order Code RL34742) November 18, 2008.
ECB 2008 – European Central Bank: Financial Stability Review; December 2008.
G-7 2008 – Group of Seven: G-7 Finance Ministers and Central Bank Governors Plan of Action. (HP-1195) Washington, October 10, 2008.
G-20 2008 – Group of Twenty: Declaration; Summit on Financial Markets and the World Economy. [and] Action Plan to Implement Principles for Reform. November 15, 2008.
G-20 SG 2008 – G-20 Study Group: Study Group Report on Global Credit Market Disruptions. 31 October 2008.
HMT 2008 – Her Majesty's Treasury: Managing the global economy through turbulent times. London, December 2008.
IMF 2007 – International Monetary Fund: The Multilateral Consultation on Global Imbalances. April 2007.
IMF 2008 – International Monetary Fund: Global Financial Stability Report; Financial Stress and Deleveraging; Macrofinancial Implications and Policy; October 2008.
IMF 2008a – International Monetary Fund: IMF Sees Global Imbalances Narrowing, But More to Be Done. By Hamid Faruqee, IMF Research Department. February 19, 2008.
IMF 2008b – International Monetary Fund: World Economic Outlook; Financial Stress, Downturns, and Recoveries. October 2008.
SNB 2008 – Schweizerische Nationalbank: Bericht zur Finanzstabilität 2008. Juli 2008.
SRW 2008 – Sachverständigenrat zur Begutachtung der gesamtwirtschaftlichen Entwicklung: Die Finanzkrise meistern – Wachstumskräfte stärken; Jahresgutachten 2008/09. November 2008. Print version: ISBN 978-3-8246-0827-0. SFG (Servicecenter Fachverlage GmbH), Kusterdingen. English summary (chapter 1): The German Council of Economic Experts: Mastering the financial crisis – Strengthening forces for growth; Annual Report 2008/09; Summary.
SSG 2008 – Senior Supervisors Group: Leading-Practice Disclosures for Selected Exposures. April 11, 2008.
UN 2005 – United Nations, Department of Economic and Social Affairs: World Economic and Social Survey 2005; Financing for Development. (E/2005/51/Rev.1, ST/ESA/298) June 2005.
UN 2006 – United Nations, Department of Economic and Social Affairs: World Economic Situation and Prospects 2006. (Sales No. E.06.II.C.2, ISBN 92-1-109150-0) January 2006.
UN 2006a: The Millennium Development Goals Report 2006. [Published by the United Nations Department of Economic and Social Affairs DESA] New York, June 2006.
UN 2008a – United Nations: The Millennium Development Goals Report 2008; [Statistical Annex].
UN 2008b – United Nations, Department of Economic and Social Affairs: World Economic Situation and Prospects 2009; Global Outlook 2009; Pre-release. 1 December 2008.

References: § 266
 § 2
 § 15
 § 262
 § 261
 § 9
 § 9
 § 9
 § 6