8.      FINANCIAL CRISIS  

 

 

Financial crises may arise where firms fail to manage their risk effectively or some other source of external instability arises and the stability of a particular sector or market are threatened.  A financial crisis may be considered to arise where there has been a major interference or disruption with the operation of a particular market or system. This is distinct from more general market volatility or specific scandals which affect a particular firm.  A financial crisis generally only arises where one or more markets or systems are threatened more generally.

 

(1)       Financial Crises

 

Markets are inherently cyclic and unstable. They have been a number of significant crises historically going back to.  Tulip Mania in the 1600s, the South Sea Bubble and Mississippi Bubble in the 1700s and Railway Mania in the 1800s. More recent examples include the Mexican and Russian defaults in the early 1990s.International markets sustained significant losses following the 1997 Asian crisis beginning with the collapse in the value of the Thai bhat in July 1997 and then with the crisis in the Long-Term Capital-Management (LTCM) in 1998 which had to be supported by a number of other institutions. There was also a fall in stock market prices following the end of the technological ‘bubble’ in 2000 and then after the terrorist attacks on 9.11.2001 although no major continuing damage was sustained.

 

Significant examples of over financial crisis include:

 

(a)        The 1929 stock market crash in New York which led to the Great Depression during the early 1930s;

 

(b)        The collapse of the Bretton Woods system of managed exchange rates beginning in August 1971 with the announcement of the closure of the Gold Window by President Richard Nixon and the move to floating currencies after the failure of the major countries to agree any alternative replacement system (above);

 

(c)         The Third World Debt Crisis during the early 1980s beginning with the declaration of the Mexican moratorium in August 1982 which triggered a number of forced restructurings and reschedulings as well as the later ‘Mexican Peso’ crisis in 1994 with the G7 having to provide a US$40bn support package through the IMF (above);

 

(d)        The Asian Financial Crisis beginning on 2 July 1997 with the collapse of the Thai baht which spread to Malaysia, Indonesia and The Philippines as well as South Korea and Japan and with the IMF having to arrange a total support package of over US$100bn (above); and

 

(e)         The Russian debt crisis beginning in May 1998 with a collapse in the value of the rouble and short-term interest rates being raised to 150% and US$40bn of outstanding treasury securities being restructured (above).

 

 

 

(2)       Financial Scandals

 

The reputation and credibility of financial markets has also suffered in recent times following a number of high profile scandals and crises. Although few created larger systemic threats, damage was sustained to the credibility and viability of specific firms and to the attractiveness of investment for smaller corporate or individual investors. Specific instances of more recent scandal include the following:

 

(a)        The provision of a support package by 14 of the largest US financial institutions to the hedge fund Long-Term Capital Management (LCTM) in summer 1998 which had leveraged its US$4.8bn equity to US$125bn;

 

(b)        The closure of the Bank of Credit and Commerce International (BCCI) in July 1991 following confirmation that BCCI had been involved in money laundering in Florida and had committed fraud in the UK with its founder Agha Hassan Abedi dying in 1995 before he could be extradited and with his co-founder Suraleh Naquvi and with 13 other executives being convicted of fraud in Abu Dhabi;

 

(c)         Orange County, California lost US$1.7bn in 1994 through speculative investment by its Treasurer Robert Citron using the County’s US$7.4bn investment pool and US$13bn in borrowing with Merrill Lynch later agreeing to pay US$400m;

 

(d)        Barings Bank was sold to the Dutch bank ING for £1 in February 1995 after its derivatives trader Nick Leeson lost £830m (US$1.3bn) in arbitraging Nikkei 225 Index contracts between Osaka and Singapore and after the Bank of England and other banks refused to provide any support;

 

(e)         Daiwa Bank lost US$1.1bn in unauthorised trading in US Treasury bonds by Toshihide Iguchi in its New York branch;

 

(f)         Sumitomo Corporation lost US$3bn after its corporate trader Yasuo Hamanaka had tried to manipulate the world copper market in 1996;

 

(g)        Morgan Grenfell Asset Management (MGAM) made substantial losses in 1996 through its fund manager Peter Young who had been investing in unquoted high technology stock with its parent Deutsche Bank having to pay £230m (US$380bn) in compensation;

 

(h)        Leading Japanese securities houses were found to have made payments in response to blackmail threats (sokayia) to Yakusa gangs with Nomura being implicated in 1991 which forced the resignation of the Finance Minister Ryutaro Hashimoto and with Nomura, Dai-Ichi Kangyo Bank, Daiwa Securities and Nikko Securities being implicated again in 1997 (with 58 senior executives resigning) and with Yamaichi Securities collapsing in November 1997.

 

(3)       Global Financial Crisis

 

Markets have again been rocked with the global financial crisis beginning in summer 2007. Markets had enjoyed substantial growth and sustained increase in earnings during the ‘bull’ conditions between 2003 and 2007. This was only halted with the tightening in credit conditions that arose during summer 2007 following the tightening of conditions on international inter-bank markets after the losses sustained by a number of smaller specialist vehicles in the US sub-prime mortgage market. The stability of the larger banks was never threatened although a number of more specialist ‘conduits’ or specialist investment vehicles (SIVs) had to be closed or supported at the same time as losses were suffered by a number of hedge funds which either had to be re-capitalised or folded.

 

The crisis became significantly more serious during summer 2008 following the difficulties experienced at the Government Sponsored Entities (GSEs) Fannie Mae (Federal National Mortgage Association) and Freddie Mac (Federal Home Loan Mortgage Corporation), with both GSEs being put into conservatorship on 6 September 2008 and the government been forced to provide US$100 of billions of support for each. The US authorities also decided to support American International Group (AIG) with $85billion later on 16 September but decided to force Lehman Brothers on 15 September 2008. While JP Morgan Chase had purchased the Bear Stearns on 14 March 2008 with a $25 facility from the Federal Reserve and Bank of America acquired Merrill Lynch on 14 September, a number of other institutions had to close including Washington Mutual (WaMu) on 25 September 2008.  The failure of Lehman's, in particular, led to massive instability in global stock markets, which persisted until early October, with the UK government announcing a three .support plan based on market liquidity, wholesale market guarantees and recapitalisation on Wednesday 8 October 2008. The significant dislocation in the market nevertheless resulted in a Global Recession which persisted until 2010/2011.

 

A large number of papers have been issued on the causes of the crisis. This can be considered in a number of different ways. Five key general factors may nevertheless be identified:

 

1. Massive accumulation of credit and debt by governments, companies and households with financial institutions becoming over-leverage;

2. Excessive innovation leading to overly complex financial products and opaque wholesale markets which undermined transparency before and during the crisis;

3. Failure of risk management and governance within financial institutions and overdependence on external counter parties including Credit Ratings Agencies (CRAs) which mispriced risk;

4. Mixing of low with high risk products with contagion and collapse in confidence undermining whole asset classes including specifically CDOs and structured finance;

5. Authorities lacked the necessary resolution tools to deal with individual institutions and support mechanisms for larger markets.

These can be summarised in terms of monetary policy or central bank failure, innovation or product failure, firm management and governance failure, market failure and regulatory and central bank support failure.

 

 

 

 

(4)       Global Crisis Response

 

A large number of papers were issued by various official and private bodies following the crisis to attempt to understand what had happened and to draw necessary lessons. These include by the Financial Stability Forum (which was renamed the Financial Stability Board (FSB)), the G20, the G30, an EU High Level Group (under Jacques de Larosiere) and Lord Adair Turner in the UK.

 

A series of significant corrective actions have also been taken at the national level in many countries to attempt to contain the damage caused and prevent similar crises in future. This included developing a number of new liquidity support facilities within the US, agreeing a $700 billion Troubled Asset Recovery Programme, the bail-out initiatives under the Emergency Economic Stabilization Act of 2008 and monetary stimulus Quantitative Easing (QE) beging in November 2008 and again in August 2010. This was followed by the adoption of the 638 page Dodd Frank Act in 2010 with 1,601 sections and 243 new rules, 61 studies and 22 periodic reports to follow.

 

A number of papers were issued by the Tripartite Authorities in the UK (made up of the Bank of England, Treasury and FSA) and with the government having to nationalise Northern Rock on 17 February 2008 after attempting to secure a private market solution with bids having been submitted by Virgin, Olivant and an internal management group. This led directly to the adoption of a range of new resolution mechanisms under the Special Resolution Regime (SRR) set up under the Banking Act 2009. The FSA was also forced to put in place a Supervisory Enhancement Programme (SEP) following its supervisory failure of Northern Rock and the strong criticism he received. A number of other Parliamentary papers commenting on regulatory matters, were issued and, in particular, by the Treasury Select Committee under John McFall and then Andrew Tyrie following the General Election in May 2010.

 

A series of measures will have to be adopted in each of the areas of monetary policy, risk management and governance, pricing and credit ratings, resolution and market support and larger macro-prudential oversight. This was not simply a bank or banking sector issue with the whole of the financial system having been affected and with consequent necessary action having to be taken by central banks, regulatory authorities, governments, corporate bodies and households as well as financial institutions. The underlying objective should be to ensure that markets operate in a stable and effective manner and provide maximum advantage. In so doing, regulatory reform should be targeted, proportionate and constructive rather than simplistic, excessive and destructive.

 

 (5)      Regulatory Adjustment     

 

The effect of the Global Financial Crisis has been to create a powerful new degree of political and public impetus and pressure to re-examine and reconsider the nature of modern financial markets financial risk, and financial regulation. Earlier assumptions regard to the efficiency of markets, ability of firms to consider and protect their own interests and the effectiveness of regulatory regimes and capacity of authorities to oversee firms and limit contagion where it arises have had to be wholly reassessed. We are now at the beginning of a new era in financial market oversight and control. It has also taken several years since the crisis to examine and consult on possible new regulatory measures and tools with the new capital requirements and Basel III only been agreed in December 2010 and with a number of for other important matters still to be finalised in 2011 (such as on Systemically Important Financial Institutions (SIFIs) and Globally Systemically Important Financial Institutions (G-SIFIs).