The sub prime crisis is the worst financial crisis since the Second World War. The excessive leverage of financial institutions in the US and the UK, revaluation of securitized assets along with the collapse of world trade and world financial markets had an impact far beyond US and UK. The financial crisis was due to excess liquidity, intra financial securitisation, unsustainable global capital accumulation that created global imbalances and consumption dynamics.
Banking sector grew rapidly and had the power to shape the entire economy. In 2007, the Bank of England stated that banking assets exploded from $10 trillion in 2000 to $23 trillion in 2006. The derivatives market exploded after 1998 down to December 2007 with growth of 826 percent, thus by December 2007 the derivative market was worth $600 trillion.
Low interest rates and global imbalances supported the financial crisis. The US and the UK Central Bankers kept their interest rates at (low) levels that fuelled the availability of credit in the economy, led to assets price inflation and increasing pool of toxic assets. From June 1989 to August 2006, the US Federal Open Market Committee (FOMC) and the UK’s Monetary Policy Committee (MPC) made 73 and 33 changes respectively in the range of 0.25 percent or 0.5 percent. The current account surplus of emerging economies corresponds to current account deficits of USand UK. Large current account deficits of US and UKwere financed by Chine and the Oil Exporting Nations.
Flaws in the supervision and regulations of financial institutions allowed the banks to obtain off balance financing without increasing their capital base and ‘originate to distribute’ model left financial institutions vulnerable to even slight change in asset prices. Financial innovation had proceeded to the point that securities could not be priced correctly. Collateralised Debt Obligations (CDOs) and Mortgages Backed Securities (MBSs) worth $500 billion and $7.4 trillion were outstanding in 2008. These complex securities were rated by incentive driven Credit Rating Agencies (CRAs). More than half of revenue of rating agencies was from rating these complex securities.
The crisis also had a greater impact on the Eastern European (EE) Transition Economies with their growth rates declining significantly. After the collapse of Soviet Union, the Eastern European economies provided the world with cheap labour, low tax brackets and low cost raw material. After the recession inWestern Europein 1990s, there was significant relocation of factories to the EE region with real growth rate between 7 to 10 percent per year.
EE exports to the EU increased 2.5 times over the decade 1998 until 2008 and at the time of financial crisis two thirds of exports from the EE go to the Eurozone. Over the period of 1990–2004 exports from the CzechRepublic, Estonia, Hungary, Latvia, Lithuania, Poland, Slovakia and Slovenia increased 7 times. The export to GDP ratio increased from 29.3 percent in 1995 to 46 percent in 2004. In 2004 EU15 absorbed 65.9 percent of total exports of EE economies compared with 46.0 percent in 1990.
The enormous imbalances in these economies followed by cross border lending and exports resulted in credit flows from developed Western Europe Economies. This led to the transformation of the domestic financial sector into large foreign owned universal banks with weak links towards domestic production sector. This also burdened the EE economies with interest and currency risks.
During the financial crisis, the average growth rate in Eurozone decline from 2.8 percent per annum in 2007 to 0.6 percent in 2008 to a negative growth rate of 4.1 percent in 2009, with the exception of Poland that grew at 1 percent during financial crisis due to its less dependence on exports, import and robust domestic consumption. Latvia’s double digit growth rate was amongst the highest in the EU, was forced to accept $10.5 billion from the IMF, the EU and other sources. Hungary’s stock market decrease by 14 percent in 2008 and the Czech Republic’s stock market fell by 24 percent in the same period. There was lack of foreign capital in the EE countries due to decrease in exports and banks found it difficult to fund their growing deficit.
Economic growth strategy followed by EE countries was foreign savings led growth in three senses: Foreign Direct Investment (FDI), cross border lending and finally exports. The depressed economic conditions in EE was due to accumulated imbalances (most EE countries had high current account deficits since the 1990s) and increases in foreign currency borrowing of households. The imbalances in EE region was driven by huge inflow of Foreign Direct Investments (FDIs) in EE region. Estonia, Latvia, Belarus, Russia, Ukraine and Bulgaria attracted large capital inflows, boosting money supply and inflation in the economy.
The second important driver was the increase in domestic household borrowings. The credit to household sector increased significantly from year 2000 to year 2007 that led to asset price inflation and foreign currency mismatches. The subsequent collapse in the house prices eroded bank capital and prolonged recession in EE economies.
The recent financial crisis called for reforms and revision of regulations and supervision on international and national basis. The regulatory standards in these economies were strengthened through the adoption of Basel II Capital Standards and the Basel Core Principles for Effective Bank Supervision (BCPs). Despite this the crisis emerged in the economies where the regulations and supervision were thought to be the best in the world. This crisis exposed the weaknesses in regulatory and supervisory frameworks and provided the basis of debate about the roles these have played in causing and aggravating the crisis.
In the current financial system the domestic banks has the power to the shape the entire economy. The supervisory and regulatory powers should devise policies take away power from banks to shape the entire economy. The radius of financial sector supervisory should be increased to wider range of institutions and institutions should be required to wider range of disclosure as their contribution to systematic risk increases. Regulators should demand more information disclosure to access off balance sheet risk. Capital, provisioning and liquidity norms should be more demanding in good times to build buffers in bad times to offset procyclical pressures. Harmonized regulations and resolutions of cross border institutions should be developed for better crisis responses. The crisis management responses should be well coordinated both within the country and internationally.
Finance should be restructured to seek profit rather than in ‘finance financing finance’. Countries need to re specialize in line with coming technological revolution. Eastern European Economies have now to rely more on domestic demand, so that they can grow without US or developed Western European households’ indebtedness. Third is to reduce global imbalances and reduce income concentration.
The turmoil in financial markets are still ongoing and consensus on appropriate policy responses is still emerging, the policy developments should be focused on risk management practices, where supervisors and regulators should ensure adequate risk management practices in financial institutions, particularly where complex financial products are used. Supervisors should be very vigilant with regard to liquidity, effective contingency planning, and deposit guarantee frameworks. Supervisory bodies should also coordinate with foreign supervisors, if they have significant presence in domestic financial markets.
Some of the issues are also relevant to central banks, where central banks do not have supervisory functions, it should cooperate with banking supervisors for coordinated and early intervention, in case of financial market stress. The cross-border supervisory arrangement should be made if risk of contagion is significant in countries in which large current account deficits are financed by debt creating capital inflows and/or financial sectors dominated by banks from mature markets. If we do not learn lesson from the current and previous crises we will surely be facing another crisis in near future. There is a need for change in regulatory and supervisory framework to prevent excess credit creation in the economy so as to minimise the risk of future crisis.