The Maintainability of the Current Financial Market

The Maintainability of the Current pecuniary MarketIntroductionTo argue that we argon not watercoursely in the midst of a global fiscal crisis is merely on maintain adequate to(p), given the saturation that the issue has had in the mainstream media. at that dapple is no secret that there is a global liquid deficit in the pecuniary sector, mortgage assets declining in quantify and subsequently limiting the ability of pecuniary insertions service their add and interest payment fates to dressors. As a consequent m any political congresss get to taken proactive measures to affix liquidness in the financial sector and stave off pretentiousness and different negative factor outs. It is the purpose of this paper to critically analyse the topical financial crisis, in conjunction with the sub-prime mortgage issue which rose to projection in late 2007. In light of the current frugal temper this paper leave al ace discuss whether employing a financial re variety unclutter allow for serve to address the pressures that atomic number 18 being laid on financial institutions in terms of their liquid assets and overall frugal viability. It will similarly limn the main ingredients of a sound financial recourse force out, and it is all-important(prenominal) to pit that all of these factors moldiness generally be empower in guild for a financial natural rubber engagement to dish out in effect in correcting the economic imbalance which the global economy is onward long experiencing.The Current monetary ClimateThe financial situation at present around the world is not one of economic prosperity and stability. In the last 12 months the world has had to resist the financial crisis of 2007-2008 sparked by the pressures placed on financial institutions as a result of the sub-prime mortgage crisis. virtually recently, beginning in September 2008, is a global financial and liquidness crisis which has led to a number of Ameri open fire and European lodgeing companys collapsing pay up to(p) to s croupet(predicate) liquid assets to service its obligations to its customers. Essentially the about recent crisis began with the fall in States regimen takeover of Fannie Mae and Freddie Mac, which were to judicature-sponsored enterprises servicing the United States home loan perseverance. This, among otherwise factors, because sparked a rapid decline in the value of global dribble food market indexes and currency indicators, such as the Dow Jones (United States), FTSE 500 (United Kingdom) and the ASX 200 (Australia) to several(prenominal)ize a few. This saw a rapid decline in the value of assets held by mortgage related entities, leaving them with significantly less lawfulness and liquidity to service their lending and interest payment obligations.Response to the crisis the commutation cants of many countries withalk measures to inject capital into the cash flow of the financial serve industry. For exa mple, the reserve edge of Australia injected AU$1.5 one thousand thousand ( approximately 3 time to a greater extent than the estimated take up), Indias Reserve fix pumped in approximately US$1.32 billion and the Reserve Bank of China provided a stimulus package of approximately 4 trillion yuan (US$585 billion).1 In the United States the Emergency stinting Stabilisation Act of 2008 was passed by Congress and gave the Bush administration the confidence to purchase up to US$700 billion of unserviceable mortgage assets in an attempt to maximise liquidity.2 In the United Kingdom, on 8 October 2008, UK government announced a 500 billion rescue package. All these measures were in an attempt to increase liquidity in the financial services industry, and were lots accompanied by reductions in the national cash interest evaluate as determined by the central buzzwords.In light of the kickshaw of the current global economic situation, is important to cipher the effect of the financi al services industry rubber inter pelf as a mechanics of consumer entertainion. As this paper will uncover in forthcoming chapters, the prophylactic simoleons often comprises a number of key portions in order to maximise its scope of application and effect. A number of jurisdictions feed desire to implement postulate guarantees and similar justification organizations, and the effectiveness and seeks associated with these projects will be discussed more thoroughly in payable course. However it is important to note in passing that the current economic crisis plays a significant social occasion in the ability of a financial gumshoe elucidate to endure efficaciously, due to the extraneous pressures which argon placed on the economic form as a result of a shortage of liquidity in the global financial industry. This affects every global financial institution from study banks right d profess to small time debenture businesses.An Overview of the Financial empyrean prec aution utmostIt is difficult to confine the financial sector safeguard net into one concise and succinct definition. Rather one must consider the safety net in light of its many factors. As the World Bank itself points out, atomic number 18 significant difficulties experient with implementing a safety net, which ar get hold ofly defined in the following releaseBank safety nets are difficult to design and administer, because they have the conflicting objectives of defend bank customers and reducing banks incentives to invade in risky activities. In several countries including the U.S., the financial safety net, structured to reduce the vulnerability of the financial carcass, appears to have had quite the opposite result. Indeed, Kane (1989) identifies the U.S. financial safety net, and notably fixed-rate unsex form _or_ system of government and belated bank closures, as the single most important factor in explaining the catastrophic Savings and Loan crisis of the 1980s . Similarly, Demirguc-Kunt and Detragiache (1998) find international consequence that the existence of an explicit pay back insurance policy policy connive has contri howevered to banking system fragility.To strangle bank risk taking, financial safety nets generally rely on two mechanisms (i) market discipline, and (ii) bank regulation. Bank book of factsors can exert market discipline by with blow uping their investment firms, or demanding higher interest rates from riskier banks. In case of publicly traded banks, equity holders can also effect discipline.3The higher up passage demonstrates that safety nets are not effective on their own rather they require cooperation among all the different classes of bursties involved in the financial industry in order to maintain a anicteric financial market. However implementing a safety net is not without its risks and, as the above passage indicates, some clock the mechanisms employed by a safety net programme of them contri hard lye to the fragility of the financial system is not use properly and in consideration of the context in which they are to apply.In light of the above this skeleton has presented a basic overview of the precept of the safety net in the financial industry and the aims it sets out to achieve. This brief will now go on to explore the fundamental elements of a safety net system, as it is important to consider the effect of separately of these individual mechanisms in appropriate de dope in order to draw an appropriate conclusion as to whether or not consideration should be given to a safety net scheme to be implemented in a broad manner across global jurisdictions in light of the current financial crisis.Elements of the safe NetFrameworks for Liquidity sustentationFor most banks and financial institutions the assume to maintain a certain kernel of fixed liquidity to service lending and interest payment obligations is native to consider the long-term viability of the institutio n, and also to ensure that the bank or institution can continue providing a service to its customers and therefore generate notwithstanding revenue. Most of these institutions have certain cash militia available to play off these obligations in the event that the institution becomes temporarily illiquid, however it is important to consider the strength of these measures given the current economic climate and also whether other measures exist in the event that the liquidity reserves of the institution are unable to service its obligations to its customers. whence it is important to distinguish between the liquidity reserves which are available to financial institutions during normal operating times and those which are to be relied upon in a time of crisis, and there is a need for a financial institution to consider the efficiency of two of these measures.A common form of day today liquidity reserves banks rely upon is the lender of last resort (LOLR) function, where central bank s in most splited jurisdictions around the world have the authority to provide credit support in the event of a bank becoming temporarily illiquid, however still remaining solvent.4 LOLR actions do not guarantee a take upst banks from failing, but rather serve to protect liquidity shortages in flowing from one bank to another. As the World Bank puts itThis kind of support can provide an important buffer against temporary disturbances in financial markets. LOLR actions whitethorn help to prevent liquidity shortage in one bank from being transmitted to other financial institutions, for example, by dint of the payment system. LOLR actions are not intended to prevent bank failures but, rather, to prevent spillovers associated with liquidity shortages peculiarly in specie and interbank markets from interrupting the normal intermediation function of financial institutions and markets.5Therefore the purpose of LOLR is to ensure the overall faithfulness of the financial market, throu gh containing any liquidity shortages to one bank and attempting to prevent it from reaching other institutions.In a time of crisis a financial institution may need to seek liquidity resources from the central bank over and above those that would normally be available to them for day-to-day activities. These emergency lending procedures need to be considered in the strongest possible manner, and the worldwide fiscal Fund has outlined a number of guidelines which should be taken into account in this regardresources should be do available only to banks that are considered solvent but are coping with liquidity problems that might endanger the entire system (e.g. too big to fail cases)lending should take place speedilylending should be short-term even then, it should be provided conservatively because of the situation of the bank might deteriorate quicklylending should not take place at subsidised rates, but the rate should also not be penal because it might then deteriorate the bank s positionthe loan should be in full collateralised, and collateral should be valued conservatively. However, at times of serious crisis, it might be prerequisite for the central bank to relax this beat or to organise a government guarantees or to ar mark government credit, even if the loan is executed from the central banks balance sheet rudimentary bank supervisory authorities and the Ministry of Finance should be in slopped contact and should monitor the situation of the banksupervisory sanctions or healing(p) actions should be attached to the emergency lending.6Therefore it is important to the above factors in emergency lending in order to ensure that the overall integrity of the financial system is not placed under threat through a central bank advancing credit to an illiquid financial institution. unsex redress or GuaranteesIt is one of the simple principles of banking that, in order for a financial institution to profit from lending products, it must have the liquidity resources to advance to the borrowers. These generally come from term deposits, everyday accounts and other consumer-based banking products, not to mention larger institutional banking deposits. In order for these customers to be able to bank with confidence with a particular institution, it may be necessary for the government to introduce a type of deposit insurance which serves to protect the deposits of customers in the event of a failed investment by the bank. It could be argued that by having all deposits protected by a deposit insurance scheme, a financial institution is effectively promoting excessive risk-taking given that the particular customer may feel they have nothing to lose and all to gain by allowing the customer to gamble with what is essentially free money. Therefore it is important to consider whether large deposits should be protected by such a scheme as, in the event of a payout being required, the deposit insurance scheme may be unable to meet its obligations in a timely and efficient manner, which is said to be a key requirement in order for such a scheme to function effectively.7 A fine balance therefore inevitably to be struck between defend the interests of customers while also ensuring that the deposit insurance scheme is in a position to meet its obligations in the event that it is called upon, and it would therefore need to be well funded.Investor and/or form _or_ system of governmentholder Protection SchemesAnother key element of an appropriate financial sector safety net is the need for customers who engage in investing through that institution to be afforded some sort of insurance breastplate, which would otherwise be unavailable under a deposit protection scheme. These schemes would be limited in their application, as they would generally avoid losses arising from a customers short(p) investment closing-making in the like unless a causal link can be established between the decision and advice obtained from the financial institution in question. The World Bank and International Monetary Fund fully describe the function of such a schemeInvestor compensation schemes generally cover customer accounts in which a range of investment activities defined in the respective licensing laws and broader regulatory regimes take place. salary schemes generally do not cover losses on the part of the investor as a result of poor investment advice or vigilance by member firms, although in some schemes, compensation may be available where a causal sexual intercourseship is established between the poor investment advice or solicitude and the inability of the firm to meet claims by clients. In most jurisdictions, the compensation scheme is statutory in temperament8therefore a member institution cannot simply wash its workforce purveying financial loss sustained by a customer who invest through the institution, unless it can be proven that the poor decision made by the investor was not induced (either whole or i n part) by the institution itself. An investor should be afforded some protection in relation to investment, but should still be in a position to accept obligation should they not heed appropriate financial advice.Crisis ManagementThe final appropriate element of an effective financial sector safety net is the structure of both an institution and the responsible government to manage a crisis if and when it occurs. For example, high-profile policy committees and consultants should be in place to establish the framework mentioned in the preliminary three chapters of this paper, and to ensure that it is implemented in such a steering that is effective in that institutions particular context. Financial institutions also need to ensure they have the appropriate resources, both financial and in personnel, to address is in particular important area of policy especially given the current financial climate and the strange places on banks to provide some form of protection to its custome rs while also attempting to remain prosperous and loyal to its shareholders.The International reckonThe financial sector safety net has been met with mixed reviews in discordant jurisdictions around the world in response to the current economic crisis. This is due to the fact that central banks and governments have encountered a number of problems when seeking to implement features of the financial sector safety net. For example the United States, given the current Wall Street crisis, and sought to implement a safety net measure, however Reserve Bank Chairman Alan Greenspan has statedThe safety net, on with our improved understanding of how to use monetary and fiscal policies, has played a critical role in this country in eliminating bank runs, in assuaging financial crises, and arguably in reducing the number and amplitude of economic contractions in the past sixty years. Deposit insurance, the discount window, and access to Fedwire and twenty-four hour period overdrafts provid e depository institutions and financial market participants with safety, liquidity, and solvency unheard of in forward years. These pull aheads, however, have come with a cost distortions in the price signals that are used to allocate resources, induced excessive risk-taking, and, to limit the resultant good hazard, greater government charge and regulation. Clearly, the latter carries with it attendant inefficiencies and limits on innovation.9Mr Greenspan has eloquently highlighted one of the key deficiencies with the financial safety net, particularly in relation to government and regulatory supervision of banks during its operation. By increasing government supervision on the financial sector, it severely limits the ability for banks to become innovators in their knowledge domain and seek to implement new ideas to better service the industry. By implementing rigid supervisory guidelines, the government would be forcing financial institutions to conform to set principles whic h would effectively contact all institutions the same, and limit the ability of these institutions to be granted the familiarity required to be innovative in this industry. Therefore one needs to consider whether the benefits of the financial safety net outweigh the costs associated with it. Mr Greenspan also highlights the increase in costs the taxpayer in the event of the safety net taking effectThe usual suggested tributes for deposit insurance are, of course, far from those that would fully eliminate the subsidy that insurance provides to depository institutions and their borrowers and depositors, especially at times of financial crisis. Indeed, to eliminate the subsidy in deposit insurance, the FDIC insurance premium would have to be set high enough to cover the extreme-loss vestige of the distribution of possible outcomes and thus the perceived costs of systemic risk. Since so high a rate appears politically infeasible, the subsidy in deposit insurance cannot be fully elim inated. Moreover, no private insurer will be able to match the actual FDIC premium and cover its risk from the extreme-loss tail. Obviously, if premiums were fully priced, the level of insured deposits would be significantly lower.10The above passage demonstrates that it is difficult to lower the deposit insurance premiums associated with a safety net programme, while also ensuring that the deposit insurance fund is still adequately funded to meet its obligations in the event is called upon. By lowering deposit insurance premiums, a financial institution would place a significant credit line on itself to be able to cover potential loss associated with the extreme-loss tail which Mr Greenspan discusses and recognises as a serious threat. American newspapers have also highlighted the risks associated with deposit insuranceIt has long been known that this feature of the safety net induces deterrent example hazard. Because of the reality and perception that bank deposits are fully pro tected, banks are voluntary to engage in riskier activities, insured depositors are less willing and able to monitor the activities of banks, and creditors are less sensitive to the risks incurred by banks. Therefore, it is imperative to develop a system that appropriately prices this insurance and the risks associated with providing it.11I fully protecting deposits, the government is inviting banks to be far less accountable for losses incurred as a result of mis centering of depositors and investors funds, and therefore the deposit insurance scheme needs to be appropriately justified and risk assess for can have any significant practical effect in granting customers tranquillity of mind that there investments are protected, given the current fragile economic climate.Other countries such as Australia have moved to guarantee bank deposits in light of the current financial situation around the globe. Particularly, the Australian government has guaranteed deposits up to an amount of $20,000,12 despite previously stating that moves by other foreign governments to guarantee deposits were uncoordinated.13 Interestingly, it has been said that the legal and regulatory framework in place in Serbia and Montenegro sufficient to encourage a deposit protection insurance scheme which would serve to appropriately protect banking customers and the financial industry therein.14 therefore the results encountered the international arena in relation to the financial safety net are mixed, with some systems acknowledging that certain reforms need to occur before the safety net will function effectively, and others seeking to implement the safety net within their jurisdiction.ConclusionIn conclusion, and in consideration of the discussions passim this brief, would be appropriate to conclude that a financial safety net scheme may be appropriate in certain draw in order to provide banking customers with peace of mind in relation to their investments. However it is important to no te that a safety net scheme does not bring with it guaranteed success, and one must consider the risks associated with implementing such a scheme and their possible contribution to the dire financial situation which is soon being experienced throughout the world. While the rationale of the safety net may have good intentions, it is clear that deposit guarantees and poor crisis management can have adverse effects on the financial market and therefore affect consumers in a negative way when the intentions are all positive.The international experience with financial safety nets is inconclusive. It is primarily due to the fact that underlying financial pressures in particular jurisdictions can have adverse effects on the effectiveness of the financial safety net, and make it difficult for the safety net to be effective in correcting these imbalances. In the case of the United States cost of deposit and investment insurance is simply too high to justify, whereas in say Australia or Japa n the benefit outweighs the cost based on sound financial infrastructure and crisis management techniques. Therefore it is significantly easier to implement a safety net system in these jurisdictions, given the sturdy financial history of the Asiatic markets. The United States present difficult challenge, with the major financial institutions having capital tied up in high risk investment portfolios, such as what was experienced with the sub-prime mortgage crisis beginning in mid-to late 2007. In short, the question must be asked whether a safety net would increase the liquidity resources of financial institutions, which is universally accepted to be the significant cause of the current financial crisis. The short answer is yes, given that deposit and investment insurance should effectively encourage customers to invest with a particular bank given that their money is effectively insured for a certain amount. However this insurance policy is not worth the paper its written on the i nsurance fund does not itself have the liquidity service obligations should be called upon to do so. This is a problematic situation, and cannot be effectively answered in a simple form. merely time will tell whether the financial crisis eases as a result of governments purchasing bad mortgage debts from financial institutions, and whether the liquidity shortage ends as a result.BibliographyArner, D.W., Financial Stability, Economic Growth and the image of Law (2007), capital of the United Kingdom CambridgeAustralian Broadcasting Corporation, governance considers upping bank deposit safety net (2008) http//www.abc.net.au/news/stories/2008/10/12/2388583.htm at 14 declination 2008Australian Broadcasting Corporation, No need for Government guarantee on bank deposits Rudd (2008) http//www.abc.net.au/news/stories/2008/10/10/2387244.htm at 14 celestial latitude 2008Demirguc-Kunt, A., and Detragiache, E., The determinants of banking crises in developed and developing countries (1998), IMF Staff news reports 45, 81-109Demirguc-Kunt, A., and Huizinga, H., Market subject area and Financial Safety Net Design (1999), World Bank Policy Research Paper WPS2183Gerda, O., beer maker III, E., and Evanoff, D.D., The Financial Safety Net costs, benefits and implications (2001) The wampum Fed Letter http//findarticles.com/p/articles/mi_qa3631/is_200111/ai_n8986952 at 14 December 2008Greenspan, A., origin federal Reserve Chairman, Speech The Financial Safety Net, 10 May 2001, http//www.federalreserve.gov/Boarddocs/Speeches/2001/20010510/default.htm at 14 December 2008Herzsenhorn, D.M., Administration is seeking $700 billion for Wall Street (2008), peeled York Times, 20 September 2008IMF Monetary and Financial System Department, Operational Paper OP/00/01, Emergency Liquidity Support FacilitiesKane, E.J., The SL Insurance locating How Did it Happen? (1987), Lanham, MD University Press of AmericaMarinkovic, S.T., Designing an Incentive-Compatible Safety Net in a Financi al System in alteration The Case of Serbia (2004), plaza for the Study of Global Governance, Discussion Paper 35, http//se1.isn.ch/serviceengine/FileContent?serviceID=ISNfileid=07ECE3C0-79BF-BEF2-62FF-A5CF5F97D730lng=en at 14 December 2008Reuters, Asian central banks spend billions to prevent smash-up (2008), International Herald Tribune, 16 September 2008World Bank and International Monetary Fund, Financial celestial sphere Assessment A Handbook (2005)Footnotes1 Reuters, Asian central banks spend billions to prevent crash (2008), International Herald Tribune, 16 September 2008.2 David M. Herzsenhorn, Administration is seeking $700 billion for Wall Street (2008), New York Times, 20 September 2008.3 Asl Demirguc-Kunt and Harry Huizinga, Market Discipline and Financial Safety Net Design (1999), World Bank Policy Research Paper WPS2183, 2-3 citing Asl Demirguc-Kunt, and E. Detragiache, The determinants of banking crises in developed and developing countries (1998), IMF Staff Papers 45, 81-109 and Edward J. Kane, The SL insurance Mess How Did it Happen? (1987).4 See also Douglas W. Arner, Financial Stability, Economic Growth and the Role of Law (2007), 139-140.5 World Bank and International Monetary Fund, Financial Sector Assessment A Handbook (2005), 105.6 Ibid, 105-6. See also IMF Monetary and Financial System Department, Operational Paper OP/00/01, Emergency Liquidity Support Facilities.7 Ibid, 106.8 Ibid, 107.9 Federal Reserve Bank Chairman Alan Greenspan, Speech The Financial Safety Net, 10 May 2001, http//www.federalreserve.gov/Boarddocs/Speeches/2001/20010510/default.htm at 14 December 2008.10 Ibid.11 Oscar Gerda, Elijah Brewer III, and Douglas D. Evanoff, The Financial Safety Net costs, benefits and implications (2001) The Chicago Fed Letter http//findarticles.com/p/articles/mi_qa3631/is_200111/ai_n8986952 at 14 December 2008.12 Australian Broadcasting Corporation, Government considers upping bank deposit safety net (2008) http//www.abc.net.au/news/s tories/2008/10/12/2388583.htm at 14 December 2008.13 Australian Broadcasting Corporation, No need for Government guarantee on bank deposits Rudd (2008) http//www.abc.net.au/news/stories/2008/10/10/2387244.htm at 14 December 2008.14 See, generally, Srdjan T. Marinkovic, Designing an Incentive-Compatible Safety Net in a Financial System in Transition The Case of Serbia (2004), Centre for the Study of Global Governance, Discussion Paper 35, http//se1.isn.ch/serviceengine/FileContent?serviceID=ISNfileid=07ECE3C0-79BF-BEF2-62FF-A5CF5F97D730lng=en at 14 December 2008, 17.