As we all know, global financial crisis which started in early 2007 until present has major impacts on global financial markets and also global economy. It has harsh effects not only on financial institutions across the world, securities markets but it also throws economies into recession, "creating levels of unemployment not seen for decades" (Lewis, 2009). Originally, the subprime crisis in the United Stated led to credit markets freeze which further has implications beyond the US, especially series failure in banking sector: the collapse of Northern Rock in the United Kingdom, the collapse of Lehman Brothers, Bear Stearns in the US, which led to crisis of confidence in financial sector (BBC news, 2009). Blundell-Wignall and Atkinson (2009) indicate that "banks are special: they are interrelated with the economy and with each other, and the collapse of the few can bring down the whole system". It is said that subprime loans (also called "toxic assets") - one small part of US residential mortgage market- "were the symptom but not a catalyst for the crisis". In fact, the current crisis is caused by global macro liquidity policies and by poor framework of banks, together with bad regulations, governance standards and tax systems. Consequently, these factors have triggered the so called subprime crisis, later led to credit crunch and global financial crisis. Niinimäki (2009) examines how and why subprime banks in the USA are failing, arising with the problem of the value of loan collateral (house property) which creates moral hazard problem between banks and deposit insurance agents.
First, the journal gives the definition of subprime loans, which are high-risk loans that given to the borrowers who fail to meet credit quality requirements in the standard mortgage market. It is risky for banks to lend borrowers who may not earn enough income to repay the loan, however, their loans are secured by collateral- in this case is house property. As the result of the rising value in houses, banks assisted those borrowers, who desire for consumption purposes, by making loans that up or exceeding 100 per cent of valuation (125 per cent in the case of Northern Rock in the UK) (Lewis, 2009). The paper then questions whether collateral can fuel moral hazard problem in banking, especially with deposit insurance. In banking theory, collateral reduces bank risk, nevertheless, its fluctuating value generates moral hazard problem. With empirical evidence, the journal points out that the banking crises are likely to happen after a collapse in the value of the real estate, moreover, the lending methods which are based on collateral also lead to crises. The author gives examples of banking failures in the Asian crisis in 1997; in particular, the banking crisis in Japan was preceded by collateral-based lending policy. Later, he provides theories which examine how outside and inside collateral may generate the moral hazard problem. In economy, there are two types of borrowers (entrepreneurs): good and bad. To separate these two, banks have the task of monitoring since they operate under limited liability; however, since monitoring incurs costs and it is unobservable to regulators, banks often neglect it and the moral hazard problem is present (MacDonald and Koch, 2006). In addition, since there are deposit insurance schemes which operate by government to reduce banking panics and protect the depositor; thus lenders tend to place their deposits with banks that offer the highest interest rates. In order to pay the interest, bank's managers then invest these funds to speculate on risky projects; if the bank obtained enough deposits, it could cover the problem assets. Conversely, if the investments failed, the bank regulator has to pay the costs of excessive risk taking. In example, many banks are considered to be "too big to fail" as the bank failure could significantly damage the rest of the industry and the overall economy. As the result, in recent crisis, the US government agrees a $700bn bail-out that will buy up Wall Street's bad debts. The US government plans to borrow the money from world financial markets and hopes it can sell the distressed assets back once the housing market has stabilised. While in the UK, government launches its own bail-out of £400bn extra capital to eight of the UK's largest banks and building societies in return for preference shares in them(BBC news, 2009). Thus, moral hazard which "occurs when insuring against an event makes the insured-against event itself more likely to occur" (Pilbeam, 2005), is a severe problem in economy. In an originate-to-distribute (OTD) model, "where the originator of a loan sells it to various third parties", the banks did not use resources in screening their borrowers (Purnanandam, 2009). Overall, lack of screening incentives combined with leverage induced risk-taking behaviour significantly contributed to the current sub-prime mortgage crisis.
Second, another reason for the recent global crisis as mentioned above is bad regulation, in particular, lack of regulation of banking sector led to current subprime crisis. Keys, Mukherjee, Seru, et al. (2009) examines the regulations on the quality of mortgage loans originations in the OTD market, in which, due to it, most of the mortgage loans "with low margin money and with initial low teaser payments" has been securitised (Mohan, 2009). Securitisation which was seen as the greatest financial innovation in the 20th century- among other financial innovations such as: hedge funds, structured finance, private equity- is a factor which pushed the subprime crisis into large part of financial crisis, and also an example of moral hazard problem (Shah, 2009). Securitisation is where banks convert their various loans into liquid securities, thus they pass on risky loans onto others and by doing so, reducing the incentives of lenders to carefully screen borrowers. Most banks rely on collateralised debt (over-collateralisation ratio), "when the collateral values go down, they reduce debt through sales of assets for the repaying a fraction of the debt contracted" (Bessis, 2010). The sales of assets will continue when the value of the asset keep declining, which contribute to the concept of the contagion to the capital markets. Hence, collateral-based financing has contributed to the downturn of the market. In the US, banks are regulated from various regulators such as: the Office of the Comptroller of the Currency (OCC), Office of Thrift Supervision (OTS), Federal Deposit Insurance Corporation (FDIC), and the Federal Reserve Board. Thus, it can be argued that since banks face more supervision and being monitored better, they may suffer less from securitisation-induced moral hazard. On the other hand, FDIC insurance for bank deposits (deposit insurance) could magnify the moral hazard problem as banks are less exposed to market discipline. Blundell-Wignall and Atkinson (2009) specify four aspects of policy which caused the crisis, one of which is: "(i) cumbersome regulatory structures with a poor allocation of responsibilities to oversee new activities in the financial sector were in place". Multiple federal and state regulators are responsible for supervision of financial activities also led to numerous problems. For example, in the case of AIGs, the OTS was not equipped to supervise either insurance or AIG Financial Products, its role based from the fact that AIG owned a "thrift" (Saving and Loans Co.) although it had no expertise in credit default swap (CDS).
Third, along with securitisation, there are also other complex financial innovations such as: mortgage-backed securities (MBS), the adjustable-rate mortgage, the collateralised debt obligations (CDO) (which is also a type of securitisation), and credit default swap (CDS)-a form of credit insurance (Anon., 2010). Credit rating agencies also played important role in causing the subprime crisis. They have been criticised for failing to price the risk of mortgage-involved products, involving in the conflict of interests (as they are paid by the firms which manage and sell the debt to investors). The subprime crisis was also originated by the policy errors in the US, especially in its monetary policy for an extended period in advanced economies. The US current account deficit also explains why the subprime crisis has had such global ramifications. After the post dot com crash period, the "easy money" policy of 2002-2004 with too low interest rates, especially in the US, resulted in exacerbating global imbalances. Its external deficit was made by excessive borrowing and spending, too little saving by US households. There was a direct connection between the US external deficit and the US mortgage market as a combination of the US's role as world banker, allied with the role of the US dollar as international money and the American banking sector's financial innovation (centred on housing finance). Mortgage debt was securitised, bundled into different risk categories and then sold to both domestic and foreign investors. As the crisis began, the tightening of monetary policy led to falling in housing prices and rising in interest rates, encouraged defaults on sub-prime loans, resulting in large losses for banks and financial institutions, sharp increase in risk aversion, complete lack of confidence and trust amongst market participants. "In brief, the large volatility in monetary policy in the major reserve currency countries contributed to the initial excesses and their subsequent painful correction" (Mohan, 2009).
In conclusion, the subprime crisis is caused by numerous factors which seem primarily related to the moral hazard problem such as: the lack of incentives of banks to screen borrowers (as deposit insurance schemes and collateral-based financing), financial innovations (securitisation), and etc. Niinimäki (2009) concludes in the case when the deposit insurance is priced correctly, and banks neglect monitoring since it is unprofitable, the regulator cannot grant banking licenses at all. "The moral hazard problem is so severe that no banks can be established". Numbers of solutions have been proposed to resolve the moral hazard problem. There has been an increased interest in regulation at the state level concerning the mortgage broker laws as it may influence the performance of the OTD market in which appropriate incentives for the originators (brokers) may also help to prevent moral hazard problem. It is also suggested that policies which require originators to hold some risk have the potential to reduce the moral hazard problem. Moreover, in order to eliminate moral hazard problem, regulations must take account of the interactions between competition, efficiency, and financial stability. Regulations should look after the risk-taking incentives of banks, for example: greater protection offered by a country's bank safety net (deposit insurance, bail-outs, etc) increased the risk of bank instability (Pasiouras, Tanna and Zopounidis, 2009) and that prudential bank regulation should focus on promoting discipline and limiting risk-taking by subjecting bank liabilities. Hence, the regulators should consider redesigning their deposit insurance schemes. Keys et al. (2009) shows that the less regulation, the more fragile of capital structure, hence, banks/lenders would be more careful to give out the loans and so improve the loans' qualities. More lenders also mean more competition among participants, which can help improve relative evaluation and mitigate the moral hazard problem. It concludes that market forces may have been more effective in alleviating moral hazard in the OTD market rather than regulation.
- Niinimäki, J. P. (2009) Does collateral fuel moral hazard in banking? Journal of Banking & Finance 33 (3): pp. 514-521.
- Keys, B. J. , Mukherjee, T., Seru, A. & Vig, V. (2009) Financial regulation and securitization: Evidence from subprime loans. Journal of Monetary Economics 56 (5): pp.700-720.
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