DR. ARUP RATAN MUKHOPADHYAY
“The essence of capitalism’s dilemma in its monopoly stage was captured by the ‘symbiotic embrace’ that had emerged between stagnation and financialization. The Economy could not live without financialization and it could not in the end live with it.”
Magdoff & Sweezy, The Casino Society, 1985
TERM PAPER OF BANKING LAW
PGDBL 2014-15
WEST BENGAL NATIONAL UNIVERSITY OF JURIDICAL SCIENCES
1/1/2015
The Great Financial Crisis of 2007-08 which is better known by its cause, Sub-prime Crisis, is the massive failure of the investment banking system in US. Some economists compare this crash with the great depression of 1929-33 which engulfed the US economy in prolonged depression. This paper claims that, the Great Depression of 1929-33 can be explained by circumstances dominated by uncertainty whereas the Great Financial Crisis of 2007-08 is explained by man-made economic disaster governed by the ideal ‘greed is good’.
The neoclassical economy is based on the hypothesis that, competitive capitalism is self-equilibrating in character. If any disequilibrium is created in the short run it is likely to be restored in equilibrium in the long run. This hypothesis is the basis of free market doctrine which pleaded for non-intervention of the government in economic activities and the role of the Central Bank should be confined in controlling inflation only. But the economic system in the so-called ‘free world’ failed to prevent mass unemployment without direct intervention of government. The economists working on ‘business cycle theory’ failed to address the causes and remedies of the prolonged depression of 1930s. Policy makers became skeptical about the ‘neoclassical’ postulates. The escape route was found in the writings of Keynes who brought about an adjustment between the propensity to consume and the inducement to invest through governmental intervention in the market. The ‘New Deal’ measures of the Roosevelt Government in the USA directed the economic functions of the government to the stabilization of the aggregate level of production near full employment. John Maynard Keynes in his General Theory argued in favour of State intervention to influence the aggregate volume of income and employment. Keynes’ basic conclusion was that, capitalism may return to growth and profitability without a return to full employment.
Alvin Hansen follower of Keynes, argued that, ‘capitalism did not inherently follow a path of full employment and rapid growth, but could be stuck for decades, even permanently, in a condition of slow growth, high unemployment /underemployment and excess capacity—or stagnation.’
In fact, there are a number of contradictions inherent in the capitalist system which leads to slow down of investment. The accumulated surplus (savings) generated may not be invested fully. The investment decisions are dominated by the circumstances of uncertainty in future. Investment may be a function of rate of interest but investment decisions are also guided by the aggregate demand in the market.
Marxist economists Baran and Sweezy argued that, “the enormous productivity of the monopoly-capitalist economy, coupled with oligopolistic pricing, generated a huge and growing surplus, which went beyond the capacity of the economy to absorb it through the normal channels of consumption and investment.”
Insufficient effective demand therefore required external stimulants to boost up production and bigger and bigger injections were needed just to keep the ball rolling. This bigger injection came in the form of Second World War which in fact pulled up the US economy and the Western Europe from depression. The demand for war-weapons acted as an external stimulant to help the western capitalism to come out of economic depression.
The abysmal misery inherent in the capitalist system was exposed by Hyman Minsky[1] in his ‘Financial Instability Hypothesis’. He argued that, “capitalism is a flawed system in that, if its development is not constrained, it will lead to periodic deep depressions and the perpetuation of poverty.”
The internal contradiction of the capitalist system shifts the gravity of the economy from production to finance, the process known as ‘financialization’, which makes the whole economy susceptible to debt-deflation. Stagnation of productive opportunities within production system leads the speculative finance gradually taking the place of productive investment as a secondary engine of growth. The system becomes more and more dependent on a series of financial bubbles to keep the ball rolling. It is something like riding on a tiger. Since late 1960s the US economy could avoid sinking into a deep slump riding on debt and speculation without get rid of underlying tendency of stagnation. This is being manifested by a decline in the rate of goods production as a percentage of GDP and a simultaneous rise of debt as a percentage of GDP during 1959-2007.
2. The Sub-prime Crisis
The great recession of 2007 started with the US sub-prime mortgage crisis in household debt and real estate bubbles which is the greatest financial market crisis since the Great Depression of 1930s. Though it was historically unprecedented, but It was preceded by a whole series of lesser economic shocks , viz., the US stock market crash of 1987, the savings and loan crisis of the late 1980s and early 1990s, the Asian Financial Crisis of 1997-98 and the New Economy (dot-com) crash of 2000. The Financial Crisis of 2008 not only put the US economy in an unprecedented state of deep decline but it spread a prolonged stagnation throughout the world resulting loss of job and home for millions and appalling poverty for the masses.
Global pool of fixed-income securities increased from $36 trillion in 2000 to $80 trillion by 2007. This giant pool of money entered global capital markets. Investors searching for higher yields than those offered by US Treasury Bonds sought alternatives. This came in the form of real estate bubbles. This has been fueled by low interest rate in household debt. Bubbles burst causes asset prices to decline. Soaring family debt burdens paved the way to default and bankruptcies. Result is credit crunch. The economy moved from stability to fragility, which is known as’ Minsky Moment’, named after the noted economist Hyman Minsky.[2]
The priests of the so called ‘supply side economics’ put forward a theory that, if the market of debt is liberalized by reducing the rate of interest on debt, the aggregate demand will keep on rising and there will be an acceleration in economic growth. The liberal attitude of Fed and commercial banks towards debt did give birth a pool of sub-prime borrowers who had poor credit worthiness. The commercial banks who gave home loans on low rate of interest knew that, they will pass on their risk if they can sell the mortgage papers to investment banks. The investment banks knew that, they can make profit and pass on risk if they could sell bonds/debentures on the mortgage papers. Those who purchased the bonds/debentures at once insured them to the insurance companies. Insurance companies had the notion that, since all mortgages do not fail at a time, therefore, if suitable premium is charged on the insured items they could make profit. Everyone tried to cheat other in order to make money and took resort to the ‘supply side economics’ and eventually the US economy crashed. The logic of the priests of the ‘supply side economics’ was proved nonsense because the underlying philosophy that, ‘supply creates its own demand’[3] is itself nonsense. As Business Week put it: ‘In this game almost every player wins—except for the cash-strapped homeowner.”[4]
In order to analyse the underlying reason of the crash one discrepancy catches the eye. Between 1994 and 2004 while the real wages in the US economy remained sluggish but the consumption grew faster than national income, with the share of personal consumption expenditure in GDP rising from 67 to 70 percent. The consumption-income gap was squared up by borrowing which is reflected by the fact that, debt as a percentage of disposable income has been increased from 62% in 1975 to 127.2% in 2005.[5]
The biggest portion of debt is secured by primary residence, the asset of vast majority of families. The surprising strength of consumption expenditures, rising faster than disposable income, has most often been attributed to the stock market wealth effect but the housing wealth effect was significantly larger than the stock market wealth effect. This acceleration of household debt has been aided when Federal Reserve Bank reduced interest rates to historically low levels, from 6% in January 2001 to 1% in June 2003,[6] to keep the economy from falling into a deep recession. Fed by low interest rates and changes in the reserve requirements of banks, capital flowed massively into the real estate market, paved the path for mortgage lending. As a result real estate prices soared and hyper-speculation set in.
Cheap financing expanded the pool of mortgage borrowers despite the soaring real estate prices. Household mortgage debt increased as homeowners refinanced and obtained larger mortgages. With fall in rate of interest more and more people participated in the housing boom. Homes sold at increasingly inflated prices to those with low credit ratings. This had the effect of shifting the stock price bubble to bubble of home prices. The amount of sub-prime mortgages issued and imbedded in Mortgage Backed Securities shot up from $56 billion in 2000 to $508 billion at the peak in 2005.[7]The economy was running on the belief that bricks and mortar never loses value, so house prices do not fall. Therefore, the banks did not bother about the credit worthiness of the borrowers. The underling simple equation was that, if the borrowers fail, bank will en-cash the house. It got even simpler when it came to financing the mortgage. Banks like Northern Rock did not even bother to find lender for 90 days which they would use to finance mortgages for 20 years. It was not even considered that, short term funding may dry up but long term financing of mortgages will remain. This led to the first run on the bank in Europe. By 2008 it transpired that, the investment banks had huge investments in toxic sub-prime papers, sold to them by the masters of the universe like Goldman Sachs, Lehman Brothers or Merrill Lynch. Confidence started to decline steeply. By 2008 almost no bank was ready to lend money even overnight to any other bank at LIBOR[8] rate. This eventually lead to fall in mortgage lending as the banks did not have enough deposits or could not borrow from the market .Little lending by banks has led to close down of business. In February 2006 the average interest rate for variable rate cards accelerated to 15.85 from 12.8% in 2004. Soaring family debt burdens naturally paved the way to defaults and bankruptcies. Unpaid credit card balances at the end of 2005 amounted to a total of $838 billion.[9]
Four decisions taken by the federal Reserve Board under the chairmanship of Alan Greenspan can be identified in nutshell as the principal cause of the disaster:
Alan Greenspan himself became skeptical about the self-equilibrating mechanism of competitive capitalism by saying that, “US economic growth is zero. We are at stall speed. US recovery may take longer than usual.”[10]
The escape route was found through government intervention in the Keynesian logic. The federal government stepped in with a $150 billion stimulus package. The Federal Reserve Board lowered the federal funds rate from 4.75% in September to 35 in January, 2008.
3. Basel III ACCORD
After the Credit Crunch of 2008, it was universally admitted that, the financial regulatory framework had serious lacunae which led to the worldwide financial crisis. The package of measures that had been adopted over last six years to plug these lacunae is known as Basel III accords[11]. These include:
The Reserve Bank of India (RBI) notified implementation of Basel III on April 1, 2013 in a phased manner to be completed by end-March 2019. RBI has prescribed a minimum Capital Adequacy Ratio, also known as Capital to Risk Assets Ratio (CRAR) of 9%, which is higher than the regulatory minimum prescribed by the Basel Committee on Banking Supervision (BCBS).
Despite the comfortable capital position of Indian banks as reflected in overall CRAR[12] at 13.5% (at end-June 2013), the challenges in implementing Basel III cannot be underestimated. First, Basel III would significantly increase capital requirements of Indian banks to finance growth. Second, given the strong presence of public sector banks, the fiscal constraints of Basel III cannot be overruled if majority shareholding by the government is to be maintained. Apart from capital raising exercise, Basel III calls for scientific risk assessment of three major risks—interest rate risk, exchange rate risk and credit risk.
[1] Hyman Minsky in Philip Arestis and Malcolm Sawyer, A Biographical Dictionary of Dissenting Economists, Northampton, Massachusetts, 2000.
[2] Hyman Minsky, Financial Instability Hypothesis.
[3] J. B. Say, Say’s Law, “sum of the values of all commodities produced was equivalent (always) to the sum of the values of all commodities bought”.
[4] Nightmare Mortgages, Business Week, September 11, 2006.
[5] Source: Board of Governors of the Federal Reserve System, Flow of Funds Accounts of the United States, Historical Series and Annual flows and Outstandings, Forth Quarter 2005 (March 9, 2006). http://w.w.w.federalreserve.gov/releases/ZI/Current/.
[6] Federal Reserve Bank of New York, “Historical Changes of the Target Federal Funds and Discount Rates,”http://www.newyorkfed.org/markets/statistics/dlyrates/federal.html.
[7] Landa, “Deconstructing the Credit Bubble”.
[8] LIBOR stands for London Inter-Bank Office Rate, the rate at which banks borrow money from other banks for various tenors.
[9] The Credit Card Catapult, Wall Street journal, March 25, 2006.
[10] Alan Greenspan, Reuters, February 25, 2008.
[11] Basel III : A global regulatory framework for more resilient banks and banking systems, Basel Committee on Banking Supervision, Dec. 2010 (rev June 2011)
[12] CRAR (Capital to Risk Assets Ratio) is the ratio of a bank’s capital to its risk, expressed as a percentage of a bank’s risk weighted credit exposures. This ratio is used to protect depositors and promote the stability and efficiency of financial system around the world. Reference: Wikipedia