Research Paper on "New Regulatory Framework of Financial Institutions in the Aftermath of the Global Financial Crisis"

Research Paper 12 pages (3792 words) Sources: 1+

[EXCERPT] . . . .

New Regulatory Framework of Financial Institutions in the Aftermath of the Global

Financial Crisis

Over the last several years, the total amounts of regulation in the financial sector have been increasingly brought to the forefront. This is because of the elimination of key guidelines (i.e. The Glass Steagall Act) allowed firms to engage in tremendous amounts of speculation. What was happening is a number of banks had combined their operations with different brokerage firms. The basic idea was to offer consumers with greater amounts of products and services. (Rottman, 2008)

The newest and most popular was the adjustable rate loan (a.k.a. subprime mortgage). This is a home loan that was underwritten by U.S. government backed agencies (such as Fannie Mae and Freddie Mac). They would encourage banks to offer mortgages to consumers with low income or less than perfect credit. What they did not tell borrowers is that interest rates were sitting at multi-decade lows. When they start to increase, their mortgage payments will rise. This is problematic because it will force borrowers to default simultaneously. (Rottman, 2008)

To make matters worse, many of these banks worked with their retail brokerage units and began marketing these investments around the globe. These were called collateralized mortgage obligations (i.e. CMOs). Since the 1980s, this was used as way to purchase many different mortgages and bundle them together (in what is known as a tranche). The idea is that this would reduce default risk and help to increase the total return for investors. In the early 2000s, these kinds of investment schemes became more complex with many tranches established (which had nothing but subprime mortgages). These assets were sold to investors with the belief that the U.S. government was guaranteeing these loans (from their involvement in the underwriting process). This meant that investors could realize higher returns with reduced amounts of risk (which increased their popularity). (Rottman, 2008)

These conditions set off a wave of foreclosures that would lead to the worst housing crisis since the Great Depression. To make matters worse, the reduced trade barriers created the near collapse of the financial system with a number of large banks holding subprime mortgages. The problem is they could not be sold, as the credit markets were frozen and they needed access to fresh working capital. The results were that a number of firms became "too big to fail" and were provided with assistance from the federal government. This is the only way they were able to avoid bankruptcy. The purpose of this study is to focus on the causes of crisis and what steps can be taken to prevent these situations in the future. (Rottman, 2008)

The working hypothesis that we created is:

The past and current challenges have transformed the financial system. This is has resulted in greater amounts of regulation and oversight. These changes are leading to a shift in the regulatory framework that is focused on protecting the interests of the general public. Over the next 20 to 30 years, this will create a series of standards that will provide the system with long-term stability.

This theory will help to focus the research and concentrate on specific areas of this problem. It is at this point that the findings will be more precise. (Rottman, 2008)

The methodology that will be utilized is the qualitative approach. This is when an analysis of different sources and their findings are conducted on the underlying causes of the crisis / how it can be prevented. This will help actuaries to identify key trends and the impact of current initiatives. To achieve these objectives a number of areas will be examined to include: conducting a literature review, providing a model for core analysis and offering empirical evidence. Together, these elements will highlight the way these problems are being addressed and what the regulatory framework will look like in the future. ("What is Qualitative Research," 2012)

Literature Overview

The Causes of the Financial Crisis

The different sources of literature are showing how there are many causes of global financial crisis. For example, in a study that was conducted by the University of Virginia. They determined that the financial crisis was worse in select firms (i.e. those with large institutional ownership and independent boards). According to Erkens (2012) (the lead author of the study) a total of 296 firms in 30 different countries were examined which exhibited these characteristics. (Erkens, 2012)

Commenting about their findings he observed, "Using a unique dataset of 296 financial firms from 30 countries that were at the center of the crisis, we find that firms with more independent boards and higher institutional ownership experienced worse stock returns during the crisis period. This is because (1) the organizations with higher institutional ownership took more risk prior to the crisis, which resulted in larger shareholder losses during the crisis period and (2) companies with more independent boards raised more equity capital during the crisis, which led to a wealth transfer from existing shareholders to debt holders." These insights are showing how despite an independent board of directors, any excessive capital was used to satisfy bondholders. This is because the firm had taken on so much debt and risky assets that they needed to use all liquidity to address these concerns. When this happened, all working capital was utilized to satisfy these obligations vs. helping the company adapt with new challenges. (Erkens, 2012)

The information from this source is useful, in showing how the primary causes of the financial crisis were from excessive amounts of risk taking. This is because large institutions were placing pressure on executives to meet the Wall Street consensus. The only way that this could be achieved was to target subprime borrowers and begin aggressively underwriting these securities. In the short-term, the earnings for the firm increased. However, over longer periods of time is when the debt and total number of risky assets rose exponentially. This is the point that the firm needed to restructure its balance sheet. Any kind of working capital that was received only paid off some of the bondholders. As a result, a large number of institutions were hurt by their inability to reduce risks over the long-term. (Erkens, 2012)

Moreover, Crawford (2011) found that the repeal of the Glass Steagall Act played a major part in determining the amounts of risk financial firms were taking. This is a Depression Era law that was enacted in 1933 as a part of the New Deal. When it was first ratified, many banks vowed to repeal it. This is because it gave the government too much oversight into the activities of private firms. This made it difficult for American banks to compete against international conglomerates. (Crawford, 2011)

However, the law prevented abuses by making it illegal for banks, brokerage firms and insurance companies to become involved in each other's activities. This prevents large institutions from developing that could be taking excessive abuses with the working capital they are receiving from investors and shareholders. (Crawford, 2011)

Until the late 1990s, the Glass Steagall Act was accepted as an economic reality for 65 years. Then, the banks began to complain how they cannot compete against international organizations. This would limit their ability to offer a variety of products to customers in numerous regions of the world. At the same time, this will lower the total amounts of fees consumers are paying for these products. (Crawford, 2011)

To monitor the sector the self-regulatory approach was utilized. This is when firms will have the industry establish an organization to ensure that everyone is following different standards. These changes, led to abuses with these entities not carefully examining the financial records of these firms. (Crawford, 2011)

To make matters worse, subprime mortgages were created after many of the different securities regulations were first enacted. This meant that they did not qualify as bond, because this asset class did not fall into one of the defined categories. Over the course of time, these areas were unregulated and traded on a market that was only available to financial institutions. When the crisis began, this set the stage for most regulators and executives not to understand their exposure to these risks. This is the point that bankruptcies could be announced overnight for some of the strongest firms on Wall Street (i.e. Lehman Brothers). (Crawford, 2011)

The combination of these events occurred because the Glass Steagall Act was not in place to limit the activities of firms. This created a situation where executives focused on increasing their profit margins at all costs. Evidence of this can be seen with a plea from Senator Paul Wellstone (who was opposed to repealing the law) with him saying, "The repeal of Glass-Steagall would enable the creation of financial conglomerates which would be too big to fail. Furthermore, the regulatory structure would not be able to monitor the activities of these financial conglomerates and they would eventually fail due to engaging in excessively risky financial transactions. Ultimately, the taxpayers will be forced… READ MORE

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