The financial system, measured by assets, profits, contribution to GDP, stock market capitalization, employment etc, has expanded rapidly since 1990. For example, global financial assets were about 50 trillion in 1989 and increased to about 200 trillion by 2007, during the same period financial depth increased from 200% of world GDP to 400% in 2007. The financial crisis has raised a plethora of issues, many of which are inter-twined. There have been failures on all fronts – market failures in the form of financial firms innovating new instruments while neglecting risk management practices, credit rating agencies failing in rating assets without much thought to risk, private auditors not checking Lehman Brothers’ assets and liabilities, government failures in the form of central bank keeping interest rates low in the run up to the crisis, and government entities such as Fannie and Freddie involved in mortgage lending and making enormous losses, and failure by regulators for not checking the books of financial firms such as Lehman Brothers that were moving toxic assets of the balance sheets, and last but least the financial economists who failed to foresee to crisis. There is plenty of blame to go around but one thing is clear: State ownership of financial firms is back. After decades of rising foreign ownership of banks (shrinking state ownership) in almost all regions, except the Middle East and South Asia, the trend could be reversed especially in the developed countries.
The crisis has shifted focus from foreign private ownership to some state ownership, from micro to macro prudential regulations, to re-assessment of deposit insurance, lender of last resort, and implicit guarantees, to consumer protection and taxpayer protection, from mark to market accounting to mark to funding, to revamping of credit rating agencies, to crisis in corporate governance and questioning of remuneration in financial firms, and to strengthening of supervision. These and a number of related issues of interest to policy makers are discussed below.
Given the large set of issues arising from the crisis, the major challenges facing countries are essentially two: (i) Government entities which are subsidizing directed credit (e.g. Frannie and Freddie in USA; similar type of ‘chaebol’ lending to industrial firms triggered the Asian crisis of 1997); and (ii) universality of too big to fail entities, where systemic important firms, often politically powerful conglomerates that are controlled by elites, have to be bailed out, which in turn leads to the moral hazard problem, where the large entity is considered worthy saving at all costs, including use of lender of last resort facilities from the Central Bank and tax payers money from the Treasury. The too big to fail entities also then knowingly max-out on leveraged lending (40 to one in case of USA) and ‘gamble’ on financially innovative instruments (e.g. mortgage-backed securities and credit default swaps in case of USA). The large entities also have the political clout to suppress regulations and/or evade regulations. Successful regulation requires that the regulator should have information on exposure to systemic risks. Too big to fail institutions were exposed to CD swaps (e.g. AIG in USA) and we knew little about its exposure. The reason is that there is data on a firm by firm but there is no agency that can put it all together. But policy makers and politicians are reluctant to address these two problems head on. Instead the focus on a large set of problems, as detailed below, and obfuscate the issues.