Seminar paper on ‘How to Avoid the Next Financial Crisis’

…Distinguished ladies and gentlemen.

The word “crisis” has become a jargon in business, management, and academic circles such as this one, yet, it remains as topical as it was a decade ago when the most recent financial crisis vibrated across Greece and beyond. Crisis, according to the Cambridge dictionary, refers to “a situation that has reached an extremely difficult or dangerous point.” More specifically, financial crisis is a general term used in describing sovereign defaults, disorderly functioning of markets, banking panics, decline in stock market prices, currency devaluation and bursting of asset price bubbles, among others.

The origins of crises are hard to identify but the Greek example shows it can occur anywhere and at any time. The impact of Troika-imposed structural programmes on the Greek government has been among the most severe and hard-hitting in global history. This is evident in Greece’s recent downgrade of its status as developed to an emerging market thanks to the government’s careless decision to spend its €206.9 billion on creditor bail-outs. The resultant impoverishment and deindustrialisation is ongoing and could lead to other types of crisis such as:

  • Grexit: The Greek government could withdraw its European Monetary Union (EMU) membership to reduce impact from using the EURO as a single Eurozone currency. This “time-out” from the euro area will aid the Athens government in debt restructuring but the strategy will most likely lead to another crisis since the stringent modalities for re-entering eurozone, in reality, makes it permanent.
  • A currency crisis: If eurozone leaders approve Grexit, it implies the European Central Bank (ECB) would relinquish control of Bank of Greece for a return to the drachma. This situation may lead to currency devaluation with its attendant impact on the economy.
  • A sudden stop: This implies a “balance of payments crisis” and is an offshoot of currency value depreciation which triggers a sudden fall in international capital inflows with its attendant rise in credit spreads.

Financial crises don’t occur often, but they do start with an incremental build-up of systemic risks in the macro-financial system, as was the case in Greece. Globalization, as a catalyst for development, has shrunken international boundaries and its contagion effects are felt by the common man, real economy, governments, financial systems and all stakeholders. This highlights the increasing interconnectedness of global markets, institutions and economies as well as underlines the need for policymakers to anticipate such high-impact events and take appropriate precautionary measures when they set in, using an effective crises management framework. Globalization, through inter-border cash flows, can propel development as well as create broad-ranged systemic risks if protective politico-economic strategies are not implemented properly.

Each crisis has certain unique features and should be treated separately although they are all triggered by excessive high credit growth or flat fall in asset value. According to the U.S. Congressional Service Report on the Greek Crisis, the action roadmap involves the following:

  • A prompt intervention to contain contagion and restore confidence in the system. This starts with identifying the main factors driving crises such as booms in assets and credit markets that turned to busts for Greece.
  • Recession or capital flight, as suggested by Troika, is a long but promising path to economic resurgence. The impact of three bail-outs offered to Athens is expected to blossom from 2022.
  • Structural adjustment in the financial system to control impact and avoid recurrence. Financial institutions must reinvent themselves and strategize on transforming regulatory constraints into competitive advantage.

On the global level, the following should be taken into consideration:

  1. There should be a clear delegation of responsibility for financial stability, with clear coordination protocols during crisis. This authority should not be shared among separate agencies.
  2. Flexible monetary policies and crisis management strategies should be adopted by central banks and global financial institutions by upgrading technology and developing tools and techniques that can accurately assess risks to the financial system on a regular basis.
  3. Effective crisis management entails an ability to identify and handle systemic risks at an early stage.
  4. Lastly, governments should recognize the importance of interdependence and integration, considering that certain risks actions may need international cooperation which, in turn, requires adequate preparation, solid framework and unwavering commitment.

In light of the strategic roadmap to avoiding a next financial crisis, popular economist Hyman Minsky, however, pointed out that though each crisis leaves behind some set of lessons when it recedes, it is only natural that these lessons are soon forgotten together with the fact that there’s always a financial breakpoint that could lead to another crisis. For example, Greece ignored warnings from its inefficient pension system and doled out money to public sector employees because they attended work and not for quality outputs. Politicization of the public sector, high unemployment and work culture issues, and tax evasion all played contributory roles as underrated corrosive elements in the Greek crisis.

Notably, Greece joined the European Monetary Union (EMU) in 2001 and enjoyed abundant access to cheap capital but capital flows were not maximised to increase competitiveness in the economy. Worse still, the EU financial regulation framework designed to control excessive accumulation of public debt failed in its responsibilities, leading to strained public finances and consequential falsification of statistical data that increased Greece’s borrowing costs until 2010, when it risked defaulting on its public debts. The Greek economy was stable and productive prior to its acceptance of EU membership, which highlights the decision as a political rather than an economic move.

Writing on the Washington Consensus, New Structural Economics and Creative Destruction point of views, the ex-Senior VP at World Bank, Justin Yifu Lin, explained that the gap between countries is a result of market failures. His adoption of Keynesianism in analysing determinants of economic growth in low-income countries which did not adopt policy recommendations from dominant development theories further pointed at government intervention and structural reforms as tools for controlling market imperfections and reducing growth gap between industrialized and developing nations. However, this approach failed, especially for Latin American countries in the 90s, and prompted advanced research which discovered the important role of markets in resource allocation and provision of development incentives. Yet, this approach abandoned structural differences between countries but believed structural change can happen spontaneously in the development process. In furtherance, the Washington Consensus preached privatization, liberalization and stabilization, and was widely accepted by development organizations around the world, but it left a vacuum for controversies on growth and development. A retrospect on some 20-century countries that achieved growth through traditional approaches clearly shows that the heterogeneity and unique characteristics of individual countries were taken for granted. Justin’s final analysis uncovered the need for markets to be a resource allocation medium while governments were advised to play more significant roles in managing investments and compensating for externalities created by champions in the growth process.

On this backdrop, the impact of regulating bank operations as a crisis management strategy is better understood through an assessment of banking business model such as Basel 3 or “the dog and the frisbee.” This refers to a set of standards established by G-20 and voluntarily accepted by financial institutions to ensure that active international banks have access to adequate funds during crisis. While these standards have been implemented by countries which are not even parties to the agreement, the problem lies with the following:

  1. Not all countries applied the regulations in the same way. The standards of Basel 3 are implemented through national laws, and countries have considerable discretion in how they go about it.
  2. Banks are required to maintain a minimum common equity of 7% of their assets and a “countercyclical buffer” of 2.5%. This regulation includes a capital conservation buffer of 2.5%.
  3. Each nation or group of nations such as the EU, implements the accord through an independent body, using threat of fines or disassociation to enforce compliance.

These factors undermine Basel 3’s objective to enhance productivity and soundness in the banking sector, especially on the grounds that any bank that fails to maintain the required capital conservation buffer only faces restrictions on payments to executives and shareholders – a pointer to the same management and law enforcement failures which nearly destroyed the EU.  

However, the frisbee-catching dog entails “running at a speed so that the angle of gaze to the frisbee remains roughly constant,” according to A. G. Haldane & V. Madouros. Like catching a frisbee, keeping pace with crisis is a difficult task which requires the regulator to analyse a complex list of psychological and financial factors which include innovation and risk appetite.

Restoration of confidence in the government’s ability to act credibly and wisely in its interventions is the key to crisis resolution.

Thank you.

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