Failure of shadow banking system: Will banks survive?

[LRE]

Will banks survive? The question asked is not with reference to the banks in Pakistan. It refers to the banks in the West – to those in America and Europe – that have been brought to their knees.

Some of them have been virtually nationalised while many others have been seriously mauled. No matter what happens to those that are still fighting for their lives, one thing is certain. Once this crisis is over, what will emerge is a financial system that will have little resemblance to the one that existed when the current turmoil began.

One thing is already clear: the nexus of financial markets and non-banks that made up the “shadow banking system” has failed. Something different will replace it.

The developing world may not have participated in producing the crisis. It will, however, be affected by the shape the financial system takes once the crisis is over and stability returns. This may take a few years. The developing countries would do well to watch what happens to the system as it gets transformed.

Some emerging markets that are members of G-20 may actually participate in designing the new system. Pakistan, unfortunately, is not represented in this important group of economies. It will have to watch the evolving situation from some distance.

Progress in finance has always been interrupted by crises. This has happened right from the days the system that we know as financial services came to be developed in Italy. That was several hundred years ago.

The system was based on trust. Nothing exemplifies this more than the use of paper money. People are prepared to sell real products – crops, manufactured goods, and their own labour – in return for a piece of paper that other people will also accept. If trust disappears, it destroys the system and without well functioning finance, modern economies cannot function. Lot of people lose a lot of money in periods of crises and these losses eat away the underlying trust. It is, therefore of concern to economists that the frequency of crises has increased.

Two American academics, Michael Bordo and Barry Eichengreen, have identified 38 crises between 1945 and 1971 and as many as 139 between 1973 and 1997. In the second, more recent period, 44 crises affected the developed world and the remaining 95 developing countries

Crisis prevention, therefore, became an important part of public policy. New regulatory institutions were put in place, required to follow new regulations. However, the financial system was continuously evolving and managed to remain a step or two ahead of the government-managed regulatory infrastructure.

The financial system’s constant evolution was propelled by some dramatic changes in the structure of the global economy. The most significant change was the emergence of huge savings with the countries that exported goods and commodities to the West, in particular to the United States, thus accumulating large foreign exchange reserves which were invested mostly in America.

In 2006 America’s current-account deficit increased to six per cent of GDP. Between 2000 and 2007, the country received more than $5.7 trillion from abroad to invest. This was equivalent to 40 per cent of GDP. The United States was not the only beneficiary. Spain received flows equal to 50 per cent of GDP, the United Kingdom around 20 per cent.

The consumers in America went on a buying binge; after all the former President George W. Bush told his nation after 9/11 that it would be patriotic to go shopping. On the other hand, manufacturers in countries such as China went on a production binge. In America savings fell from around one-tenth of disposable incomes in the 1970s to only one per cent in 2007.

The inflow of vast amount of money into the United States fueled the housing markets and led to the creation of asset-backed securities by the commercial banks which, having received thumbs up assessments from the rating agencies, became hot commodities in the financial markets. The inevitable result was a boom.

Political Scientist Jeffry Frieden has estimated that about three-fourths of all credit booms financed from abroad result in crashes. This one did not prove to be any exception. Financial booms are different from other types of booms. It takes time to create the capacity to produce products that are in great demand because of the boom mentality; on other hand, financial contracts can be written quickly.

Also, in real markets a rise in price reduces demand; a fall increases it. However, the reverse may happen in the financial and capital markets. An increase in the price of shares fuels further increases in their values. The boom becomes self-generating for a while. When prices fall they may produce the urge to flee which makes the fall even more precipitous. Financial cycles, therefore, have much more volatility than normal economic cycles. In the present crisis, stock market prices have fluctuated widely from day to day.

The current financial crisis has already taken a heavy economic toll. For the first time in a decade and half, global average income per head of the population will decline; incomes in developed countries will fall by significant margins, a fall that will not be compensated by the increase in incomes in emerging markets.

Some observers believe that for the first time in half a century, average per capita income in China may not see any increase. There have been crises before but it is the intensity of the one that is currently affecting the global economy that is confounding the policymakers all over the world. To find a solution policymakers must know the causes that brought the situation to where it is today. There is agreement among experts as to what drove the banks and other parts of the financial system towards its present predicament. But devil is in the details. And it is these details that are still not fully understood.

What will come now that the attention of the policymakers is focused on reforming the current system that has played havoc with the global economy. In 1984, James Tobin, the Nobel Prize winning economist, made a remarkably prescient statement. It is worth quoting it at some length. “I believe we are throwing more and more of our resources, including the cream of our youth, into financial activities remote from the production of goods and services into activities that generate high private rewards disproportionate to their social productivity. I suspect that the immense power of the computer is being harnessed to this ‘paper economy’ not to do the same transactions more economically but to balloon the quantity and variety of financial exchanges …I fear that as Keynes saw even in his day, the advantages of the liquidity and negotiability of financial instruments come at the cost facilitating nth-degree speculation which is shortsighted and inefficient.”

Since these words were spoken almost a quarter century ago, the computational power of all kinds of machines has increased enormously. The financial rewards for doing new things – for spreading risks and for integrating different parts of the markets – have increased phenomenally. The machines not only compute rapidly, they can also communicate at high speed. This makes it easier to transmit contagion.

The world has become a small place. All these things and many more will have to be kept in view as a reformed financial system is put in place. Western banks will survive but in a very different form and the banks in developing countries will have to make their own adjustments.


http://www.dawn.com/2009/02/02/ebr3.htm