Question

Multinational banks whose exposure in foreign markets is primarily through subsidiaries may find it easier to exercise an exit option should losses become too high in the event of a major economic crisis; other banks, however, exposed through branches or through direct cross-border lending, as well as through loans to their subsidiaries, may find it walking away from their affiliate far more complicated. (300 words)

Answer 1

Major crises always come out of distortions. At the level of the global financial system, the basic problem has been the undervaluation of Asian (managed) exchange rates that have led to trade deficits for Western economies, forcing on them the choice either of macro accommodation or recession. The choice of easy money policies results in excess liquidity, asset bubbles and leverage.

The basic lesson of the past solvency crises is that three steps are always required:

1. Insure all relevant deposits during the crisis to prevent runs on banks.

2. Remove the „bad assets’ from the balance sheet of banks.

3. Recapitalise the asset-cleansed banks.

Finding in Major Economic Crisis:

The period preceding the financial crisis was one of considerable exuberance, primarily in the banking sectors of many advanced economies. Banking system assets, credit and profits grew at a much faster pace than economic activity. Risk was often neglected in compensation and other incentive structures.which heavily rewarded short-term gains over long-term sustainable returns and not properly assessed in bank strategies.

Credit standards were relaxed, and many banks relied on short-term wholesale markets to fund activities. The inherent procyclicality of the financial system also helped fuel credit and economic growth in mutually reinforcing ways. Banks in some countries operated with relatively thin capital and liquidity buffers. The crossborder business of large banks expanded sharply, as did revenue generation from complex and opaque activities, including structured securitisations and over-thecounter (OTC) derivatives.

Although pre-crisis developments in the banking sector were at the heart of the crisis, other factors contributed, including misaligned incentives in the securitisation process and in the implicit government support of banks, inadequate bank regulation and supervision in many countries, a lack of risk discrimination in credit markets and increased leverage in some parts the non-financial sector.

The crisis was triggered around mid-2007 by the deflation of the US housing boom, resulting in sizeable reported losses on US structured mortgage credit and uncertainty about the extent of institutions’ exposures to these assets. The tightening of financial conditions over ensuing months exposed the much broader pattern of excessive risk-taking, maturity transformation and acute vulnerability within the global banking industry. As some banks (and other financial intermediaries) came under liquidity strain, central banks significantly expanded their liquidity facilities. The closure of bank funding markets after the Lehman Brothers failure in September 2008 prompted governments to guarantee banks’ wholesale funding. Numerous banks in Europe and the United States failed or received government capital injections, and some were nationalised. Asset disposal schemes were set up in some countries to help banks address their problem assets.

These efforts succeeded in preventing a collapse of the financial system and the economy. But the resultant fiscal costs from direct banking sector financial support, output losses and increases in public debt were very substantial, in some cases raising concerns about the solvency of sovereigns.