Question

Financial regulation

The system of finance is currently a highly regulated system on a global scale. Please discuss how this system is currently being regulated and compare this system to the system of regulation that existed prior to the 2008 Global Financial Crisis. Discuss whether you believe whether this new system will potentially prove more effective or not, and why.

Answer 1

A decade after the global financial crisis: What has (and hasn’t) changed?

In the early 2000s, US real estate seemed irresistible, and a heady run-up in prices led consumers, banks, and investors alike to load up on debt. Exotic financial instruments designed to diffuse the risks instead magnified and obscured them as they attracted investors from around the globe. Cracks appeared in 2007 when US home prices began to decline, eventually causing the collapse of two large hedge funds loaded up with subprime mortgage securities. Yet as the summer of 2008 waned, few imagined that Lehman Brothers was about to go under—let alone that it would set off a global liquidity crisis. The damage ultimately set off the first global recession since World War II and planted the seeds of a sovereign debt crisis in the eurozone. Millions of households lost their jobs, their homes, and their savings.

The road to recovery has been a long one since those white-knuckle days of September 2008. Historically, it has taken an average of eight years to recover from debt crises, a pattern that held true in this case. The world economy has recently returned to robust growth, although the past decade of anemic and uneven growth speaks to the magnitude of the fallout.

Central banks, regulators, and policy makers were forced to take extraordinary measures after the 2008 crisis. As a result, banks are more highly capitalized today, and less money is sloshing around the global financial system. But some familiar risks are creeping back, and new ones have emerged. In this article, we build on a decade of research on financial markets to look at how the landscape has changed.

1.Global debt continues to grow, fueled by new borrowers

As the Great Recession receded, many expected to see a wave of deleveraging. But it never came. Confounding expectations, the combined global debt of governments, nonfinancial corporations, and households has grown by $72 trillion since the end of 2007. The increase is smaller but still pronounced when measured relative to GDP.

Underneath that headline number are important differences in who has borrowed and the sources and types of debt outstanding. Governments in advanced economies have borrowed heavily, as have nonfinancial companies around the world. China alone accounts for more than one-third of global debt growth since the crisis. Its total debt has increased by more than five times over the past decade to reach $29.6 trillion by mid-2017. Its debt has gone from 145 percent of GDP in 2007, in line with other developing countries, to 256 percent in 2017. This puts China’s debt on par with that of advanced economies.

2.Households have reduced debt, but many are far from financially well

Unsustainable household debt in advanced economies was at the core of the 2008 financial crisis. It also made the subsequent recession deeper, since households were forced to reduce consumption to pay down debt.

Mortgage debt

Before the crisis, rapidly rising home prices, low interest rates, and lax underwriting standards encouraged millions of Americans to take out bigger mortgages they could safely afford. From 2000 to 2007, US household debt relative to GDP rose by 28 percentage points.

Other types of household debt

Looking beyond mortgage debt, broader measures of household financial wellness remain worrying. In the United States, 40 percent of adults surveyed by the Federal Reserve System said they would struggle to cover an unexpected expense of $400. One-quarter of nonretired adults have no pension or retirement savings. Outstanding student loans now top $1.4 trillion, exceeding credit-card debt—and unlike nearly all other forms of debt, they cannot be discharged in bankruptcy. This cycle seems likely to continue, as workers increasingly need to upgrade their skills to remain relevant. Auto loans (including subprime auto loans) have also grown rapidly in the United States. Although overall household indebtedness is lower since the crisis, many households will be vulnerable in future

3.Banks are safer but less profitable

After the crisis, policy makers and regulators worldwide took steps to strengthen banks against future shocks. The Tier 1 capital ratio has risen from less than 4 percent on average for US and European banks in 2007 to more than 15 percent in 2017.The largest systemically important financial institutions must hold an additional capital buffer, and all banks now hold a minimum amount of liquid assets.

Scaled back risk and returns

In the past decade, most of the largest global banks have reduced the scale and scope of their trading activities (including proprietary trading for their own accounts), thereby lessening exposure to risk. But many banks based in advanced economies have not found profitable new business models in an era of ultra-low interest rates and new regulatory regimes.

Digital disruptions

Traditional banks, like incumbents in every other sector, are being challenged by new digital players. Platform companies such as Alibaba, Amazon, Facebook, and Tencent threaten to take some business lines, a story that is already playing out in mobile and digital payments. McKinsey’s Banking Practice projects that as interest rates recover and other tailwinds come into play, the banking industry’s ROE could reach 9.3 percent in 2025. But if retail and corporate customers switch their banking to digital companies at the same rate that people have adopted new technologies in the past, the industry’s ROE could fall even further.

4.The global financial system is less interconnected—and less vulnerable to contagion

One of the biggest changes in the financial landscape is sharply curtailed international activity. Simply put, with less money flowing across borders, the risk of a 2008-style crisis ricocheting around the world has been reduced. Since 2007, gross cross-border capital flows have fallen by half in absolute terms

Global banks retrench

Eurozone banks have led this retreat from international activity, becoming more local and less global. Their total foreign loans and other claims have dropped by $6.1 trillion, or 38 percent, since 2007 (Exhibit 6). Nearly half of the decline reflects reduced intra-eurozone borrowing (and especially interbank lending). Two-thirds of the assets of German banks, for instance, were outside of Germany in 2007, but that is now down to one-third.

Foreign direct investment is now a larger share of capital flows, a trend that promotes stability

Global FDI has fallen from a peak of $3.2 trillion in 2007 to $1.6 trillion in 2017, but this drop is smaller than the decrease in cross-border lending. It partly reflects a decline in corporations using low-tax financial centers, but it also reflects a sharp pullback in cross-border investment in the eurozone.

Global imbalances between nations have declined

Ben Bernanke pointed to the “global savings glut” generated by China and other countries with large current account surpluses as a factor driving interest rates lower and fueling the real-estate bubble. Because much of this capital surplus was invested in US Treasuries and other government bonds, it put downward pressure on interest rates. This led to portfolio reallocation and, ultimately, a credit bubble. Today, this pressure has subsided—and with it, the risk that countries will be hit with crises if foreign capital suddenly pulls out

5.New risks bear watching

Many of the changes in the global financial system have been positive. Better-capitalized banks are more resilient and less exposed to global financial contagion. Volatile short-term lending across borders has been cut sharply. The complex and opaque securitization products that led to the crisis have fallen out of favor. Yet some new risks have emerged.

Corporate-debt dangers

The growth of corporate debt in developing countries poses a risk, particularly as interest rates rise and when that debt is denominated in foreign currencies. If the local currency depreciates, companies might be caught in a vicious cycle that makes repaying or refinancing their debt difficult. At the time of this writing, a large decline in the Turkish lira is sending tremors through markets, leaving EU and other foreign banks exposed.

Real-estate bubbles and mortgage risk

One of the lessons of 2008 is just how difficult it is to recognize a bubble while it is inflating. Since the crisis, real-estate prices have soared to new heights in sought-after property markets, from San Francisco to Shanghai to Sydney. Unlike in 2007, however, these run-ups tend to be localized, and crashes are less likely to cause global collateral damage. But sky-high urban housing prices are contributing to other issues, including shortages of affordable housing options, strains on household budgets, reduced mobility, and growing inequality of wealth.

CONCLUSION

The world is full of other unknowns. High-speed trading by algorithms can cause “flash crashes.” Over the past decade, investors have poured almost $3 trillion into passive exchange-traded products. But their outsized popularity might create volatility and make capital markets less efficient, as there are fewer investors examining the fundamentals of companies and industries. Cryptocurrencies are growing in popularity, reaching bubble-like conditions in the case of Bitcoin, and their implications for monetary policy and financial stability is unclear. And looming over everything are heightened geopolitical tensions, with potential flash points now spanning the globe and nationalist movements questioning institutions, long-standing relationships, and the concept of free trade.

NOTE - PLEASE APPRECIATE THE WORK