FinancialCrisis and Financial Institutions
FinancialCrisis and Financial Institutions
Inthe book “Debtors’Prison: the Politics of Austerity Versus Possibility,”Robert Kuttner provides insightful information on the effect ofrecession on the European Union (E.U). The period that led to theformation of the E.U. was characterized by the struggle of variouscountries such as the United States, Britain, Germany, Russia, amongothers, to compete in the global market. With the World Wars and ColdWar having affected the economic condition of the European nations,it was impossible to compete with the U.S. regarding financialresources. Kuttner (2013), states that the E.U. was established basedon a balance between the market and state. It means that typicalsocial markets were formed to stabilize the economy of Europe so thatthey could compete in equal measure with the U.S. Kuttner (2013)argues that the U.S. was the invisible fist that pushed for theregulation of European markets. The U.S. dollar through thelimitation of speculative movements in the capital market gainedtraction in Europe. The political environment promoted the invisiblefists because most of the countries feared the communist’s power ofgovernance advocated by Russia and Germany (Kuttner, 2013).
Onthe other hand, the article “Thepermanent effects of fiscal consolidations,”Antonio Fatas and Lawrence H. Summer try to discredit theconsequences of the E.U. on the money market across the world. Thegrowth domestic product (GDP) is an important factor in measuring therate of growth and development in a country (Fatas & Summers,2015). There is an assumption that states in the union should haveequal GDP rates. However, this is not the case because there arecountries that benefit from the union as compared to others (Fatas etal., 2015). With the recent global crisis in 2008, it was establishedthat there is a disparity between countries in the union. Forexample, the Greece economic crisis was a result of massiveborrowings from European Central Bank. Some nations have resorted toengaging in fiscal consolidation as means to manage the financialcrisis. Conversely, the alliance has adversely affected the growthrates. The article expands the standpoint of Blanchard and Leighconcerning the fiscal policy multiplier (Fatas et al., 2015). Evenafter the global financial crisis, most of the advanced economies, asregarded by the International Monetary Fund, still suffer from theaftermath since their GDPs continue to fall drastically. The fiscalcondition is self-defeating in nature, particularly in a depressedeconomy. The results and financial shocks experienced in Greece canbe attributed to the need for consolidation. The fiscal contractionin the European nations such as Germany and Britain has reduced theoutput on a permanent basis.
Thetwo articles have a compounding similarity in their trial to expoundon the effects and role played by the E.U. in the global financialcrisis. The austerity of the European nations and the falling in theGDP rates is attributed to the European Union’s governing structure(Fatas et al., 2015). With the single currency in place, mostcountries had their domestic currency such as Sterling Pound, andDeutsche mark in circulation despite the directive in 2002 (Kuttner,2013). Although the money was worthy for some countries such asGermany, they saw no need to help others in overcoming the financialcrisis. Consequently, the need for political dominance was present inthe E.U. governing structure (Kuttner, 2013). It was assumed thatwhen a country has financial power, then it is easy to manipulate themarkets towards their selfish interests. The permanent change in theGDP has been contributed by the weaknesses in the E.U. governingcouncil. There are no known frameworks to protect other Europeannations against their debts. The attempt to reduce the debt throughconsolidation will translate to high debt to GDP ratio (Fatas et al.,2015).
RISKAND INTERNATIONAL FINANCIAL INSTITUTIONS
Mostcountries still struggle with improving their economic, social, andpolitical aspects. It has been challenging due to insufficientdomestic funds to finance the various projects that seek to improvethe living standards of the citizens (Hull, 2012). With the changesin the social thinking among the advanced nations, there have beenefforts to improve on the economic and social perspectives ofdeveloping countries. Notably, this was done through funding ofgovernments because it was an indirect means to uplift the citizens(Rahman, Tafri & AlJanadi, 2010). As a result, the developedcountries used the international financial institutions (IFIs) toreach the governments of the third world countries. IFI signifiesthose financial bodies that provide loans, technical assistance, andgrants to state agencies. They are also obliged to give the loans toprivate entities that seek to invest in the target localities. Thereare various IFIs in the globe. However, the leading and well-knownIFIs include World Bank, International Monetary Fund (IMF), and AsianDevelopment Bank (Wang, Dulaimi & Aguria, 2004). Most of theinstitutions have adopted the structural adjustment approach whenadvancing aid to governments. In their efforts to lend to thegovernments, IFIs face considerable risks. Some of the risks includemarket, liquidity, foreign exchange, and operational risks (Hull,2012).
Oneof the common risks faced by the IFIs is the operational risk. BaselII has defined the risks as that which result from the failedinternal or external processes (Hull, 2012). These mean that itincluded legal risks. When operating in a new environment, IFIs areuncertain of the current prevailing conditions. There is littleawareness of operational risks in many countries because of thebelief that it only affects the private sector (Hull, 2012).Operational risks occur in different forms in the government. Forexample, the government may have a poor strategic decision makingcontributed to inadequate training of the staff and system support.In this case, the IFIs face the risk that the government may notdeliver their mandate in proper utilization of the resources.
Politicalrisks have been a challenge to IFIs, especially in the developingcountries. The political aspect of a country depends on thegovernment objectives in the management of resources (Wang et al.,2004). However, the political climate of a country is vital inensuring that the funds are used in an appropriate manner. The actsof government such as waging war to certain factions in the countrycan restrict the repatriation of the funds. The government mightdivert the funds required for particular projects in fighting fortheir personal goals. Moreover, the government-regulated companiesthat provide necessities such as electricity can be affected by thepolitical environment (Rahman et al., 2010). For example, if the IFIsdecide to fund connection of electricity in rural areas in a country,the government might object the decision because of politicalreasons.
Withthe ever-changing global rates in the global currencies such as theU.S. dollar, Euro, and Sterling Pound, there is a high likelihoodthat IFIs would face foreign exchange risk when lending to thegovernment. Foreign exchange risk is the probability that theoperating and financial results will for short of the expected budget(Wang et al., 2004). The lending to developing nations carries a lotof risks because there are no organized mechanisms that control theforeign exchange (Hull, 2012). The risk can be categorized dependingon the kinds of exposure in the market. Translation exposure is wherethere is foreign exchange gain or loss resulting from the conversionof financial statements from international to local currency.Transaction exposure is where the various transactions have not beenascertained or settled from the date of engagement. For example, IMFmay pledge $600 million. However, before they resolve the pledge, theforeign exchange rate may have increased or decreased meaning thatthe amount would be higher or lower.
Thereare various ways that the IFIs have adopted in managing theoperational, political and foreign exchange risks when dealing withgovernments. IFIs manage operational risks by promoting transparencyin the public sector especially those that have applied the use ofthe given funds. It is hard to avoid operational risks rather IFIshave adopted means that reduce the likelihood of the event fromoccurring in the future. There is the promotion of staff training andimplementation of checks in the governments that prevents frauds andoperational laxities (Rahman et al., 2010). IFIs have also used risktransfer techniques to manage operational risks. Some of theoperations have been outsourced and insured by relevant thirdparties. By doing this, IFIs is satisfied that the government has tostreamline their operations to suit the regulation of the thirdparties. IFIs such as World Bank have established guarantee programsto manage political risks in developing countries (Wang et al.,2004).
Moreover,there have been taking of insurances such as the MultilateralInvestment Guarantee Agency (MIGA). World Bank provides loans forfunding the guarantee programs (Hull, 2012). The third partyinvolvement would help to manage the complex structures in thegovernment. Foreign exchange risks have been managed through theinternal and external techniques in the organization. Internalmethods involve matching inflows and outflows and transfer pricingagreements. Alternatively, external approaches involve the use ofhedging tools such as swaps, futures, options, forwards and debts(Rahman et al., 2010).
CASESTUDY: FINANCIAL CRISIS AND PUBLIC POLICY
Withthe global recession of 2008, most countries in the world wereaffected by the changing economic conditions. Spain was not spared inthe case, in that there was economic slump as indicated by themassive debts, capital, and money market instability. The governmentof Spain has played a significant role in promoting economic recoveryand the restoration of financial stability. The deep recessionaffected the banking system which is the most vital component in theeconomy of a country. Banking institutions are responsible foraddressing the inflation and offering support through loanfacilitation to the government. The financial sector reformundertaken by the Spain authorities in June 2012, aims at addressingthe challenges in the country resulting from the recession (IMF,2014). The 18-month program was supposed to provide the much-neededchanges in the sector. Various stakeholders controlled the program.They include the Bank of Spain, IMF, and government through theMinistry of Economy and Competitiveness. With Spain being a member ofthe E.U., Spain was obligated to support the European StabilityMechanism (ESM)-supported programs (IMF, 2014). Theundercapitalization of the banking system in Spain is attributed tothe bust in real estate and the ever-increasing sovereign debts.These factors led to a sharp rise in the nonperforming loans (NPLs),falling savings in banks, rising unemployment and weak economicactivities (IMF, 2014).
Thedeep recession affected the government and citizens in various ways.The government had to raise the minimum capital requirements,increase loans for real estate development and restructure the banksaving sector (IMF, 2014). The banking institutions faced the mostsevere consequence because they were unable to provide themuch-needed service to the citizens and government. The banks alsolost the resilience to restore their market fluctuations brought bythe deep recession. Spain’s government, through the EuropeanFinancial Stability Facility (EFSF), had to recapitalize andrestructure the financial segment (IMF, 2014). On the other hand, thecitizens were affected in that they lost jobs because companies hadto restructure by cutting down the number of employees to remainprofitable in the market. Moreover, the recession increased theinflation rate which translates to improved standards of living inSpain.
Thedeep recession showed a variety of weakness in the Spain’sfinancial system. Some of the risks the company faced includeliquidity, credit, and operational risks. From the recession, it wasestablished that the financial sector faced liquidity challenges.These mean that Spain was unable to convert their readily availableassets to liquid cash. The financial sector reforms helped in theformation of an asset company (SAREB) which was responsible formanaging the liquidity risks (IMF, 2014). The reforms mandated thatthe banks that were being aided by the government are supposed totransfer their real estate development loans (REDs) and otherforeclosed assets that were over the minimum size to SAREB (IMF,2014). In exchange, the banks would be given government-guaranteedsenior bonds under SAREB. There is a reduction in uncertainty risksin the banking sector in regards to the assets owned by theinstitutions. There would be more liquid resources on the banks thusit will increase the lending rates towards the taxpayers. Moreover,the transfer of the assets to SAREB would enable the banks to focuson providing the services to the citizens and government (IMF, 2014).
Thecapital risk was also a problem in the financial sector. Themanagement of capital risk involves the raising of minimum capitalrequirements for the institutions. State-aided banks were alsorequired to share the burden regarding public financing. Thegovernment of state through their legislations ensured that the bankswere valued independently to determine their assets and liabilities(IMF, 2014). These assists in managing capital risks because thepublic money injected into the bank can be easily protected as stateresources. Operational risks arise from the inadequate structure inthe Spain’s finance sector. The financial sector reforms haveestablished frameworks to mitigate the operational risks. There hasbeen increased supervisory power placed on the Bank of Spain as a wayof strengthening the transfer sanctions and authority to license.Additionally, the bank should operate independently without influencefrom the government and other banks (IMF, 2014).
Themeasures adopted by Spain have significantly improved the financialmarket conditions. Spain’s real economy has started to recover withthe steady reduction of the potential risks. The real economy hasgrown by 0.35% in the last quarter of 2013 (IMF, 2014). There hasbeen increased reliance, particularly on equity funding. The bankshave implemented the strategy of building their capital throughdividend restraints and share issuance (IMF, 2014). The creditors andtaxpayers now enjoy the services because undercapitalization has beenaddressed appropriately by strengthening the liquidity and capitalrequirements. Investors have started flocking Spain because of thefavorable financial status. The increase in cash by the governmentthrough SAREB has encouraged the citizens to invest in the seniorbonds.
Fatás,A., & Summers, L. H. (2015). Thepermanent effects of fiscal consolidations.NationalBureau of Economic Research.
Hull,J. (2012). RiskManagement and Financial Institutions,+ Web Site (Vol.733). John Wiley & Sons.
IMF.(2014). Spain:Financial Sector Reform—Final Progress Report.InternationalMonetary Fund.Retrieved 10 December 2016, fromhttp://www.imf.org/external/pubs/ft/scr/2014/cr1459.pdf
Kuttner,R. (2013). Debtors`prison: The politics of austerity versus possibility.New York: Alfred A. Knopf.
Rahman,R. A., Tafri, F. H., & AlJanadi, Y. (2010). Instruments and Risksin Islamic Financial Institutions.
Wang,S. Q., Dulaimi, M. F., & Aguria, M. Y. (2004). Risk managementframework for construction projects in developingcountries. ConstructionManagement and Economics, 22(3),237-252.