Global Financial Crisis Of 2007/08

Caused By Inappropriate Incentives

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Introduction

In the present research emphasize is given on assessing the impact of inappropriate incentives leading to financial crisis in 2008. There are several banks such as investment and commercial as well as central banks which controls the money supply and interest rates are responsible for leading to crises situation in the market. It is because of the fact that, financial institution were unable to manage the funds which indeed led the huge market slump. Thus, researcher focusing on understanding how inappropriate incentives cause financial crises.

In 2008, financial crisis happened because of several reasons which consist of subprime lending, growth of housing bubble, easy credit conditions, deregulations, increased debt burden and overleveraging, inappropriate incentives etc. Herein, researcher emphasize on assessing the role of inappropriate incentives in causing financial crisis. According to the study by Pesch (2011), banking crises can be found throughout history. Herein, author argues that inconsistent incentives have cause the financial crisis. However, the roots of current financial crisis lie in the housing bubble due to which banking has suffered from the burst of bubble doe two main reasons: firstly, banks have been able to place assets in off balance sheet vehicles and does not have to possess capital buffers against the institutions (Pesch, 2011). While secondly, banks could lower their regulatory capital requirements by investing in triple “A” rate securities, mainly mortgage backs or related derivatives.

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Similar to this research conducted by Brek (2008) states that, it has been often argued that the crisis was due to the creation of pertinacious incentives in the management of financial institution. However, incentives, financial or otherwise are intended to promote certain behavior that are expected to lead to desired results, but they can also cause unwanted effects, perhaps because they are poorly designed i.e. improper reward system (Brek, 2008). For instance Bank of England and the Federal Reserve, reward an increase in the share price in the short term rather than the achievement of grater value in the long term. It is because they assumed that agents are only motivated by economic interest, so that the introduction of incentive of this nature crowds out other possible targets such as the quality of their work or the creation of teams which are effective in long term.

It is likely that many of the inappropriate behaviors in the recent crisis are related to the existence of perverse incentives (Malinen, 2016). For instance, the attempt to align the interest of managers and analysts with those of shareholder has led to compensation systems that emphasize short term results, which may have led to undesirable behaviors such as excessive risk taking and manipulation of financial results. In particular to the case of inappropriate incentives, the major conflict is regarding interest that have arisen for instance in the rating agencies, whose income depended in large measure on the valuation of their clients assets. In the banking sector, a US bank incentivized employees to lend to small business and increased lending by 47%, but parallel to this defaults also increased sharply (Allen, 2009). However, as per the book published by Bratton (2015) researcher evaluated that, risky behavior fuelled by inappropriate incentives has been cited has the cause of financial crisis that began in 2008. Further author criticizing that, new pay paradigm is based on the ethical deficiencies because the practice increases employee risk and simultaneously diminishes collective representation in pay system (Bratton, 2015). On the basis of this, employee risk increases as a larger proportion of pay is contingent on individual performance which along with the growth of zero hours contracts means that earnings are far less predictable.

Further in the article of Financial Crisis & Recession, researcher identified that, financial crisis in 2008 occurred because banks were able to create too much money, too quickly, and used it to push up house prices and speculate on financial markets (Financial crisis and recession, 2010).

Every time a bank makes a loan, new money is created. In the run up to the financial crisis, banks created huge sum of new money by making loans. In the period of just seven years, banks in UK, doubled the amount of money and debt in the economy. However, very little of the trillion pounds that banks created between 2000-2007 went to businesses outside of the financial sector. In this context, around 31% went to residential property, which pushed up house prices faster than wages. In addition to this, future 20% went into commercial real estate which consist of office building and other business property (Kumar and Singh, 2013). Moreover to this, around 32% went to the financial sector and the same financial markets that eventually imploded during the financial crisis. While on the other hand, further 8% were used into credit cards and personal loans. This eventually created the situation wherein debts become unpayable as because loans were given to such people who does not possess any home, money or deposited any security which clearly highlights their incapability to repay the money (Gregg, Jewell and Tonks, 2011).

However, lending large sums of money into the property markets pushed up the price of houses along with the level of personal debt. It is important that interest need to be paid on all the loans that banks make and with the debt rising quicker than incomes, eventually most if the people were not in state to keep up with repayments. In this situation, borrower stopped repaying their loans and banks find themselves in danger of going bankrupt (Tonks, 2012). In this regard, former chairman of UK’s Financial Services Authority, Lord (Adair) Turner stated in February 2013 that, the financial crisis of 2007 to 2008 occurred because we failed to constrain the financial system’s creation of private credit and money. However, this process caused the financial crisis. As the crisis struck, banks limited their new lending to businesses and households. Further, the slowdown in lending cause prices in these markets to drop and this means those that have borrowed too much to speculate on rising prices have to sell the assets in regards to repay their loans (McKibbin and Stoeckel, 2009). Herein, prices of house dropped down significantly which burst the bubble as a result of which banks panicked and cut lending event future. A downward spiral thus begins and the economy tips into recession.

During the period of recession, big financial institutions like, Central bank, Bank of England and the Federal Reserve refuse to lend the money which resulted in shrink of the economy. Thereafter, banks lend when they feel confident that they will be repaid. So when economy is doing badly banks prefer to limit their lending (Rajan, Seru and Vig, 2008). During this period, financial institutions of UK limits their amount of new loans they make but still public have to keep up repayments on debts they already have. The problem arises when the money which is used to repay loans are being destroyed or disappeared from the market or economy. In this regard, Bank of England illustrated that, just as taking out a new loan creates money, the repayment of bank loans destroy money. However, the banks making loans and consumers repaying them are the most significant ways in which bank deposits are created and destroyed in the modern economy (Lo, Repin and Steenbarger, 2010).

In addition to this, the theory of laissez-faire capitalism clearly indicates that financial institutions would be risk averse because failure would result in liquidation. But in this context, Federal Reserve’s 1984 rescue of continental Illinois and the 1998 rescue of the long term capital management hedge fund, among others showed that institutions which failed to exercise due diligence could reasonably expect to be protected from the consequences of their mistakes (Financial crisis and recession, 2010). However, when too big to fail syndrome the short term structure of compensation packages creates perverse incentives for executives to maximize the short term performance of their companies at the expense of long term. According to the concept developed by Black (2010), control fraud is defined as executives whop pervert good business rules to transfer substantial wealth to themselves from shareholders and customers. During a period of strong global growth, growing capital flows and lengthy stability earlier this decade, market participants sought higher yields without an adequate appreciation of the risks and failed to exercise pro-per due diligence (Gregg, Jewell and Tonks, 2011).

From August 2007 until September 2008, there was fairly wide agreement that poor incentives in the US Mortgage industry had caused the problem. According to this explanation what had happened was that the way the mortgage sector worked had changed significantly over the years (Kumar and Singh, 2013). Traditionally, banks would raise funds, screen borrowers and then lend out the money to those approved. If the borrower defaulted, the banks would bear the losses. This system provided good incentives for banks to carefully assess the credit worthiness of borrowers.

Over the time period, change made in the process and incentives were altered. In which instead of banks originating mortgages and holding on to them, what happened was that brokers and also some banks started originating them and selling them to be securitized. This process is known as originate and distribute model. In addition to this, another major issue with incentive is concerned with the ratings agencies (Lo, Repin and Steenbarger, 2010). Since the buyers of the tranches looked at ratings the question arises: are the rating agencies doing a good job? There are several experts, who argued that the answer was no because the agencies began to receive a large proportion of their income from undertaking ratings of the securitized products. It is because of the fact that, agencies started losing their objectivity and to give ratings that weren’t justified.

As per the mortgage incentives view of the crisis, the whole procedure for checking the quality of the borrowers and the mortgages underlying the securitizations broke down. This clearly indicated that world suggest it is fairly simple to solve the crisis and stop it from reoccurring (Financial crisis and recession, 2010). Herein, government needs to regulate the mortgage industry to make sure that everybody has the correct incentive and this will stop the issue. However, it seems from the statements provided by Federal Reserve and the Treasury at the time that initially this was the view that they took. However, as the crisis continued and then after the default of Lehman the dramatic collapse in the global real economy made this view that subprime mortgages were to blame less (Malinen, 2016).

In addition to this, Chairman of Financial Services Authority (FSA) Adair Turner in UK claimed that, inappropriate incentive structure played significant role in encouraging behavior which contributed to the financial crisis (Kumar and Singh, 2013). While contradicting to the US Financial Crisis Inquiry Commission stated that, Lehman’s failure resulted in part from significant problems in its corporate governance. Further, in the recent result conducted by Gregg and et.al. (2011), investigated that whether bank executives has been incentivized to take undue risks. Herein, author evaluated that, short term profits in the banking sector meant that remuneration structure in banks and financial services were to blame for the crisis (Tonks, 2012).

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In conclusion to the study it can be stated that, incentive contracts are nearly impossible to be created in an accurate way. However, to prevent banking systems from crisis due to flawed incentives the incentives contracts must be evaluated on a more regular basis and have to account for existing as well as expected risks and uncertainties. By the means of this, government can minimize the possibility of system failures due to misinterpreted incentives. However, it can be said that banking crisis occurred due to multiple influencing factors and are expected to happen again.

References

  • Bratton, J., 2015. Introduction to Work and Organizational Behaviour. Palgrave Macmillan.
  • Brek, B. J., 2008. Incentives and the Financial Crisis. [Online]. Available through: <https://www.gsb.stanford.edu/insights/incentives-financial-crisis>. [Accessed on 26th July 2016].
  • Financial crisis and recession, 2010. [Online]. Available through: <http://positivemoney.org/issues/recessions-crisis/>. [Accessed on 26th July 2016].
  • Gregg, P., Jewell, S. and Tonks, I., 2011. Executive Pay and Performance: Did Bankers’ Bonuses Cause the Crisis?. [PDF]. Available through: <http://www.bath.ac.uk/management/research/pdf/2011-01.pdf>. [Accessed on 26th July 2016].
  • Kumar, N. and Singh, P. J., 2013. Global Financial Crisis: Corporate Governance Failures and Lessons. [Online]. Available through: <http://www.gsmi-ijgb.com/documents/jfam%20v4%20n1%20p02%20-naveen%20kumar%20-global%20financial%20crisis.pdf/>. [Accessed on 26th July 2016].
  • Lo, A., Repin, D. V. and Steenbarger, B. N., 2010. Fear and Greed in Financial Markets: A Clinical Study of Day-Traders. American Economic Review. 95. pp.352-359.
  • Malinen, T., 2016. Who Caused the Great Recession?. [Online]. Available through: <http://www.huffingtonpost.in/entry/who-caused-the-great-rece_b_9805056>. [Accessed on 26th July 2016].
  • McKibbin, J. W. and Stoeckel, A., 2009. The Global Financial Crisis: Causes and Consequences. [PDF]. Available through: <http://www.lowyinstitute.org/files/pubfiles/McKibbin_and_Stoeckel,_The_global_financial_crisis.pdf>. [Accessed on 26th July 2016].
 

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