Role of Monetary Policy in Financial Crisis

1. Introduction

To begin with, it is noted that over the last year or so, financial institutions in the major economies have reported losses on a large scale. Some of these have become insolvent, or have had to be taken over or rescued by their governments. The 2008 Global Financial Crisis “Credit Crisis” has affected millions of Americans specifically and others around the World in general terms. Associated with all of that has been a massive swing in the appetite of the World financial markets for risk, and in their capacity to accept risk. Thus, the result has been a shift from an easily available credit to tight credit.

This crisis which began in industrialized countries has shifted dramatically spread to emerging market and developing economies. Many wealthy investors or so have pulled their capital from countries, even those with small levels of perceived risk, and hence causing values of stocks and domestic currencies to plunge. Moreover, the crisis has now moved from containing the contagion to coping with the global recession and changing regulations to prevent a reoccurrence of such a problem. Some security and foreign policy effects of the crisis also are beginning to appear.

In addition, policy proposals to change specific regulations as well as the structure of regulation and supervision at both domestically and internationally levels have been coming forth through the legislative process. As one can bear in mind, In June 2009, the Obama’s administration announced its plan for regulatory reform of the U.S. financial system.

For example, in Congress, numerous bills have been introduced that deal with issues such as establishing a commission or selecting a committee to investigate causes of the financial crisis, provide oversight and greater accountability of the Federal Reserve and Treasury lending activity, acting towards the problems in the housing and mortgage markets, provide funding for the International Monetary Fund, address problems with consumer credit cards and establish a systemic risk monitor.

Therefore, the transmission of the crisis from the U.S. and Europe to the rest of the world came through a number of channels. The financial institutions in most emerging market economies had not been involved in practices that are seen in the institutions that populate the financial centers in the major industrial countries. To that extent, financial institutions in the emerging economies either shied away from the more exotic instruments, including such things as credit default swaps and collateralized debt obligations, or were prevented by regulation from holding or trading such instruments. Banking had to come of the most “boring�, old fashioned ever!

(The New York Times has reported on last September 2009 about the moves to replace the bust securitized mortgage market with a similar scheme dealing in life insurance policies, products that are as distasteful as they are foolhardy). The question is, can anything be done to ensure more responsible financial practice? If we are suppose to talk about the US economy, we would notice that President Barak Obama marked the anniversary of Lehman collapse with a plea to bankers to not get complacent, telling them to get their house in order, or else face further regulation.

We can indicate that over the past year, the financial male storm has battered the global information and communication technology industry, affecting profits and pushing down the industry in a manner reminiscent of the 2001 – 2002 dotcom busts. It is gradually finding its feet again, but it isn’t out of the woods yet. The global financial tumult has forced a number of companies to reanalyze their cost benefit analysis, ensure efficiency and improve productivity. Companies in sectors such as telecom and finance have already realized the need of IT outsourcing as a solution in the changed market dynamics.

Therefore, this research paper provides a review of how the financial crisis has affected many regions of the world, proposals for a regulatory change, indication about the role of Monetary Policy & the level of Political Economics that have been intervening in the Financial Crisis. It also identifies some basic challenges facing the globe & suggests possible solutions for the “Banking Field” to overcome the crisis.

2. Literature Review

The financial crisis was triggered by the bursting of a credit-fuelled bubble. Regulation and regulators did not cause this fatal bubble, but they did indirectly help it to grow by fostering the illusion of financial security. Many developing country economies are yet growing strongly, though the forecasts have been downgraded in the space of few a few months. What does the turmoil mean for such developing countries? And for how much longer can growth persist? What are the channels through which the crisis could spread to and how are the effects being felt and in what cases? What is the role for development policy and what do policy-makers need to know?

Brooke Masters (2009) claimed: “So far, most countries are avoiding a regulatory race to the bottom – if anything, they are going the other way. The UK, for example, is pressing ahead with its own liquidity rules, while the Netherlands has pushed through curbs on bankers’ bonuses. Even Singapore, which has long been favored by financiers for its “light-touchâ€? regulatory regime, considering tightening up its rules.”

However, Joshua Aizenman (2009) indicated that “costly regulation can mitigate the probability of the crisis. We identify conditions where the regulation level supported by the majority is positive after the reform, but below the socially optimal level.”

A big portion of the financial crisis has had to do with under regulation and regulator duplicity with malefactors. If we look at the banking rules, we shall discover that allowing investment and commercial banks to merge, without a specification of a tighter capital rules, and hence, these new mega banks became overleveraged without examining their loans or the instruments that derived from the bad loans these banks made in the first place.

In his writings about Liberalism Ludwig von Mises (1927) indicated that “government intervention in markets would lead inevitably to unintended consequences that resulted in further government intervention.”

It is difficult to correct a problem when the cause of the problem is misunderstood. The presidential and vice-presidential candidates in the United States have all said that “Wall Street greed� has led to the financial mess we are in. On the very face of it, this does not seem likely. Even if greed leads to problems, is it possible that greed has suddenly become much greater than before?

To raise an interest rate at some a time is a mistake and is likely to make a bad situation even worse. In many respects, central banks, including the Federal Reserve, have drawn heavily on important threads of monetary policy research in responding to the financial crisis.

Lang Wang (2005) had explained “with a binding capital requirement, the effects on bank lending supply depend on the size, the capital level, the balance sheet liquidity of banks and the capital distribution and market structure in the banking sector.” In a similar context, Thorbecke (1997) finds that expansive monetary policy tends to increase ex-post stock returns. He reported that small firms tend to be affected more severely by the change in monetary policy stance.

In addition, Paul Krugman (1999) indicated “But when a financial disaster struck Asia, the policies those countries followed in response were almost exactly the reverse of what the United States does in the fact of a slump.”

Currently the traditional monetary policy of the Federal Reserve is to focus on targeting the federal funds rate, now that this rate has approached the zero-bound; it has shifted to focus on other ways to lower the cost of credit in the marketplace. Federal Reserve programs have intended to offset disruptions to interbank lending & short-term credit financing. Since the credit crunch is caused by conservative lending policies during periods of financial duress and reduced profitability, one may finds that monetary policy is somehow ineffective in alleviating the credit crunch. Instead loan regulation can erase it.

George Macesich (1992) argued that the poor performance of monetary policy can be attributed historically to the ease with which “money” has so often been made a political issue. He stated that “For Monetary Policy to be credible, and thus successful, the hands of the Monetary Policy- makers are better tied than left free.” Sun Ruijun and Bao Erwen (2008) have reported “The in-depth development of economic globalization has made economic ties and interdependence between countries even closer, boosting the sustained growth of world economy, and benefiting many countries.”

The global financial crisis is more than just an economic event: It puts pressure on the geopolitical system and is driving states to change their behavior. Taking a snap shot on the GCC states, one can clearly define how largely it has been insulated from the global credit crunch because they are the proud owners of some of the world’s largest oil deposits. Much of this has been caused by massive infrastructure and development projects such as Qatar’s liquefied natural gas facilities, Dubai’s fanciful real estate explosion and Bahrain’s attempts to convert itself into a financial Mecca. The economic system has an effect on the political outcomes. Well-functioning financial institutions, in turn, can increase the political support for anti-corruption measures.

Kira Boerner & Christa Hainz (2006) argued “When banks possess a perfect screening technology that allows them to deny credit to those debtors who use the money for financing an entry fee, the corrupt officials will still borrow from their relatives. However, compared to the case without financial institutions, the interest of corrupt officials and relatives in corruption decreases: Both parties have the opportunity to save at a bank.” In similar terms, Torsten Persson (2000) had explained “Economic policy is the equilibrium outcome of a well defined no cooperative game under preemptive assumptions about economic & political behavior.”

At all levels, the present financial crisis requires a co-ordinate response on a global scale. The real risk to the world economy is the temptation to revert to protectionism by each individual country in order to solve their own domestic problems.

3. Research Methodology

In choosing the correct research method to be used in this research paper, the survey research method by “Questionnaires” will be the basic research design. Each respondent will be supplied with a questionnaire titled “How banks can overcome the Global Financial Crisis”? The questionnaire is estimated to take no longer than 6 minutes for each reached individual regardless of the age.

A survey of 68 individuals located in many counties throughout the country will provide the database for this study. The sample was selected on a probability basis from as much “decision maker” playing role individuals as possible in Bahrain.

The questionnaire took place in Bahrain & the response from the respondents took almost one week.

Questionnaires were distributed randomly depending on many aspects such as: age, gender, employment condition & most important of all, the level of knowledge regarding the topic under study. This research paper sampling volume totaled 68, out of which, males represented 38 and the rest 30 were for females. The original sample was 70, in which the researchers found that 2 individuals were students below the age of 18 and were unemployed. That made a quiet confusing decision to remove the two from the total sample, since at that age and being unemployed is ” not a truly decision maker” respondent.

4. Challenges

As the world look beyond the economic crisis, what are the most urgent challenges that are needed to be addressed?

Gaining a proper perspective on the crisis itself is a first challenge. In recent decades, it has been demonstrated that a market which operates responsibly offers a more secure life and a best hope to people who seek a better standards of living wherever in the world they may live. This is absolutely fundamental. While it is true that the direct causes of the crisis – the combustible mixture of excess leverage in both consumer and financial markets, the bank failures, the credit collapse – have led to some painful consequences, it would be folly to conclude that the foundations of market economics have been irreparably damaged.

A second challenge facing the Global is how to deal intelligently with the huge fiscal challenges ahead. The response of central banks and governments to the economic crisis may very well have averted a global catastrophe. However, massive fiscal obligations have been assumed by governments and this might take many years to unwind. What is needed is for countries to create and develop smart “exit� strategies. Furthermore, as the private sector returns to some growth, this requires a determined pullback in government expenditure. Not an easy task: as we all know, the politics of unwinding government programs can be daunting. Here political courage and good public policy go hand in hand.

The third challenge needs an urgent attention. It is acknowledged that the global economy is out of balance and that this is one of the reasons for the financial crisis. Massive reliance on external demand carries with it real consequences as does the excessive reliance on foreign investors to finance consumption and deficits for long periods of time. As one could realize, such imbalances can cause serious and long-lasting economic damage.

There is also the challenge, or opportunity, of what to do with a country’s immense foreign exchange reserves. A Chinese think tank has come up with an exciting idea: that the reserves could be put to good use through the development of a ‘Marshall Plan’ for Africa, Asia and Latin America. Such a development fund, or loan facility, would increase living standards in the targeted countries.

The fifth challenge is enormously complex challenge that deserves attention. Sometimes we feel that we have loaded so many expectations onto the climate change agenda that it cannot help but fail. You would think that tackling this issue will give us infinite new sources of cleaner energy, and allow for the transfer of substantial amounts of financial and technological support to emerging economies. On the global side, No existing architecture is found to be proficient in preventing global crises from erupting.

Since financial crises occur even in relatively tightly regulated economies, the likelihood that a supranational influence could prevent an international crisis from occurring is questionable. The financial crisis has been characterized as a “wake-up call� for investors who had put their faith & confidence in. For example, credit ratings placed on securities by credit rating agencies operating under what some have referred to as “wicked incentives and conflicts of interest.�

Moving forward to a sixth challenge, the Council on Foreign Relations explained the problem in a report on systemic regulation, as follows:

“One regulatory organization in each country should be responsible for overseeing the health and stability of the overall financial system. The role of the systemic regulator should include gathering, analyzing, and reporting information about significant interactions between and risks among financial institutions; designing and implementing systemically sensitive regulations, including capital requirements; and coordinating with the fiscal authorities and other government agencies in managing systemic crises. We argue that the central bank should be charged with this important new responsibility”.

Centers of financial activity such as New York, London, and Tokyo, race with each other and multinational firms can determine where to carry out particular financial transactions.

This is to be addresses as one of the considerations in policy making.

A seventh challenge is that a large financial institution that may be defined as “large to fail” represents the heavy arm that the world economy depends greatly on. If an institution is considered to be “unsuccessful & too big to fail,â€? its bankruptcy would cause a major risk & collapse to the system as a whole. Yet, if there is an implicit promise of governmental support in case of failure, the government may create a moral hazard, which is the motivation for an entity to be engaged in somewhat “risky behavior”, knowing that the government will rescue it if it fails.

A further challenge is that the nature and size of accumulating financial and systemic risks have not been well identified by the existing micro regulation. It even didn’t impose appropriate remedial actions. Even though some analysts and institutions were sounding alarms before the crisis erupted, there were hardly any regulatory tools available to handle with the increase of risk in the system as a whole or the risks being forced by other firms either in the same or different sectors. It seemed to be an insufficient response to some of these risks either by the authorities responsible for the mistake of individual financial institutions or specific market segments.

A last fundamental challenge deals with the nature of regulation and supervision. Banking regulation tends to be specific and detailed and places requirements and limits on bank behavior. Federal securities regulation, however, is based primarily on disclosure. Registration with the Securities and Exchange Commission is required, but that registration does not imply that an investment is safe or secured, only that the risks have been fully disclosed!

5. Analysis & Discussion

When the U.S financial System falls down, it may bring major parts of the rest of the world down with it. The global financial crisis has opened the World eye on an important point: that the United States is still a major center of the financial world. Hence, Regional financial crises (such as the Asian financial crisis, Japan’s banking crisis or even the current Dubai’s Credit Crisis) can occur without seriously infecting the rest of the global financial system as does the United States economy.

The reason behind, is that the United States is the main guarantor of the international financial system, the provider of dollars widely used as currency reserves and as an international intermediate for exchange, besides being a contributor to much of the financial capital that around the world seeking higher yields. The rest of the world may not appreciate it, but a financial crisis in the United States often takes on a global hue.

To analyze the questionnaire, the researchers have used the SPSS program and the regression analysis in order to define some relationships that best help identify the problem under study.

The descriptive statistical analyses questionnaire will be used, including calculations of sampling error, and statistical adjustments for unequal selection probabilities.

Cross-classification analyses with demo-graphic, ANOVA, linear regression and T-Test is much more applied in order to explain some judgments.

Since the researchers think that the gender is one of the independent variables that could test many hypothesis, three hypothesis were applied based on the dependant variable:

First Hypothesis: There is no relationship between gender and understanding what is going on in the current financial news.

Second Hypothesis: There is no relationship between gender and being informed about the “Global Financial Crisis�.

Third Hypothesis: There is no relationship between gender and the decision that thinks of governments around the world should take in the financial sector towards their economies.

The table below, represents the Statistical Data Analysis of the designed questionnaire:

Table 1: SPSS Statistics for all questionnaire questions

One-Sample Test

 

Question No.

 

Test Value = 0

Test Value = 0

N

t

df

Sig. (2-tailed)

Mean Difference

95% Confidence Interval of the Difference

t

df

Sig. (2-tailed)

Mean Difference

95% Confidence Interval of the Difference

 

Lower

Upper

Lower

Upper

Question_1

68

23.758

67

0

1.441

1.32

1.56

23.758

67

0

1.441

1.32

1.56

Question_2

68

17.636

67

0

4.206

3.73

4.68

17.636

67

0

4.206

3.73

4.68

Question_3

68

21.715

67

0

1.706

1.55

1.86

21.715

67

0

1.706

1.55

1.86

Question_4

68

22.401

67

0

3.868

3.52

4.21

22.401

67

0

3.868

3.52

4.21

Question_5

68

13.683

67

0

2.074

1.77

2.38

13.683

67

0

2.074

1.77

2.38

Question_6

68

8.596

67

0

2.029

1.56

2.5

8.596

67

0

2.029

1.56

2.5

Question_7

68

10.618

67

0

3.5

2.84

4.16

10.618

67

0

3.5

2.84

4.16

Question_8

68

17.868

67

0

2.191

1.95

2.44

17.868

67

0

2.191

1.95

2.44

Question_9

68

23.953

67

0

2.676

2.45

2.9

23.953

67

0

2.676

2.45

2.9

Question_10

68

15.557

67

0

5.059

4.41

5.71

15.557

67

0

5.059

4.41

5.71

Question_11_1

68

14.691

67

0

3.529

3.05

4.01

14.691

67

0

3.529

3.05

4.01

Question_11_2

68

18.302

67

0

4.809

4.28

5.33

18.302

67

0

4.809

4.28

5.33

Question_11_3

68

21.056

67

0

5.029

4.55

5.51

21.056

67

0

5.029

4.55

5.51

Question_11_4

68

17.835

67

0

4.426

3.93

4.92

17.835

67

0

4.426

3.93

4.92

Question_11_5

68

20.978

67

0

4.897

4.43

5.36

20.978

67

0

4.897

4.43

5.36

Question_12

68

16.241

67

0

2.735

2.4

3.07

16.241

67

0

2.735

2.4

3.07

Question_13

68

14.707

67

0

2.676

2.31

3.04

14.707

67

0

2.676

2.31

3.04

Question_14

68

26.329

67

0

2.765

2.56

2.97

26.329

67

0

2.765

2.56

2.97

Anova

Model

Sum of Squares

df

Mean Square

F

Sig.

1

Regression

4.074

1

4.074

4.173

.045a

Residual

64.440

66

.976

 

 

Total

68.515

67

 

 

 

a. Predictors: (Constant), Question_1

 

 

 

b. Dependent Variable: Question_8

 

 

 

Coefficientsa

Model

Unstandardized Coefficients

Standardized Coefficients

t

Sig.

B

Std. Error

Beta

1

(Constant)

1.481

.368

 

4.025

.000

Question_1

.493

.241

.244

2.043

.045

a. Dependent Variable: Question_8

 

 

 

Table 2: Anova statistics & coefficients’ relationship Q1 & Q8 – Hypothesis.

From the Questionnaire, we have selected the relationship among the following questions. However, Gender will always be constant.

Question (1):

Please indicate your gender:

Male

Female

Question (8):

In general, how knowledgeable do you consider yourself to be when it comes to understanding what is going on in the current financial news?

I know enough to be able to explain what’s happening in the financial industry to other people.

I understand enough to make sense of the detail behind the financial news stories.

I just follow the headlines but my understanding of financial news is fairly vague.

I don’t really understand what’s going on in the financial news.

Question_8: On the One-Sample Test it is showed that the Significance is = 0.00 which is less than 0.05, so we reject any initial premise that the average Question_8 is not equal to 0. Since the answer to this question fell where the value of t = 17.868, positive, meaning that people have a significant understanding and knowledge about the current financial news. About 35.3 % of the answers to question 8 went in to that both, males & females find themselves having enough understanding to make sense of the detail behind the financial news stories. On lower confidence levels, 29.4% find themselves confident enough to answer bitterly regarding the financial crisis.

Question (9):

How informed are you about the “Global Financial Crisis� that is said to be impacting the U.S. economy & the rest of the Globe?

Very informed—I have actively sought additional information on this story.

Somewhat informed—I know a bit about it, but wouldn’t be able to hold my own in a conversation about it.

Informed—I’ve read/seen stories about it when I’ve come across them in the news.

Not informed at all—I don’t know anything about this story.

Question_9: The mean for this particular sample is 2.68, which is statistically significantly different from the test value of Zero. 34 out of 68 sample volume representing almost 50% who have been really informed to have read/seen stories about the global financial crisis when coming across it in the news.

The researchers find that the relationship between gender and being informed about the “Global Financial Crisisâ€? is positive with (.493) and based on the t-value of (2.043) and p-value of (0.045), this relationship is statistically significant.  Hence, there is a statistically significant positive linear relationship between people’ gender being informed and know ledged enough about the crisis.

Question (13):

What role, if any, do you think that governments around the world should take in the financial sector towards their economies?

Hands on—the government should intervene whenever the financial sector is at risk.

Intermediary—the government should act as an intermediary between concerned parties.

Laissez Faire—the government should not interfere with economic affairs beyond the minimum.

Completely hands off—the government should let Wall Street solve its problems on its own.

Case by case—the government should take a case-by-case approach.

ANOVAb

Model

Sum of Squares

df

Mean Square

F

Sig.

1

Regression

14.714

1

14.714

7.132

.010a

Residual

136.168

66

2.063

 

 

Total

150.882

67

 

 

 

a. Predictors: (Constant), Question_1

 

 

 

b. Dependent Variable: Question_13

 

 

 

Coefficientsa

Model

Unstandardized Coefficients

Standardized Coefficients

t

Sig.

B

Std. Error

Beta

1

(Constant)

1.326

.535

 

2.480

.016

Question_1

.937

.351

.312

2.671

.010

a. Dependent Variable: Question_13

 

 

 

Table 3: Anova statistics & coefficients’ relationship Q1 & Q13 – Hypothesis.

The relationship between gender and the choice to think of the role that governments around the world should take in the financial sector towards their economies is positive (.937). Based on the t-value (2.671) and p-value (0.010), it is to be clarified that this relationship is statistically significant.  Hence, there is a statistically significant positive linear relationship.

Most of the questionnaires’ answer to question 13 went to choose that the role of government can be best suggested as to: Hands on—the government should intervene whenever the financial sector is at risk.

Question (4)

Which of the following best describes the highest level of education you have attained?

Some high school

High school graduate

Some college

College graduate

Some post graduate studies

Post graduate degree

Question (13): What role, if any, do you think that governments around the world should take in the financial sector towards their economies?

1

Hands on—The government should intervene whenever the financial sector is at risk.

 –

3

1

7

1

8

2

Intermediary—The government should act as an intermediary between concerned parties.

 –

2

7

3

1

2

3

Laissez Faire—The government should not interfere with economic affairs beyond the minimum.

 –

3

7

4

- 

1

4

Completely hands off—The government should let Wall Street solve its problems on its own.

 –

1

 –

2

 –

- 

5

Case by case—The government should take a case-by-case approach.

1

2

3

4

 –

5

Table 4: Cross Checking Analysis between Q4 & Q13.

To provide a better understanding of a cross classification, the table below indicates that, most of people holding a college degree, agreed with the choice that governments should intervene whenever the financial sector is at risk and in need for it’s support.

Therefore, we see that the Global Financial Crisis can be broken down into major phases. Although each phase has a policy focus, it seemed that until t