The Aftermath of the Credit Crunch

Nowadays that we see the financial markets are going up again, many people started to analyze: what’s next to prevent another crisis of this magnitude? Some months ago, companies such as RBS or AIG were about to be declare in bankrupt but the bail out from the governments prevented a major catastrophe. At the end, it was a an action to prevent the consequences of excessive risk taking from first-class banks (a very posh way to disguise the terrible effect of greediness).

How can we sort out the dichotomy of the operations of the financial markets and to establish proper rules of the game to prevent another disaster? During last January, the president of the US, Barack Obama, publicly announced his intentions to approve a new regulation for the financial markets known as the Volcker Rule. This rule obtains its name after former chairman of the FED inspired the reform. Basically, this new regulation establishes a limitation to banks to simultaneously assume proprietary trading and retail banking operations under the same umbrella. Why is that? Banks found really convenient to assume extremely risky position by leveraging on the deposits of their clients.

The announcement of this new regulation brought as consequence that the share value of many banks dropped because liquidity would be affected under these new frame. Besides, information given was too broad which generated uncertainty in the market.

I think there is a consensus among the different actors: no one wants another financial crisis of the same dimension again. In order to approve a regulation that addresses the concerns from the taxpayers, guarantees a healthy business atmosphere and keeps enough liquidity in the market, it is a must to understand the causes behind the credit crunch.

Some specialists, including Volcker, have pointed out that after the abolishment of the Glas-Steagal law in 1999, which precisely divided commercial from investment banking, was the turning point to facilitate the crisis. Therefore, the new efforts to regulate the financial markets are meant to be inspired in this former law.

It is important to recall that Adam Smith’s invisible hand and Friedman’s principles seem to have not more room in the economic models because they proved to fail due to the fact that it is evident that market cannot auto-regulate themselves. On the other hand, it seems that regulation was the key to keep the financial markets relatively healthy before and it was government intervention which saved the economy. George Soros, a well-known financial guru, pointed out that the academia duty now is to rethink the economic theory due to the conventional theory failed.

We cannot be naïve thinking again that the same conventional banking practices will reconsider their actions, knowing the fact that their aim is just utility maximization. On my belief, regulation must exist but should be oriented to the limit excessive risk taking and the creation of toxic financial products such as the Credit Default Swaps of subprime mortgages. To separate investment from commercial banking nowadays could bring leveraging problems because the investment banks would not have enough funds to provide liquidity to the market and enhance the economy through private equity and hedge funds. In addition, I am from the side to limit bonus paid to the bankers. In this fashion, it is less likely that greed will step on the cleverness of the bank leaders again.

There is another point to consider as well. After this nasty experience, it is evident that financial markets are interdependent and easily affected among each other. This, because we have a globalised connotation, actions taken must be global as well. Whatever may be the final result of these new regulations, these should be calibrated among at least by the major financial actors. I precisely point out the case of the US, the UK, Europe and Japan. Otherwise, the possible restrictions to a specific market and keep business-as-usual in others may lead to speculative flows of capital that could damage in first instance those who approved the regulations first.

Who is not able to recall his past is condemned to live it again. It is clear that regulation and government intervention play a major role than we used to think. History seems to be on Keyne’s side. Therefore, it is necessary that world takes into account that is a more integrated and fragile place which needs new measures in order to guarantee a sustainable economic growth.