Greed and Irresponsibility Within the Financial Institutions as Factors in the Global Financial Crisis

The financial crisis of 2008-09 has triggered a large amount of speculation not only among the general public but also in the media and policy makers. This speculation largely revolves around why this crisis occurred with the reasons being varied. The only consensus it seems is on the fact that the bursting of the housing bubble which subsequently led to increasing rates of defaults on sub prime mortgages. This exposure to negative mortgages led to the collapse of Bear Stearns in March of 2008. This action triggered the banking crisis and the effects went global when the government made the decision not to rescue Lehman Bros in September 2008. This is however where the consensus ends and whereas there has been no sufficient condition, several possible conditions have been put forward to explain why the crisis occurred (Davis, 2009). This paper critically examines the argument that greediness and irresponsibility within the banking sector were largely responsible for the world-wide financial crisis as well as the current recession.

A large number of economists, politicians as well as media personalities have claimed that capitalism and its underlying greed are to blame for the current financial crisis. In this regard, the claim is that society allowed and even embraced greed encouraging the cultivation of a winner takes all environment. It has been further argued that the United States government intervention through establishment of government-sponsored enterprises has done more to destroy capital than to save taxpayer’s money (Davis, 2009). This is because these enterprises have often been manipulated by politicians seeking to protect their campaign funds. This has been done by ensuring the promotion of seemingly cheap home mortgages capitalizing on every American’s dream of owning a home. It has also been seen that in today’s environment, it has become normal to encourage risky as well as reckless behaviour by companies that would have otherwise not survived within a free market. In this regard, there was a distinct emergence of a market that was largely unsupervised and therefore not held to account. This essentially meant that financial institutions were able to put the entire financial system at risk. These institutions also placed a large amount of faith on mathematical models that led them to vastly under price unpredictable types of risk. It has also been noted that several strategies put down by the United States government were also responsible for the financial crisis. Consider the fact that President George Bush actively agitated for the pushing of schemes such as the Zero Down Payment Initiative despite warnings from the Congressional Budget Office that in the long run, the scheme would only work to push up default rates (Davis, 2009).

Moreover, bush also passed legislation as well as approved budgets that added in dollars as well as a large amount of regulation that further pressured the weakened mortgage and housing sector. It should also be noted that a large number of government backed enterprises often went on spending sprees that were largely unregulated refusing to heed to calls to cut back on their excessive risk taking ventures (Davis, 2009). Short term bonuses offered to financial executives have also been seen as key in ensuring the cultivation of a culture of irresponsibility and greed among bank employees. This culture has in turn led to the creation of mismanagement and a subsequent disruption of the world’s economies. At the climax of the financial crisis, it emerged that short term bonuses are responsible for encouraging bank executives into making publicly wasteful investments. These bonuses have, instead of cultivating moral responsibility among the bank employees and stimulating them to work in a more accountable manner have spurred them to completely regard their productivity levels (Davis, 2009). This is largely because they are aware of the presence of these bonuses regardless of the amount of effort they put into their work. Moreover, it should be noted that a short term bonus culture in most financial institutions has led many of these firms to adopt a situation where they encourage excessive lending as well as expansion strategies that served to greatly weaken internal management policies. This subsequently led to a deterioration of the overall management of the financial institutions (Davis, 2009).

It is also important to note that credit rating agencies who were seen as key towards ensuring that there was both quality and thorough analysis of the credit ratings of financial institutions became more involved with making profit than ensuring corporate integrity. It emerged that credit rating agencies were willing to assign high ratings to financial institutions they were well aware had the riskiest debt (Stglitz, 2008). It should also be noted that risky trading that largely encouraged bankers to place large and risky bets using little amounts of capital was allowed to continue unquestioned. Moreover, these banks were allowed to sell their risky debts not only to investors within the United States but also around the world pushing forward the notion that there was little risk covering the debt. This essentially means that the technical as well as managerial competence of leadership which should have been present during the financial crisis was sorely lacking. Consider that in 2004, the Security and Exchange Commission significantly loosened the capital rules that are meant to provide a cushion during times when the financial market is going through turbulent times. By taking this decision, the Commission essentially gave the financial institutions the chance to regulate as well as monitor themselves using their own risk models (Stiglitz, 2008). The investment banks were increasingly able to invest in risky investments that were related to mortgage-backed securities largely unchecked. In addition, the Federal Reserve Bank was seemingly operated by the will of management rather than on a systematic set of guidelines. In this regard, the Reserve bank was seen to not only encourage but also entertain the setting of risk prices at a lower point than should have been allowed. In this regard, Alan Greenspan, the Federal Reserve Bank chairman is responsible for the bursting of the housing bubble by ensuring that interest rates were kept at a lower minimum than they should have been (Stiglitz, 2008).

It has also been argued that the global financial crisis which was largely triggered by the mortgage as well as financial derivates scandal originating in the United States did not occur because of a failure of technical regulations (Stiglitz, 2008). Instead, it was clear that politics as well as corruption played a large role in ensuring that there was a shaping of accountability systems that were flawed and subsequently lacked transparency. By extension, there was a distinct lack of strictness in ensuring that financial institutions adhered to the set down rules. In these cases, regulators allowed financial institutions to operate under less than fair rules as the case of Freddie Mac and Fannie Mae shows. Reports showed that both companies invested millions of dollars in attempting to ensure that some members of Congress deemed as influential, in exchange for the companies support in any lobbying efforts, agitated for the loosening of capital reserve requirements. As a result of these efforts, these two firms, which later collapsed, enjoyed a large amount of political and regulatory immunity (Stiglitz, 2008).

Critics have however argued that the theory mainly pushed by mainstream media that bankers were largely encouraged by the structure of their bonuses to engage in reckless risks as well as the distinct failure of the relevant policy makers are to blame for the financial crisis are not factual (Friedman & Krauss,2011). It has instead been argued that a number of financial regulations and not the excesses or irresponsibility of financial institutions are to blame. Regulations such as the Basel-II capital adequacy rules as well as the United States equivalent of the rules unintentionally encouraged banks to manage their balance sheet risks in a similar manner. This was largely done by employing a distinct combination of independent debt as well as mortgaged backed debt in a bid to lower their regulatory capital. However, instead of the positive returns that were envisioned, this strategy was affected by small decreases in the value of these debts. When combined with downgrades in credit, financial institutions had to contend with significant reduction of their assets and an overall loss of confidence in the credit worthiness of the financial system. This situation is what led to the global recession. In this regard, the recession was a result of poor regulation. With this in mind, Freidman and Kraus argue, “Thus, causal responsibility for the crisis should not be attributed not so much to capitalism-which is to say, the errors made by capitalist investors, including bankers- as to capital adequacy regulations- which is to say, the errors made by regulators of capitalism.” (p.78). Moreover, they argue that the crisis was triggered by a blind faith in strict regulation accompanied by higher capital requirements in spite of the constant evidence that proved the above factors were slowly creating the environment for the creation of the financial crisis (Friedman & Krauss, 2011).

While it might be easier to blame bank executives for their excesses especially with regard to taking short term bonuses, there is the argument that a large majority of these executives lost money when their firms eventually collapsed. For instance, James Cayne who was the Chief Executive Officer at Bear Stearns as well as Richard Fuld, the Chief Executive Officer at Lehman Brothers are estimated to have lost well over $1 billion each. It should also be noted that in many instances, management at the financial institutions were not aware of the excessive financial risks that were being taken by their employees (Friedman & Krauss, 2011). While this might seem negligent, it does not provide clear evidence that the structure of bonus schemes awarded to executives was responsible for encouraging levels of irresponsibility and reckless risk taking at the institutions. It has also been argued that there should be a clear distinction between the effect that actions taken have and the intention underlying the taking of these actions. Whereas banking executives might appear to have acted in a reckless manner, perhaps their intentions were not to act in such a manner. In addition, whereas the majority of the losses were seen on risky assets, these losses were significantly lower than they could have been had the capital possessed by these firms allowed them. Therefore, the argument put forward that compensation packages awarded to bank executives largely motivated them to take on excessive risk taking has no evidentiary basis. Moreover, if the bank executives had any perception that the housing market was about to go into crisis, it stands to reason that they would have sold off their assets that exposed them to vulnerability within this sector. This would have been done by replacing the mortgage-backed securities. The same case applies to financial regulators who would have changed the risk prices accompanying mortgage backed securities which would have essentially made them less attractive for banks. Instead the regulatory framework present at the time encouraged banks to largely increase their exposure to the property market (Friedman & Krauss, 2011).

Conclusion

With the world’s financial institutions struggling to recover from the negative blow brought about by the global financial crisis, debate has now emerged over the reasons that caused the crisis and why it was widespread. A large majority of the public as well as policy makers and the media have put forward the notion that the financial institution’s greed and lack of accountability is to blame for the crisis. The argument that the regulatory framework present at the time of the crisis which exposed the banks to more risk is a sound one. This is especially when one considers that had the financial institutions had the foresight of the impact of the crisis they would have done more to protect themselves and thus protected the consumer. However, it is impossible to deny the fact that the financial institutions, being largely unchecked and unregulated, took the opportunity to engage in risky financial behaviour. Moreover, the bonuses awarded to bank executives had the opposite effect of encouraging moral and accountable behaviour among employees of financial institutions. Instead the bonuses seemed to give the executives a sense or entitlement which motivated them to choose profitability over corporate integrity.

References

Davis, G.F (2009). Managed by the Markets: How Finance Re-Shaped America. New York: Oxford UP. Pp. 15-17

Friedman, J., Kraus, W (2011) Engineering the Financial Crisis: Systemic Risk and the Failure of Regulation. Pennsylvania: University of Pennsylvania Press pp. 76-79

Stiglitz, J (16 September, 2008). The fruit of hypocrisy: Dishonesty in the finance sector dragged us here, and Washington looks ill-equipped to guide us out. The Guardian. Available at:

<http://www.guardian.co.uk/commentisfree/2008/sep/16/economics.wallstreet> Accessed 20 May 2013