Government and Market Effects on Financial Institutions

Government and Market Effects on Financial Institutions

Banks are meant to assign capital to businesses and consumers efficiently; instead, they handed out credit to anyone who wanted it. Banks are supposed to make money by skillfully managing the risk of altering short term debt into long term loans; instead, they were undone by it. They are supposed to expedite the flow of credit through economies; yet instead, they ended up blocking it.

The costs of this failure are enormous. Agitated efforts by governments to save their financial systems and withstand their economies will do long term harm to public finances. Despite public rage over bank bailouts, the industry has also widely failed its owners. The credit crunch has been a series of multiple disasters, starting with subprime mortgages in America and progressively sweeping through asset classes and geographies. (Rosengren, 2008)There are now some gleams of optimism in the in-vestment banking world, where trading has already been marked down drastically and credit opportuni-ties to the real economy are more limited. But most banks are hunkering down for more desolation, as defaults among consumers and companies get out of control.

For most industries, failure on this scale would mean complete obliteration. Banks, infamously, are different. They tend to be a must in the world’s economy, often being saved by the surrounding politicians and government regulations. Severe actions by governments are included in the form of capital injections and liability guarantees, and more recently through schemes to buy or offer guaranteed loans, have signaled their determination to stabilize and clean up their big banks. (Sokolov & Rothstein, 2013) Politics nonetheless, the commitment of the governments to defend their banking systems eliminates the threat to the largest financial institutions. There is still great hesitation about the nature and extent of the support that governments will end up offering to their banks. But governments are now surrounded in banking systems. They are guaranteeing far more retail deposits than before the financial crisis which is basically promising the issuance of new debt. They own preferred shares in many banks, common equity in others and stand ready to offer money in others still. (Sokolov & Rothstein, 2013) Banks that have not taken any of the government money still benefit from their steadying presence.

The difficulty of structured finance made it difficult to know how losses would cascade down to the investors in secured assets. The irregular credit histories of subprime borrowers made it hard to model default rates accurately. Along with low documentation is made even harder. And market to market accounting intended that banks were valuing illiquid assets at prices which were based upon a lack of buyers as much as basic credit quality. Although the losses that banks face in their loan books are unpleasant, they should be more predictable due to government backing. The government backing should make assured and impending losses somewhat more predictable.

An industry that demonstrates the free market turns out to be affectively dependent on the state for its survival. Officials exercise control without formal representation, imposing pay limits and lend-ing targets. (Baciulis, 2013)The government is the industry’s largest shareholder and the guarantor of its obligations. Yet the scope of this can easily be overstated. Governments routinely step in to rescue banks at times of distress. “Rating agencies have long assessed banks’ credit worthiness in part on the likelihood of government support should they get into trouble. But the assumption that governments will try to help a big bank in crisis is nothing new.” (Baciulis, 2013)

Deposit guarantee schemes have been created around the world to help encourage savers not to remove their money if it gets into trouble. (Rosengren, 2008) Indeed, some advocates of free markets argue that this guarantee of reimbursement helped to cause the current catastrophe, by reducing the in-centives for investors to look closely at their banks. Whatever the facts of that argument, it is a red flag to propose that the state should pull out from its commitment to support banks in times of trouble. This is basically due to the fact that the economy cannot survive without banks

Even if it is possible to replace government equity fairly quickly, most believe that it will take far longer for governments to erase their debt agreements. Banks have lots of” bubble-era” debt to re-finance this year and next. The coming rush of government borrowing may make it harder for banks to attract private funding. And the more government backed bank debt is issued, the greater the risk of creating another refinancing problem when the state guarantees expire. (Sokolov & Rothstein, 2013).

The second reason why governments need to stay engaged is to counter the banks’ usual in-stincts during slowdowns. The obvious thing for banks to do in a recession is to lend less. Governments are urging banks to lend more to boost up the economy, even though in the long term they will want them to be more careful when lending.

The political commanding for governments to try to make a return on their investments compli-cates things further. Banks will have to look somewhat risk proof before they can be passed back into private ownership at a price to make a profit. All of which suggests that governments have to negotiate a lengthy transition before they will exit all of their investments in banks. The longer governments stay involved, the more they will misrepresent competition. Normally, private .firms complain about having to compete with state backed competitors but in this case government backing is likely to change from a negative outlook. There are also disadvantages to having government owned competitors. The obvious one is unfair competition. If government owned banks were to underprice risk for a long period of time in order to meet lending targets, everyone would feel under pressure to respond. (Rosengren, 2008)

Some fundamentals in a new government amendment between banks and society are already clear. Amendments to bank capital governments are certain, although regulators clearly do not want to pressure banks to raise more capital until credit shortages have eased. (QIAN & STRAHAN, 2007) There is now remarkable drive behind the idea of influence ratio, which is a measure that puts a fixed ceiling on the total amount of assets that a bank can hold relative to its capital. Some countries, includ-ing America, already have such a system, and others are coming around to the idea fast.

The liquidity of banks’ balance sheets will also be controlled more intensively. They