Background
The term “financial crisis” has become a familiar term within the finance realm. Financial crisis takes different forms depending on the underlying cause and includes crashes of stock markets, currency crises, and bursting of economic bubbles (Eichengreen, 2008). In the past century, financial crises have been somewhat frequent and have occurred in different parts of the globe. Some of the widely known financial crises include: “the collapse of the Japanese asset price bubble of 1990, the Scandinavian banking crisis of the early 1990s, the Mexican economic crisis of 1994, the Asian financial crisis of 1997 and the Russian financial crisis of 1998,” (Tarullo, 2008, p.3). However, the most recent financial crisis of 2007-2010 remains indelibly imprinted in the minds of many scholars largely because it did not affect the United States only but spilt over to other developed and developing countries. The recent crisis originated from the subprime crisis of the United States in August 2007 but quickly erupted into a global financial crisis within a matter of months (Fostel & Geanakoplos, 2008).
The frequency of financial crises across the globe is a disturbing phenomenon and one that has attracted the attention of scholars and experts. What are the factors that contribute to the financial crises? Are the causes of the crises a fundamental problem or is the problem subtler? This dissertation proposal aims to explain the frequency of the occurrence of financial crises. To be specific, the dissertation will answer the question: What is the explanation for the frequency of occurrence of financial crises: is it a fundamental problem or something subtler? Although many causal factors have been highlighted by scholars, the scope of this dissertation proposal only permits the assessment of systemic weaknesses in the banking institutions.
Literature Review
Credit cycle
It has been argued that the current financial crisis resulted from the sophistication and globalization of financial institutions such as banks. These two factors are however not new to the financial sector and existed even in the 1920s. Rotheli (2010) argues that the nature of the credit cycle is one of the major contributing factors to the financial crises. A credit cycle refers to “the tendency of banks to excessively increase their credit supply during the upswing and to strongly cut down lending during recessions,” (p.120). The length of the boom influences the risk taking behaviour of banks. During booms, banks attract more lenders by lowering their interest rates and relaxing their lending terms. This period of over-optimism usually comes to a halt when a disproportionate number of people become interested in the investment product and the speculation grows. When this occurs, the price bubble bursts and the speculations on prospective gains are upset. This often denotes the beginning of a crisis and banks incur huge losses on defaulting loans. The realization is that the interest rates offered by the banks during the economic boom were too low to cushion them against the default risks.
Competition for market share
Competition is another factor that contributes to the financial crises. The financial sector is highly competitive (Jimenez & Saurina, 2006). As a result, individual banks adopt riskier operations to stay ahead of the game. Banks’ competitive advantage is often gauged by the types of policies, particularly lending policies, they implement. A bank that adopts a cautious lending policy during an economic boom has the risk of losing its market share to the rigorous players of the industry. In addition, such a bank becomes a takeover target by the competitors as the boom continues (Greenspan, 2004). Banks take into consideration this factor and therefore tend to lend with greater restraint “as margins in the credit business deteriorate relative to the default risks incurred,” (Rotheli, 2010, p.121). Consequently, banks prefer to adopt risky lending behaviours for the sake of maintaining their competitive edge and surviving in the market. The herding behaviour of banks has been examined by Rotheli (2007) using 1980s and 1990s data of large Swiss banks. Rotheli concluded that such behaviours force banks to lend excessively during economic booms which in turn cause them to lose greatly during an economic recession. The behaviour is further promoted by the compensation schemes of financial institutions in which bankers’ incomes are determined by the level of profits made by the institution (Miller et al., 2002).
Imperfect financial markets
Financial contracts differ from other types of contracts because they involve an exchange of a payment made today for a promise of reimbursement made in the future. Financial contracts are therefore rendered to two types of risks: idiosyncratic risk and aggregate risk. Idiosyncratic risk is “specific to the counterparty, their incentives and the project they will be engaging in,” (Torre & Ize, 2010, p.113). An aggregate risk on the other hand affects all the contracts made in the financial institution. In an ideal market, these two types of risk can be completely and proficiently internalized. However, the real-world financial industry has many challenges that hinder the internalization of the risks. Such challenges include the costs of collecting information, bargaining, and understanding the complex nature of the institution/system. As a result of these challenges, various gaps arise in the system. The asymmetric information and control gap occurs when one of the parties to a contract (usually the principal) has less information and thus lower control over the other party (agent). This gap usually exposes the contract to challenges of strategic choice and time discrepancy.
The other gap is the liquidity and collective action gap that occurs when investors try to minimize their exposure to the two types of risks (Danielson & Shin, 2002). Regarding the idiosyncratic risk, the lender prefers to remain liquid by restraining lending to control the agent and maintain an advantage over the other creditors. Regarding the aggregate risk, the principal prefers to minimize lending to stay ahead of the competition and evade the problems that arise from volatility in the environment. Such an opportunistic behaviour often leads to three failures namely: externalities, free riding and coordination failures. The third gap is the systemic uncertainty and volatility gap. It is associated with aggregate risk and occurs as a result of difficulties in dealing with the doubt and instability of financial systems and in comprehending the effect of the system’s complexity on the contracts made (Torre & Ize, 2010).
Financial crises are best explained by the asymmetric information and control gap. The cause of the crises is mainly the distortion of moral hazard that induces the players of the industry to take excessive risk in the belief that they will be able to capture the upside, exit on time and leave the downside to others (Diamond & Rajan, 2000). For this to occur, the anticipated capital gains must be greater than the anticipated downside costs, for instance, through the discovery of new financial products which in turn creates a load of opportunities for the investors. Torre and Ize (2010) argue that in the case of the subprime crisis, “it was the discovery of new instruments and intermediation schemes (securitization and shadow banking) that set the process in motion leading to a moral hazard-induced under-pricing of risk and encouraging participants to make the best and take the plunge,” (p.117).
Banking regulation
The current global financial crisis has exposed the inherent weaknesses of regulations in the banking industry. Banking regulation is indeed a crucial aspect of the industry particularly because of the interconnectedness of the institutions (Leondis, 2010). Today, many banks have subsidiaries in different parts of the globe thanks to increased globalization and advanced information technology. As a result, there is a need for cooperation among the national regulators of a bank’s subsidiaries. Such cooperation can be achieved through the effective and professional exchange of information among the parties involved. This would enable the institution to discover and establish the degree of the systemic risk originating from the institution’s subsidiaries and thus take corrective measures before it is too late. Information sharing is important because a national regulator can’t know about the activities undertaken by other subsidiaries without the subsidiaries offering the information. Unfortunately, the banking system lacks these coordinated efforts and information sharing. This weakness is clearly articulated by Wagner (2010) who argues that “during the financial turmoil and government intervention in 2008, the weakness of this voluntary coordination structure became clear since many governments first took national measures before gradually taking a coordinated response,” (p.69).
Research Methodology
Research design, data type and data collection techniques
The study will be conducted using a mixed-methods research design. Mixed methods research uses both qualitative and quantitative research methods. In this study, qualitative data will be collected to assess the effect of banking regulation on financial crises. A researcher-administered questionnaire will be used to collect the required data. The questionnaire will contain both closed and open-ended questions to enable the researcher to gain a deeper understanding of the problem under investigation (Flick, 2009). The data will be collected from the information and communications managers of multinational banking institutions such as Barclays Bank and Standard Chartered Bank which have subsidiaries in different countries and regions. The qualitative data collected will include: the type of information shared among the bank’s subsidiaries, the mode of information sharing used, the hurdles faced ineffective information sharing, and how information sharing affects the bank’s performance in the global market.
Quantitative data will be collected to assess the lending behaviours of banking institutions during different economic phases of the business cycle. The quantitative data that will be collected include the interest rates of lending, the total amount of money lent at different lending rates, the types of new financial instruments introduced during the period of study and the investment volumes of the new instruments. Lastly, data will be collected on the economic growth which will be measured by the rate of growth of gross domestic product (GDP). The period of study will be 1990-2010 hence data on the above-mentioned variables will be collected for each of the years starting 1990 and ending 2010.
Data analysis
The qualitative data will be analyzed using thematic content analysis in which each of the above-mentioned themes will be assessed separately. On the other hand, the quantitative data will be analyzed statistically using statistical packages such as SPSS (Leedy & Ormrod, 2005). Specifically, the quantitative data analysis will help to determine: the effect of lending rates on borrowing practices; the effect of the introduction of new financial instruments on borrowing practices, and the relationship between banks’ lending rates and economic growth. This last analysis will help to determine the behaviour of both lenders and borrowers during different economic times (economic boom, stagnation and recession).
Data Source
The source of the qualitative data will be the information and communications managers of the banks under consideration. The logic behind the use of this source is that the managers have the authority to give out any relevant information about the banks. In addition, they have experience of information sharing in the banks. On the other hand, the source of quantitative data will be two databases namely: EcoWin and DataStream from the IFS School of Finance. The two databases have up-to-date, adequate and credible financial and economic information as well as raw data.
Work Plan
Reference List
Danielsson, J. & Shin, H., 2002. Endogenous risk. London: London School of Economics.
Diamond, D. & Rajan, R., 2000. A theory of bank capital. Journal of Finance, 55, pp.2431–65.
Eichengreen, B., 2008. Origins and responses to the crisis. California: University of California.
Flick, U., 2009. An introduction to qualitative research. London: SAGE.
Fostel, A. & Geanakoplos, J., 2008. Leverage cycles and the anxious economy. American Economic Review, 98, pp.1211–44.
Greenspan, A., 2004. Risk and uncertainty in monetary policy. American Economic Review Papers and Proceedings, 94, pp.33–40.
Jimenez, G. & Saurina, J., 2006. Credit cycles, credit risk, and prudential regulation. International Journal of Central Banking, 2(2), pp.65–98.
Leedy, P. & Ormrod, J., 2005. Practical research: Planning and design. 8th ed. Upper Saddle River: Pearson.
Leondis, A., 2010. The global financial crisis: The G-20’s most recent action plan. Banking & Finance Law Review, 25(2), pp.315-330.
Miller, M. Weller, P. & Zhang, L., 2002. Moral hazard and the U.S. stock market: analysing the greenspan put. Economic Journal, 112, pp.C171–C186.
Rotheli, T., 2007. Expectations, rationality and economic performance: Models and experiments. Cheltenham: Edward Elgar.
Rotheli, T., 2010. Causes of the financial crisis: Risk misperception, policy mistakes, and banks’ bounded rationality. Journal of Socio-Economics, 39(2), pp.119-126.
Tarullo, D., 2008. Banking on Basel. Washington, DC: Peterson Institute for International Economics.
Torre, A. & Ize, A., 2010. Regulatory reforms: Integrating paradigms. International Finance, 13(1), pp.109-139.
Wagner, H., 2010. The causes of the recent financial crisis and the role of central banks in avoiding the next one. International Economic Policy, 7, pp.63-82.