Analysing the Role of Government Intervention in Resolving the Financial Crisis The WritePass Journal

Analysing the Role of Government Intervention in Resolving the Financial Crisis Abstract Analysing the Role of Government Intervention in Resolving the Financial Crisis ). The main objective of the interventions, which was to stop the financial panic and bring back normality to the financial markets, was achieved. The intervention programmes were successful in helping financial markets to return to their normal functions (Webel Labonte, 2010). A more realistic way of evaluating whether the government had succeeded in its intervention efforts is to determine if financial normality was reinstated at the least cost to taxpayers. At the height of the crisis, non-intervention would have likely resulted in more costly losses for the national economy in terms of productivity and this would have worsened the government’s finances (Webel Labonte, 2010). Non-intervention could also prolong the crisis as successive bankruptcies may contract the economy. The government receives assets in return for interventions (i.e. recapitalization, guarantees, etc.). These assets provide the government with legal entitlement to the potential revenues of the companies it had assisted (Webel Labonte, 2010). Therefore, the interventions do not actually cause permanent losses to the government’s finances. These arguments put to rest the claim that the interventions should have not been made at the cost of taxpayers’ money. In defence of bailout packages Due to fears that the financial crisis would spiral out of control in September 2008, the leaders of western developed countries undertook radical measures to rescue financial institutions, which were in danger of collapsing. The US, in particular, embarked on the most extensive government economic interventions with the doling out of huge bailout packages for its beleaguered financial institutions. It was estimated that the US government spent USD $1.3 trillion on bailout packages; while European countries spent an aggregate amount of USD $2.8 trillion to rescue their financial institutions. This amounts to a combined total of USD $4.1 trillion (Aikins, 2009). The popular sentiment towards these government sponsored bailout packages is that it created a moral hazard because it only served to increase the risk-taking of banks. The argument is that by failing to penalize banks for their improper practices, banks may make riskier investments because their leaders believe that the government will always bail them out during the crisis (Poctzer, 2010; Norberg, 2009). Although this sentiment is understandable (and may even prove to be true in some cases), the primary purpose of the bailout packages was to restore confidence in the financial system in the short-term (Psalida, et al., (2009). From this standpoint it is apparent that government intervention had worked to stop or, at the very least slowdown, the crisis from escalating. More importantly, the public wanted to see that their government was doing something to resolve the crisis. Leaving the market to run free, in anticipation that it would inherently fix the imbalances by itself, might be difficult for most ordinary citizens to understand. At that point in the crisis, the lack of action by the government would be met with even more criticism by the public. (Aikins, 2009) Table 1. US Commitment to Financial Sector Bailout in USD $ billions (as of Nov 13, 2008)  Ã‚  Ã‚  Ã‚   Program Amount Description Troubled Asset Relief Program (TARP) 700.00 Intended for purchasing troubled mortgage-related assets; later on was used for cash injections on banks Commercial Paper Funding Facility 243.00 The Fed purchases commercial paper (short-term debts) from banks to help fund daily operations Fannie Mae/Freddie Mac 200.00 The Fed took control of mortgage firms; cash injections are used to keep them afloat AIG 112.50 Excludes $40 billion taken out from TARP; AIG successfully negotiated a bigger bailout package with easier terms Bear Sterns 29.00 Special lending facility that guarantees losses on portfolios of investment banks FDIC (Federal Bank Insurance Corporation) Bank Takeovers 13.20 The FDIC put up this fund to cover deposits on failed banks Total USD $1.3. trillion Source: (Aikins, 2010) Table 2. Western European Nations’ Commitment to Financial Sector Bailout in USD $ billions (as of Nov 13 2008) Country Amount Description United Kingdom 743.00 Half of the package is used to guarantee bank to bank borrowing; 40% was allocated for interim loans; and 10% is used for recapitalization Germany 636.50 Most of the amount is for undertaking medium-term bank borrowing; 20% is for recapitalization France 458.30 Majority of the fund is to secure bank debts; $50 billion is for recapitalization Netherlands 346.00 For guaranteeing bank to bank borrowing Sweden 200.00 For credit warranties Austria 127.30 For bank acquisitions, inter-bank borrowing, bank bond insurance guarantees Spain 127.3 For bank acquisitions; inter-bank borrowing; bank bond insurance guarantees Italy 51.00 Purchasing of bank debts Other countries 110.60 Total European USD $ 2.8 trillion Source: (Aikins, 2010) Poctzer (2010) also found that despite the possibility of increased risk-taking by banks after being bailed out, there are indications that recapitalization is an effective tool for stimulating lending, but it is most helpful for bigger banks and when implemented in combination with an asset purchase program. Figure 2 shows the comparison of risk taking by recapitalized and non-recapitalized firms. It can be observed that recapitalized firms tend to be more risk-taking compared to non-recapitalized firms. On the other hand, Figure 3 shows that recapitalized firms tend to increase their lending activities compared to non-recapitalized firms. Figure 4 illustrates that asset transfer firms have the most lending volume compared to recapitalized and non-recapitalized firms.    Figure 2. Time Series of Risk Measure between Recapitalized and Non-Recapitalized Banks    Figure 3. Time Series of Average Lending Volume between Recapitalized and Non-Recapitalized Banks Figure 4. Time Series of Average Lending Volume between Recapitalized Banks, Non-Recapitalized Banks, and Asset Transfer Firms Lessons learned The bailout packages served their purpose at the height of the crisis. However, the government cannot always employ capital injections to rescue financial institutions as this have implications not only on the issue of moral hazard (Poctzer, 2010), but more importantly, these have major impacts on the national budget and taxpayers’ trust (Webel Labonte, 2010). Breitenfellner Wagner (2010) recommend that only financial institutions that are non-liquid but solvent should be saved and the institution must pay significantly for the bailout. The authors also argue for stricter regulation, enhanced risk awareness, more advanced risk management, and a more effective alignment of interests among stakeholders. Gertler, Kiyotaki Queralto (2011) argues that a bank’s decision over its balance sheet is highly dependent on its risk perceptions, which in turn are dependent on major disruptions to the economy and their expectations on government policies. The authors also found that the incentive effects of risk taking may potentially diminish the benefits of credit policies that are intended to stabilize financial markets. It is therefore important to design appropriate and efficient macroeconomic policies to mitigate moral hazard costs. The role of the government in managing the economy cannot be overlooked. The lack of a suitable economic policy and regulatory structure will make the financial system vulnerable to recession and may jeopardize the stability of the whole economy. The government therefore should establish appropriate economic and regulatory policies: (a) to defend against market failure; (b) avoid political and institutional intrusions in the regulation of financial institutions; and (c) avert supervisory tolerance, arbitrage, and capture (Aikins, 2009). References Aikins, S. (2009). Global Financial Crisis and Government Intervention: A Case for Effective Regulatory Governance. International Public Management Review. 10(2), p.23-43. Breitenfellner, B Wagner, N. (2010). Government intervention in response to the subprime financial crisis: The good into the pot, the bad into the crop. International Review of Financial Analysis. 19(4), p.289-297. Gertler, M, Kiyotaki, N Queralto, A. (2011). Financial Crises, Bank Risk Exposure, and Government Policy. NYU and Princeton. Available: princeton.edu/~kiyotaki/papers/GertlerKiyotakiQueraltoJune7wp.pdf. Last accessed 23rd May 2013. Canova, T. (2009). Financial Market Failure as a Crisis in the Rule of Law: From Market Fundamentalism to a New Keynesian Regulatory Model. Harvard Law Policy Review. 3(1) Hodson, D Mabbett, D. (2009). UK Economic Policy and the Global Financial Crisis: Paradigm Lost. Journal of Common Market Studies. 47(5), p.1041-1061. Laeven, L Valencia, F. (2012). Resolution of Banking Crises: The Good, the Bad, and the Ugly. International Monetary Fund. Available: imf.org/external/np/seminars/eng/2012/fincrises/pdf/ch13.pdf. Last accessed 23rd May 2013. Norberg, J. (2009). Financial Fiasco: How America’s infatuation with homeownership and easy money created the economic crisis. Washington, DC: Cato Institute Psalida, LE, Elsenburg, W, Jobst, A, Masaki, K, Nowak, S. (2009). Market interventions during the financial crisis: How effective and how to disengage. International Monetary Fund. Available: imf.org/external/pubs/ft/gfsr/2009/02/pdf/chap3.pdf. Last accessed 23rd May 2013. Webel, B Labonte, M. (2010). Government Interventions in Response to Financial Turmoil. Congressional Research Service. Available: fas.org/sgp/crs/misc/R41073.pdf. Last accessed 23rd May 2013.