Short-term decisions lead to the emergence of the global financial crisis

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Table of Contents

Introduction
Managerial decisions that fueled the global crisis
Canada and the global crisis
Managerial lessons
Conclusion
References

Introduction

The management in any organization is often charged with the responsibility of planning, organizing, controlling and leading all the resources of the organization in the most effective way to ensure its secure and sustained growth in all its future years of operation. Every approved investment decision should portray the projected effect on the firm’s future by use of the various established assessment procedures.

Moreover, any investment which risk assessment cannot be articulately determined as per the existent procedures should be stalled irrespective of how promising its returns may be. After the recent global financial crisis, it is evident that most firms, even the key financial organizations in a country, make investment judgment based on the short-term rather than the long-term.

Over the years, since the great depression in the 1930’s, the role of management seems to have diverted significantly from expectations as illustrated by the global financial crisis. Managers, particularly in financial institutions and mortgage firms, have made decisions based on the current environmental changes and without much consideration of the long-term effects of each decision.

Investment alternatives that seemed promising in the first few years, turned out to be the causes of the global financial crisis in later years. The form and level of risk management by these firms has been based on short-term assessment methods that have been nullified by the succeeding events. On the same note, there were financial institutions in certain countries such as Canada that did not suffer adverse effects of the crisis. Their management decisions were sound and based more on the long-term than on the short-term.

In this easy, I intend to illustrate how certain management decisions by the top financials institutions fueled the emergence of the global financial crisis and how alternative management decisions by other firms cushioned them against the adverse effects of this crisis. Finally, I will elaborate on the managerial lessons from this occurrence that could be exploited to help reduce the recurrence of such an event in the future.

Managerial decisions that fueled the global crisis

According to Perelman (2012), the state of the economy in the 1920’s was so weak that any single occurrence could have triggered the Great Depression. This implied that short-term managerial decisions made by the financial institutions have certain minor but progressive long-term effects which accumulate to a certain level when a single occurrence can lead to fatal crisis. I think the global financial crisis of 2008 was due to the same reason. The US housing bubble is often regarded as the proximate cause of the crisis. The management of Mortgaging institutions allowed the prices of the house to increase alarming since more inflows were attractive. No efforts were made to alter the condition.

According to Tymoigne (2011), these institutions did not consider how the changes in prices would affect consumer spending and savings rate in the long run. The high cash outlay on housing had the effect of increasing the household’s spending causing them to save little no money.

Some began defaulting on their very first mortgage payments, a new occurrence in the sector. Such events occurred in Spring 2007. Managers of the subprime mortgages should have recognized something wrong and acted upon it.

However, their actions to avert the situation were based on the unexplained belief that the housing prices never decline and the noble decision to ensure that more people own their homes. The later was ineffectively executed. Moreover, the continued deterioration of the credit principles that were applied to complex mortgage instruments also amplified the bubble.

Managerial decisions in the lending process are aimed at helping people purchase homes in the short run that they ignore the requirements of the lending process. Schenk (2011) argues that loans were granted without the relevant review procedure or without verifying their income sources or securities.

All along, the house buyers depended on the house rentals to pay for the mortgage. Later, the mortgage would be used as security to secure loans form non-bank lenders. These lenders, on the other hand, did not hold the mortgages to maturity. Instead they sold them off to the investors. Such incentives had the effect of enticing the home buyers to increase their debt to the extent that they could not afford.

The later managerial decision by the U.S. financial institutions to organize the pooling of the above subprime loans with the aim of strengthening security issuance was not carefully researched. Crump ( 2011) recognizes that had the professionals in this reputable analysis surveyed the process meticulously with a bias on the long-term effects, they would have seen no need to pool the mortgage loans. These may have saved the situation or allowed more time for the implementation of measures to safeguard against the global crisis.

The Federal Reserve management was aware of the possible eventual default on the subprimes but preferred to focus their attention on the positive news of the housing industry. According to Prager (2012), a member of the Fed board had shown an optimism in the transition of the US economy to a modest and sustainable speed.

This would ensure sustained non-inflationary development. He had perceived that the burst in the bubble would not spill over since the subprimes were worth less than two billion dollars. What he did not perceive is that the subprime was large relative to the US Gross National Product and the number of defaults was increasing greatly. Therefore, the spill in the long run would have resulted in the insolvency of the financial institutions that held them.

Similarly, the United States’ yearly decision to finance its annual budget deficit through government borrowing from other nationals had led too a great liquidity in the financial system causing the housing bubble. As Schenk (2011) says, government borrowing was a short-term decision meant to supplement the annual budget.

Though the purpose was achieved in the short-run, the long-term effect of too much liquidity and huge debt greatly fueled the emergence of the global crisis. The amount of subprimes was, thus, large relative to the country’s debt leading to the mortgage anomaly. He further added that the loopholes in supervisory system of emerging nations could have been excused. However, he fails to understand why the US, a model regulator could have failed to foresee such an eventuality.

Credit suppliers had opted to use the normal evaluation procedure in the determination of the complex credit facilities in the short-term. They may have instituted measures to come up with the right procedures to evaluate such credit facilities but this did not shield them from the adverse effects of their short-term decision.

According to Wade (2011), the credit risk was under-priced, a feature that caused the credit suppliers to be undercompensated for the risk. In due process, the credit spread across the board reaching to extremely thin margins. This further aggravated the appetite for greater credit risk and thus forfeiting the opportunity for correction of the global economic imbalance through the credit markets.

Economists such as Adam Smith had long recognized the importance of leverage check in organizations. However, over the years, financial institutions lost a reasonably simple task of defining and determining the leverage due to their short-term mindset. They anticipated that if checks had not resulted in any anomalies in the period they were not conducted, then they would not do so in the few years to come.

As Wade (2011) says, the astronomical growth of activities to acquire more securities, were majorly conducted off the balance sheet. Many of the financial products offered by these institutions contained leverage that was too difficult to evaluate or the classes of leverage were layered upon each other to the point of spreading the loss to even the most refined market players.

Another reason attributed to the financial crisis is the shortcomings connected to the risk management in the private sectors, and a misunderstanding in the public sector. Schenk (2011) says, few managers had noticed the looming crisis by the summer of the year 2007. Many management decisions were based on what other firms were doing rather than by what was the right thing to do. Unfortunately, these decisions were based on faulty technical issues on the risk assessment.

For instance, many supervisory authorities had failed in their duty in monitoring the risk situation in their firm’s activities, a circumstance that indicated the industry practitioners were overdue in reporting the matter to the top management. Moreover, the management failed to appreciate the forms of liquidity intermediation in time so as to act since they only thought in the short-term.

So far I have managed to argue how the different managerial decisions either taken or not taken due to a short-term perspective of the financial institutions’ operations led to the emergence of one the financial crisis often termed as the worst in the history of the world.

To further discuss the matter, I will illustrate how certain managerial decisions in Canada had significantly reduced the effect that had the global crisis to their economy. This will substantiate my earlier claim that managerial decisions in reaction to the consistently changing environment that lay emphasis on the short-term were the real problem behind the economic crisis.

Canada and the global crisis

Unlike other countries, Canada which is a good example of a middle-sized, sophisticated capitalist economy has a banking system that survived the great financial crisis. Though it is also felt the heat of world recession, the country weathered relatively better than all other nations.

Despite a mild hit on the financial institutions, there was no need to inject more funds into the system, the banks retained their level of profitability and shockingly managed to continue with their lending culture as usual. So what managerial decisions did they take into consideration? It is vital to note that their practices were often criticized by the U.S. and the U.K as conservative since they were not opened up to new financial advancements.

Canada has instituted a regulatory management of banks, insurance agencies and large investment dealers under the Office of the Superintendent of Financial Institutions (OFSI) that meet regularly to ensure that there is a sound and stable management of the financial institutions.

According to Schenk (2011), having the securities firms bank-owned and the OSFI to monitor the operations of the banks keeps the operations checked to avoid similar occurrences to those of U.S. the regular meetings ensure that all looming issues are deliberated upon based on their long-term effects on the economy.

Pertaining to the issue of leverage, the managerial decisions by regulatory authorities on the leverage were stricter on asset-capital ratio. As Nanto (2010) says, they did not allow their companies to exceed 20 to 1 ratio. This decision was reached based on analysis of what effect the ratio greater than 20 to 1 would have on the economy at large.

Therefore, at the time of the global crisis, the Canadian banks had asset-to-capital ratio of 18 to 1 which was less that of their U.S. and European counterparts. The U.S. multiple was over 25 while that of the European counterparts was above 30. Being less highly leveraged helped Canada survive the economic turbulence of 2008.

Canadian mortgages were given by the banks to hold in the long-term unlike their US counterparts that were intended for resell to the investors. Ciro (2012) argues that this acted as an incentive to only lend in situations where there was high likelihood of repayment more than that of default.

The banks were more articulate in assessing the income sources of the home buyers and their corresponding securities to ensure the probability of default was almost zero. Therefore, when the home buyers began to default in the U.S. and U.K, the Canadian financial institutions were collecting their mortgage repayments as usual. Their purpose to hold the mortgages for the long-term cushioned them from the adversities of the global crisis.

Financial institutions in Canada have huge capital requirements as compared to those of other nations such as the UK and the US. Its banks depend more on the depository funds, which they maintain well above the required level, to safeguard them against emergence of volatility in the market.

This is a decision that carries factors in the long-term effect of the ever-changing environment. Lev Ratnovski quotes this as the reason why its banks are classified among the most resilient in the world. Moreover, he adds that this form of framework is to be accredited for the solid statement of accounts, low foreign debt and a very sound national pension plan despite the current population situation.

So far, I have illustrated that with the proper managerial decisions putting emphasis on the long-term rather than short-term, it was actually possible to survive the global financial crisis. Canada was faced by the very crisis that faced all other nations. However, it was left less scathed than the US and other European nations.

This implies that a global financial crisis is not an event that cannot be avoided. Rather it is an eventuality which can be checked by using the right managerial decisions. Having identified that is not satisfactory. We need to know what to do when we are confronted by a similar crisis or what measures to institute to prevent the likelihood of such an occurrence. Therefore in the next section we look at the managerial lessons form the global financial crisis and in particular from survivors such as Canada.

Managerial lessons

There are several observations from the economic crisis that can provide a valuable lessons for the future practices. First, it is the interdependence of the macroeconomic behaviors and systems. Discreet long-term monetary policies have a desirable effect on the financial sectors while short-term macroeconomic policies that lead to global imbalances can bring to any financial markets irrespective of how effective the regulatory systems are.

According to Schenk (2011), it would be wise to come up with exit strategies that ensure that the short-term policies do not create global imbalances. He adds that there is need for timely warning should there be such imbalances both nationally and internationally. This will ensure the high real interest rates are equally matched by the full pricing of risk.

Second, globalization and the markets has shaped to be well comprehended in their complexity. These can be ensured by enhanced communication between regulators both at the national and international levels. This will foster the identification of problems that may result form short-term decisions by the institutions and deliberation on the most appropriate wais to safeguard the future against another global crisis.

Third, prudence may be too righteous and boring but the pay off is worthwhile especially when the product is evaluated throughout the whole economic cycle. The worth and efficiency of the net systems have to be determined throughout the business cycle and not during the growth period only.

Evaluation at a particular phase would only suite the short-term which we have seen is disastrous. The level of customer confidence in Canada and the U.S. brought the differences that occurred in the recession. One country was cushioned form the extreme shocks while the other was devastated by the crisis.

The effectiveness of the regulatory authorities will depend on the line of defense of the firms. This calls for firms to have their practices imbedded in its corporate governance structures and policies. The policy makers need to be cautious in complicating any perceived reforms as the simplest policies are of ten the most effective. Canada’s 20 to 1 asset-to-capital ratio may have been simple but it was definitely effective.

Another vital aspect is the depository requirements by the banks. The reforms should increase the amount and quality of reserves that the financial institutions should hold. The amount should reflect the all the long-term eventualities of the market. According to lynch, this principle is widely accepted by the principles but the issue of how much is enough has caused lost of disagreements. This may not be accurately determined though all efforts (Bustillo and Velloso, 2009).

Conclusion

I have argued in the easy that the organization’s operations while laying emphasis on the short-term were to be blamed for the global financial crisis. First, I illustrated how financial institutions had either ignored the market tends that gave hints on the possibility of a crisis or made short-term decisions that worsened the situation.

Then, to illustrate that it was possible to emerge unscathed from the global financial crisis, I have used an example of Canada, an advanced capitalist economy, that was almost unaffected by the crisis. I have evaluated its strategies in comparison to those of other nations so as to underscore the difference. Lastly, I have made some recommendations on possible long-term managerial lessons, which if followed would ensure such events do not reoccur in future.

References

BUSTILLO, I & VELLOSO, H 2009, ‘The Global Financial Crisis: What Happened and What’s Next’, Studies and Perspectives, Washington. No. 4, 52 p.

CIRO, T 2012, The Global Financial Crisis: Triggers, Responses and Aftermath, Ashgate Publishing Company, Farnham.

CRUMP, M 2011, ‘The Irish Research eLibrary (IReL): its survival through economic crisis’, Serials, no. 24, pp. 220-224.

NANTO, D K 2010, Global Financial Crisis: Analysis and Policy Implications, DIANE Publishing Company, Darby.

PERELMAN, M 2012, ‘Business as usual: the roots of the global financial meltdown’. Choice: Current Reviews for Academic Libraries, no. 49, pp. 937-938.

PRAGER, J 2012, ‘Reluctant regulators: how the West created and how China survived the global financial crisis’, Choice: Current Reviews for Academic Libraries, no. 49, pp. 938-939.

SCHENK, R E 2011, ‘From financial crisis to global recovery’, Choice: Current Reviews for Academic Libraries, no. 49, pp. 561-561.

TYMOIGNE, E 2011, ‘Global financial crisis: global impact and solutions’, Choice: Current Reviews for Academic Libraries, no. 49, pp. 735-735.

WADE, M 2011, ‘The National Library of Scotland’, Alexandria, no. 21, pp. 67-68.

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