The financial crisis… already forgotten

Money Matters: Mar. 2010

People no longer want to read Headlines of “Financial Crisis,”  “Bankruptcy,”   and “Losses.” Spring is coming, the recession now appears to be over, but the economy is still weak and the unemployment rate is much too high.

Paul Robin Krugman, born in New York in 1953, a US Professor in Economics from Princeton University received attention when whistle blowing in April 2009 warned that  Austria could be a leading candidate for state bankruptcy.  Krugman himself made it clear in an essay about his “life philosophy” that he has no intention of following instructions since he does not claim to know anything special about life in general, but challenges people to think outside the box.

This is Richie Rich with a special series on the banking system.  In the next three series we will be focusing on the Federal Reserve System, The US banking system and how it differs to the Austrian banking system, and investments of Austrian banks in Eastern Europe.  Are we just an inch from Krugman’s statement? Will his vision become reality ?

I remember a headline in the beginning of 2009 in a well known US newspaper that stated, “US Banking System Well Positioned to Weather Recession, US government says US Banks are strong enough to survive recession.” It’s easy to speak about the past, but more than 120 have since gone bankrupt. Taking only US banks into account clearly shows that the road was more bumpy than initially expected.

It began on Sept. 15, 2008 when Lehman Brothers filed for bankruptcy and bottomed out when Citigroup traded below $1 earlier that year. Most analysts believe that mortgage-backed securities, which included packages of subprime home loans, failed when mortgage default rates went up and housing prices raced down.  Banks made a tremendous series of ill-advised loans to private equity firms, hedge funds, commercial real estate holders, and the average man, unable to pay his credit card balance. There was no way out; the crisis started to pave its way through the system.

To understand the banking system we begin by analyzing the Federal Reserve System as an initial starting point and will continue on in the following episodes with the banking structure.

The Federal Reserve System, or informally the Fed, is the central banking system of the United States. It was conceived by several of the world’s leading bankers in 1910 and enacted in 1913, with the passing of the Federal Reserve Act as a response to financial panics in 1907. The Fed is not owned by anyone and is not a private, profitable institution. It consists of four major duties:

1. Conducting the nation’s monetary policy by influencing monetary and credit conditions in the economy in pursuit of maximum employment, stable prices, and moderate long-term interest rates.

2. Supervising and regulating banking institutions to ensure the safety and soundness of the nation’s banking and financial system, and protecting the credit rights of consumers.

3. Maintaining stability of the financial system and containing systemic risk that may arise in financial markets.

4. Providing financial services to depository institutions, the U.S. government, and foreign official institutions, including playing a major role in operating the nation’s payments system.

Quite a lot of variables to consider if you think about each aspect individually.  The Fed itself explains it like this: “The Federal Reserve has supervisory and regulatory authority over a wide range of financial institutions and activities. It works with other federal and state supervisory authorities to ensure the safety and soundness of financial institutions, stability in the financial markets, and fair and equitable treatment of consumers in their financial transactions.” Clearly, the Fed supervises the monitoring, inspecting, and examining of banking organizations on and off site, through measures such as risk-focused supervision, supervisory rating systems, anti-money laundering programs, financial regulatory reports, accounting policy and disclosure to assess banks’ compliance with relevant laws and regulations.

The Fed has supervisory authority to take formal or informal action to correct noncompliant organizations.

To use common sense, dozens of regulations and surveys and still slip into a financial crisis… how is this possible? In hindsight, it is clear that the Fed and other regulators, both here and abroad, did not sufficiently understand some of the critical vulnerabilities in the financial system, including the consequences of inappropriate incentives, and the opacity and large number of self-amplifying mechanisms that were embedded within the system.

A name to remember is “Ben Bernanke,” Chairman of the Board of Governors of the Federal Reserve System. Bernanke was given the title by President George W. Bush in 2005, but in August 2009 President Obama nominated him for the second time as chairman. The Fed continuously reduced the interest rate during the crisis, which reached a low of 0.25%  in December 2008, to fight recession and reduce unemployment rate.

Strictly speaking, the Fed needs to be rock solid in overseeing the financial system and setting clear boundaries and mile stones for banks without manipulating the financial system. These boundaries will have to be adjusted on a continuous basis due to the influence of the open economy.

In the next episode we will highlight how US banks make their way through these boundaries. Until then keep above waters, this is Richie Rich…

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