Discuss what role financial institutions and financial markets can play in 2012 to help to avoid a global recession

Insert Name:

Name of Institution:

Tutor:

Date:

Introduction

Policy makers are ever worried about recession and economic crises because any slight mistake can plunge the entire global economy into recession and possibly economic depression. Financial institutions have a major role to play in alleviating the impact of recession or avoiding it at all. While a recession can be triggered easily, the effects may take longer to be healed. Volatility in established financial and securities markets such as the mortgage and bonds markets makes the threat of economic recession real and worth attention of every policymaker. When the US subprime mortgage market experienced delinquencies and foreclosures, it became evident that a financial crisis was imminent since there was a string of events that led to decline in the securities which backed these mortgages. Due to the causes of the mortgage problems starting early 2000s, mortgage institutions can learn from the mistakes and institute policies and rules that deal with lending practices, consumer speculation among homeowners, fraud in the mortgage market, among other policies meant to guard against possibilities of financial crisis in future.

Financial Institutions and Recession

Before looking at the role the financial institutions can play to avoid an occurrence of financial crisis, it is important to look at what role these institutions play in causing the crisis. The role they play in triggering financial crisis can be direct or indirect. Financial institutions that offer lending and borrowing services to clients may have lax policies, which allow for high default rates among borrowers thus creating a possibility of financial problems for the institutions involved. Timing of private demand for financial services is of a crucial importance and financial services providers must be careful when timing for the private demand. The role played by the financial markets through supply and demand of money in the economy provides an overview of how these institutions can help in avoiding financial crisis.

Looking at the financial crises that occurred in the past, several issues arise. First, sudden boom and bust in the housing industry created heavy supply of debt-financed consumption. Due to large inflows of foreign funds into the US economy, funds became readily available triggering a reduction of interest rates to attract for credit-consumption. The problem arose when individuals were allowed access to the credit-consumption even without concern for their ability to service. This implies that the financial institutions were lax in the procedures and were not worried about credibility for credit. Financial institutions should therefore establish policies that not only promote healthy consumption of credit but also maintain market liquidity at the right level. Investors must also seek for all the relevant information about the security issuers to make sure that the issuer is credit worthy. Institutions must be evaluated to guarantee investors that the information they have about the institution is correct and up to date.

Since reduction in payments for mortgage lowers the value of the mortgage-backed securities, the resulting effect destabilizes the market by eroding the financial health of the financial institutions.

Financial markets contribute to facilitation of investment and enable financing of corporate operations. Through the money markets, the financial markets ensure that the existing corporate operations are financed, hence continuity of economic activities. On the other hand, the capital markets provide capital for growth and expansion of the corporate world. While trhe financial institutions provide platforms such as the bond markets, the stock markets and the currencies markets, there must be proper regulation of these platforms to avoid speculative attacks that throw the entire sub-system out of equilibrium. The use of technology like internet has proved to increase efficiency in terms of timing, price response and adjustment and information gathering and processing.

Role of the Federal Reserve

The Federal Reserve has a major role to play to curb financial crisis. The greatest role is the regulation of the banking and financial institutions to assure the economy of a healthy banking and financial system. Therefore, the Fed must make sure that at all times it monitors financial condition of every bank. Another role that directly connected to the regulatory response of the Federal Reserve is the facilitation of bank transactions through check clearance. By doing this, the Fed ensures that there is smooth flow of banking transactions thus curbing possibility of economic standstill.

There are a number of response mechanisms which a financial institution such as the IMF can elicit in order to help in avoiding or preventing an occurrence of a financial crisis like the ones we ha witnessed in the past. According to the UN report on the role of the Economic Commission of Africa, the financial institution should provide research and development information concerning financial crises and possible preventions measures. By providing the research and development information, the financial institutions are able to give important information to vulnerable economies and help in establishing strategies to cushion themselves whenever signs of economic shocks start to show.

The Fed has another set of tools that it can use to influence the reserve ratio and quantity of reserves. The tools entail correctional measures and include adjustment of the reserve requirements, paying interest on reserves, open-market operations and lending to banks. When there is too much liquidity in the market, it may pose the danger of inflation and trigger economic crisis, the Fed may opt to open-market operations and reduce the amount of money in circulation. It may lend to the banking institutions to increase liquidity.

Another policy strategy that policymakers can have is to put forward a policy approach that addresses regional financial crisis since any crisis in one country is likely to affect the neighboring economies.

Yet, discipline in the financial institutions must be reinstituted. Even though hedging is a good risk cover mechanism for traders who deal in financial securities, financial policymakers must identify genuine hedging and separate it from speculation attacks that create artificial shortages thus triggering financial problems. Also, financial institutions such as banks must only be allowed to grow to an appropriate size and complexity to cushion other players against the spread of impact in case of failure of the institutions. This means that banks must not be allowed to become too big to fail.

Financial institutions and global policymakers have another role to play to prevent debt crisis because of runaway fiscal deficits. Since economic stimulus packages provide cushion against effects of low private demand, the policymakers must be alert to ensure that the stimulus is not maintained for too long or withdrawn when the private demand is still unreliable (Truman, 2009). Maintaining the stimulus for longer than necessary is likely to choke economic recovery and dip the entire financial system into crisis due to increased inflation resulting from monetization of deficits.

Unfortunately, it is not possible to have a unilateral mode of action for all economies given that different economies have different spending and saving capacities. In addition, fiscal austerity differs from one economy to another. Therefore, for countries where early fiscal austerity is feasible to guard fiscal crisis, the policymakers should lower policy rates in good time and offer quantitative easing to pay off for the recessionary and deflationary consequences of fiscal tightening. The Federal Reserve has a key role here where it issues the policy directive where the Fed purchases more securities to achieve the quantitative easing and supply more money to the economy. In contrast, when there is a threat of inflation, the Fed uses the same mandate to sell off securities thus create fiscal tightening.

In general, near-zero policy rates should be sustained in most developed economies to encourage the economic recovery (Truman, 2009). On the other hand, bond markets require vigilance- without which it would be necessary to institute credible fiscal consolidation plans that offer fiscal stimulus over the medium term. This approach is appropriate for economies like the U.S and the UK where the bond market is still lacking sufficient vigilance. Fiscal policymakers in countries that save more than they consume have a duty too and it entails implementing policies that reduce the need for protective or precautionary savings. Such policies would also aim at reducing current-account surpluses.

Conclusion

The financial institutions and financial markets have a big challenge in the modern business environment where information passes from one party to another faster than before. Both speculators and genuine traders are able to get this information and use it. Since speculation is likely to cause great harm by creating artificial shortage of financial instruments, regulatory bodies of these institutions must be on higher alert to dispel the speculative operations of some market players. Another role that has been looked is the response to various market forces such as too much liquidity in the market, inflation and fiscal tightening. On these, the Federal Reserve must use its mandate to respond appropriately and in a timey manner. In addition, financial institutions in different economies or countries have different roles to play. This is because different countries have different consumption and saving behaviors. Yet, economic or financial problems in one economy are likely to affect other players in the global financial markets bearing in mind the global nature of stock trading, securities exchange and money markets among others.

Reference:

Truman, E., M. (2009). “The IMF and the Global Crisis: Role and Reform” Peterson Institute for International Economics http://www.iie.com/publications/papers/truman0109.pdf.