Capital Adequacy and Liquidity of Global Financial Institutions: A Study of Reforms after the Great Recession

The global financial crises of 2007-2009 was followed by the Great Recession which was the worst since the Great Depression of 1930s. The crises left significant adverse effects on global growth and employment. Policymakers of affected countries responded differently to the outcomes of these crises. The central banks, including US Federal Reserve Bank and Bank of England, provided ample liquidity for the financial institutions and lowered the interest rate to near zero. The policymakers and regulators realized that capital inadequacy and insufficient liquidity of financial institutions were the main problems preventing the financial firms to protect themselves against major financial crises. In addition, lack of guidelines for compensations encourages managers to take the extra risks. The US Federal Reserve Bank took the initiative, in cooperation with international central banks to introduce rules and regulations to safeguard the financial systems against another major crisis. It is not guaranteed that another episode of financial instability will not happen again. However, with existing regulations on financial institutions in force, the severity of the crises on the whole global financial system may possibly become weaker. This is a conjecture we explore here.


Figure 1. World and OECD Growth 1988-2017
For the sake of comparison, the growth rate of US real GDP is plotted in Figure 2. This series almost followed the two series in Figure

Financial Crises and the Great Recession 2007-2009
The financial crises, also called the subprime mortgage crises, started in the United States after a persistent long low interest rate period caused a boom in the real estate market.
According to Monadjemi and Lodewijks (2015), in October 2009 the IMF estimated global losses in the banking sector of $3.6 trillion as a result of the Global Financial Crisis. How did this happen?
Speculative booms, often in real estate and stock markets, and the excessive accumulation of debt, are basic features of most crises. In this case housing was the source of the crisis combined with a new  1930 1940 1950 1960 1970 1980 1990 2000 2010  Securitization transferred risk from bankers to investment banks and investors around the world. Since the bank no longer bears the consequences of making bad loans it has less incentive to monitor loan quality and undertake appropriate risk management practices.
The housing market became a focus of intense speculative interest. The price of housing assets exceeded its underlying fundamental value and led to excessive accumulation of debt as investors borrowed money to buy into the boom. With its value rising, the asset that is the heart of the bubble serves as collateral so home-owners and investors can borrow more and become more leveraged. The excessive accumulation of debt, by households, the financial institutions and corporations was an essential element of the story. The housing bubble-From 1999 to 2005 led to home prices increasing by 62 percent in the U.S.-contributed to real estate and consumption boom.
The mortgages had high transaction costs, very low interest rates and no safeguards in the event of default and as more and more low-income borrowers defaulted, houses were repossessed and sold at substantially lower prices. The value of the subprime mortgage-backed securities plummeted as some 500 hedge funds perished, the shadow banking system collapsed and the conventional banking system came under pressure.
Financial institutions had undervalued the long-term risk of holding these securitized mortgages. They took unbounded risks that they thought had low probability of occurring-tail risk-by slicing and dicing credit risk but did not take due diligence in appraising the underlying financial products. The official rating agencies were no help at all. Sixty percent of all asset-backed securities were rated AAA during the lending boom, whereas less than 1 percent of all corporate bonds were rated AAA. Exotic financial engineering instruments like Collateralized Debt Obligations (CDO), Derivatives, Credit default swaps-insurance against the collapse of some asset/bank-were so complex to understand that those that held them did not know the risks involved or even the extent of their own exposure, let alone that of other financial institutions, and so trust and confidence among banks and non-banks evaporated.

Great Depression and Great Recession Compared
Blanchard and Summers (2017)  was significantly reduced and the mortgage crises led to the GR, which was the biggest since the GD of 1930s. Blanchard and Summers (2007) argued that in 2008 the US economy did not completely collapse as it did in 1933. However, the recovery in the latter period was much slower than the former. This means that the growth rate of the US economy was much higher in the late 1930s than it was in the recovery after the 2008. The authors point out that the macro stimulation policies, fiscal and monetary, and bail out of financial institutions during the GR, were significantly higher to keep the unemployment much less than the 25 percent that was experienced in 1929.
Some argue that the recovery from 2008, would have been quicker if policy makers learnt from the 1930s and took radical and aggressive measures (see http://www.history.com/topics/great-depression).
The difference between 2008 and 1930s was in 1939 the worst kind of public works program was implemented. It was called World War II. The fight with fascism made significantly large deficits to be acceptable, and, as a result the economy recovered strongly. However, in 2008 there was no war to force the government to spend a substantial amount of money. "Think of it as a reverse Goldilocks economy.
Things aren't desperate enough to force thenment to do more, but they aren't good enough to put everyone to work. It might not be a great depression, but it is a long one" (see http://www.history.com/topics/great-depression). (2007)

Regulations and Reforms after Financial Crises
Monadjemi and Lodewijks (2019) note that Duffie (2016)   In the United States, the most toxic financial institutions were investment banks that raised funds with run-prone wholesale short-term financing of their securities. A large portion of this funding was obtained from unstable money market mutual funds. A substantial amount of this money-fund liquidity was arranged in the overnight repo market, which was discovered by regulators to rely precariously on two U.S. clearing banks for trillions of dollars of intra-day credit. The core plumbing of American securities financing markets was a model of disrepair.
Just before the Great Financial Crisis of 2007-2009, the biggest sources of risk to the financial system were poorly supervising, excessively approving residential loans and accumulating risky peripheral European sovereign debt. Macroprudential regulation, however, is mainly concerned with the resiliency of the financial system to shocks originating from inside or outside. In the words of Tucker (2014), "Overall, the test is whether the reforms can increase the resilience of the system as a whole, reduce contagion when trouble hits, and mitigate the pro-cyclicality of financial conditions".
Duffie (2016)  series of unprecedented interventions into the financial system rescued both illiquid and insolvent financial institutions and even involved swapping safe government bonds for toxic assets.
In the U.S. 40 percent of conventional deposits were uninsured and the government was forced to provide a blanket guarantee-the equivalent of deposit insurance-to all existing money market funds.
They guaranteed bank debt irrespective of how prudent or otherwise these institutions had been. The

Monetary Policy Reforms
Monetary policy is generally more effective to control inflation than reversing down-turn and recession.

The ineffectiveness of monetary policy in deep recession was initially advocated by John Maynard
Keynes in 1936. Keynes named this situation liquidity trap with at a very low rate of interest, additional expansionary monetary policy leave interest rates unchanged, and hence no effect on output and employment. In recent periods monetary policy ineffectiveness was observed in Japan in 1990. In the 1970s, Japan's gross national product (GNP) was the second highest in the world, after the United States and, by the late 1980s, ranked first in GNP per capita worldwide. But all of that changed in the Lost Decade of 1990s when its economy stagnated. Most economic crises generally follow an economic boom where assets valuations do not reflect reality. Japan's lost decade was mainly caused by speculation during the boom period. Record-low interest rates led to stock market and real estate speculation that sent valuations soaring throughout the 1980s.
Knowing that the bubbles are was unsustainable, Japan's Finance Ministry increased interest rates to calm down the speculation. This action very quickly caused a stock market crash and debt crisis, as borrowers failed to make payments on many loans that were backed by falling asset prices. Finally, the problem created a banking crisis that led to amalgamations and bailouts of the banks by the government.
After the initial economic shock, Japan's economy was sent into its now-infamous lost decade, where economic expansion halted for more than ten years. The country experienced low growth and deflation during this time, while the Japanese stock markets hovered near record lows. The property market never fully returned to its pre-boom levels. Economist Paul Krugman blames the lost decade on consumers and companies that saved too much and caused the economy to slow. Other economists point blame at the country's aging population demographic or its monetary policy-or both-for the decline. In particular, the slow response of the Bank of Japan (BOJ) to intervene in the marketplace may have exacerbated the problem. The reality is that many of these factors may have contributed to the lost decade.
Following the crisis, Japanese citizens started saving more and spending less, which had an adverse effect on the economy. This development led to deflationary pressures that encouraged consumers to further hoard money, which resulted in a deflationary spiral.
The Bank of Japan reduced the policy rate to 0.25 percent in September 1998, reaching a stage where the conventional monetary policy of interest rate setting had been almost exhausted. Japan's economy was confronted with the "zero lower bound on nominal interest rates". However, prices and output did not respond. In this situation, the Bank of Japan decided to conduct various forms of unconventional monetary policy measures. Many people know about expressions such as "zero interest rate policy", "quantitative easing", "credit easing", and "forward guidance". These are terminologies for  About a year ago, the global economy faced the most severe financial crisis since the Great Depression.
Fortunately, strong and coordinated policy actions avoided a global financial collapse, and since then, assisted by a variety of government programs, financial conditions have improved substantially.
Although, the worst financial and economic outcomes was avoided, the adverse effects of the crisis have been very severe, as indicated in the depth of the global recession and the remarkable declines in employment both domestically and abroad. With the financial collapse avoided, now the policymakers should take the opportunity to reduce the probability of the recurrence of any future crises.
Although the crisis was a mixture of events with multiple causes, weaknesses in the risk-management practices of many financial firms, together with insufficient capital and liquidity, were important contributing factors. Many regulators and supervisors did not recognize and correct those weaknesses in advance of the crises. Accordingly, all financial policy makers, including the Federal Reserve, must learn from the experience of the past two years, identified shortcomings to prevent occurrence of another major crises.
It is not apparent that we have solved issues of global financial instability or economic stagnation.
Interest rates are exceedingly low (if not negative) yet there appears no resurgence of inflation or rebound Global growth rates of income and output have been mediocre in recent times. Even the Chinese economy that grew on average at 10% per annum from 1980-2010 is now approaching half that rate of growth. This is quite surprising given all the technology disruptive business activity involving artificial intelligence, blockchain, machine learning and robotics. The 4th industrial revolution does not appear to be visible in the growth and productivity statistics. What is visible is stagnant real wages for workers despite low unemployment. It is claimed that in America the real average wage has about the same purchasing power today as it did 40 years ago. Wage gains there have mostly flowed to the highest-paid tier of workers.
Another conundrum is that often stock markets reach dizzy heights but that is also not reflected in increased private investment and productivity growth. There seems a disconnect between financial markets and real economic activity. One issue that is very visible is trade and currency wars among the two largest players in the global economy. That is clearly affecting the real economy.
These places the global economy in a fragile state. Is there another crisis in the wings? Moreover, if there is, are we equipped to adequately respond? Interest rates are very low, even negative. Conventional monetary policy has reached its limits. We live in interesting times.