The turmoil in financial markets worldwide has many worrying about their national economies. Adrian Holloway asked Professor Viral Acharya to identify the best path to fiscal stability. Before all else, says Acharya, we need to untangle the banking mechanisms increasingly used in the last decade.
It has been an extraordinary period for financial markets worldwide, beginning in June 2007, when investment bank Bear Stearns revealed huge losses from beleaguered hedge funds linked to US sub-prime loans. Next, Newcastle-based Northern Rock Bank experienced severe liquidity problems, as the commercial paper market on which it relied for financing dried up, causing a run on the UK bank – the first in 150 years.
This prompted an unprecedented move by the chancellor, Alistair Darling, promising to guarantee savers against losses on their deposits. The Bank of England, the US Federal Reserve, the European Central Bank and national banks of Canada and Switzerland all slashed interest rates and offered further liquidity to associated banks in an effort to inject confidence into the global money markets, pledging more cuts if needed. And not much later, stock markets globally experienced extraordinary volatility, with some of the sharpest plunges witnessed in some time, forcing the US Federal Reserve to engage in a series of further interest-rate cuts and to request the US government for a fiscal stimulus package.
An astonishing sequence of events, all attributable to the current global credit crisis that has become a major focus of public concern and proved to have far-reaching repercussions.
Making sense of the mess
According to Viral Acharya, Professor of Finance and Academic Director of the Private Equity Institute at London Business School, to make sense of the current credit crisis, you first need to untangle the often Byzantine banking mechanisms that global banks have increasingly employed in the last 10 years.
“Some of these mechanisms have genuinely transferred the risk out of bank portfolios. Credit derivatives and securitization were developed precisely to serve this purpose. By and large, these mechanisms are helpful and good for the economy. It’s very useful to have credit risk shared, and this kind of risk sharing helped the global financial system absorb the recession of 2001-02 rather well.”
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