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Emerald Article: Global financial crisis: causes and perspectives

Elio Iannuzzi, Massimiliano Berardi
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Global nancial crisis: causes and
perspectives
Elio Iannuzzi
Department of Business Studies, University of Salerno, Fisciano, Italy, and
Massimiliano Berardi
Department of Business Studies, University of Foggia, Foggia, Italy
Abstract
Purpose This study aims at examining the current global nancial crisis, by emphasizing its main
causes and perspectives to dene the way they can be avoided in the future. The paper argues that
there is a need for a new International Financial System with the function of coordinating and guiding
the different national and supranational institutions.
Design/methodology/approach This article used complexity theory and viable system
approach.
Findings The ndings suggest they are implicit features of these kinds of markets, due to their
high uncertainty and hyper-competitiveness, rather than temporary deviation from normal
equilibrium. In this way, nancial markets can be thought as Complex Adaptive Systems (CAS),
which may precipitate in disorder and chaos because of a seemingly mild event, which activates latent
forces and leads to emerging and unpredictable consequences. The orientation of international
partners is to move towards a new international nancial system, where the stabilization of nancial
system does not pass only through the bodies created in Bretton Woods, but through the endowment
of new rules and new structures.
Research limitations/implications The research faces with evolutionary issues and it is
impossible to know the total value of toxic derivatives still circulating in the world. Furthermore, the
banks are still using the innovative nance to generate short-term prots and shareholders value.
Practical implications The ndings suggest some measures to limit future instability and crises,
and to reduce their negative consequences.
Originality/value The paper provides a new methodology to examine the nancial crises and the
way to limit them.
Keywords Financial risk, Complexity theory, World economy, International nance
Paper type Conceptual paper
1. Introduction
The traditional theory of markets considers nancial crises and speculative bubbles as
temporary deviations from efcient logic of markets, due to the irrational behavior of
operators.
The high frequency of these events demonstrates they are implicit features of these
types of markets, due to their high uncertainty and hyper-competitiveness, rather than
temporary deviation from normal equilibrium (Reinhart and Rogoff, 2008a).
In this way, we can overcome the dominant paradigm based on the assumption
that markets are efcient self-organizing systems, able to allocate nancial sources in a
The current issue and full text archive of this journal is available at
www.emeraldinsight.com/1450-2194.htm
If the research paper is the result of common reections, paragraphs 1, 3, 3.1 and 4.1 are
attributable to Elio Iannuzzi, while the paragraphs 2, 3.2, 4 and 5 are attributable to Massimiliano
Berardi.
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EuroMed Journal of Business
Vol. 5 No. 3, 2010
pp. 279-297
qEmerald Group Publishing Limited
1450-2194
DOI 10.1108/14502191011080818
rational way , which has favoured the current systemic crisis by inspiring several
wrong decisions such as the deregulation of banks, the wide spread of nancial
innovations (Greenspan, 2004), etc. and we can adopt an approach which considers
markets as systems far from equilibrium (Pitelis, 2002).
Therefore, nancial markets can be thought as Complex Adaptive Systems (CAS),
that are systems on the edge of chaos, so, while tending towards certain attractors, they
may precipitate in disorder and chaos because of a seemingly mild event which
activates latent forces and leads to emerging and unpredictable consequences (Cited by
Van de Vijver G., 1998, p. 250) they:
[. . .] can only be grasped locally, hence partially and inadequately.
They depend on decisions and dealer activities founded on partial information and
foresight, instinct, previous experiences, emotions that inuence and are strongly
conditioned by those of other irrational operators. Hence, the evolution of the system is
extremely uncertain and unstable.
In this perspective, the paper aims to examine the current nancial crisis, focusing
on its main causes and perspectives, in order to dene the way they can be avoided in
the future.
The main limitation of the research is that it faces with evolutionary issues and it is
very difcult to understand the phenomenon as a whole. For instance, it is impossible
to know the total value of toxic derivatives still circulating in the world. Moreover, the
banks are still using the innovative nance to generate short-term prots and
shareholders value.
2. The complexity approach
The complexity approach is not a scientic theory, rather, we can speak of
epistemology of complexity as interdisciplinary study of complex adaptive systems
and emerging phenomena. Although this concept has deep historical roots, the
movement of complexity gained ground in the course of the 1980s, with the foundation
of the Santa Fe Institute (Lorenz, 1963; Pascale, 1999).
The different approaches to complexity theory have the study of systems in
common, assumed as sets of components that are organized and react to the structures
and models they contribute to co-create (Arthur, 1999, 107).
These studies are focused on the problems linked to order creation and, particularly,
on the effects caused by non-linear discontinuities, rapid transaction phases and
co-evolution processes determined by events that are apparently disjointed and
unforeseeable (McKelvey, 2004).
In this way, by adopting a systemic perspective, complexity theory is focused both
on the effects of the components behavior on the overall system which they belong to,
and on the intra and inter systemic relationships (Carrol and Burton, 2000). Evidently,
we are referring to the complexity of open systems, according to Prigogine, and not to
that dened as computational complexity (Hilbert), which concerns closed systems
(Prigogine, 1990).
Indeed, the complexity theory investigates CAS, i.e. dynamic systems, characterized
by multiple and overlapped hierarchies, which, like the individuals, tend to create
interactive and evolutionary networks with other systems. The behavior of the
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interconnected agents of a CAS generates, also, emerging creativity and learning
(Plowman et al., 2007).
The complementarity and interdependence of the structures, activities, formal and
informal relations of its agents support the self-coordination and exibility of the
system. For this, the system is dened as adaptive and the more numerous are the
factors that inuence its adaptation to the environmental change (for example, random
factors, learning, etc.), the more are the complexity and unpredictability of its behavior
(David, 1992).
During the evolution of the system, its components co-change through the
development of co-adaptation strategies (cooperation, communication, etc.).
However, the rms environment and context are eminently dynamic and complex.
Therefore, the decision-maker is called to constantly monitor the evolution of the
context and to take continuous structural, organizational, strategic, managerial and
operational adjustments.
Moreover, not all the environmental changes are understandable and predictable: in
fact, the complexity often means uncertainty and ungovernability, especially in the
case of systems characterized by no fully denable borders and by latent energies and
high sensitivity to internal and external changes. In other words, the evolutionary
complexity of both internal and external contexts makes the most of future changes
and their implications on markets and competition unpredictable and uncontrollable.
It follows that the complexity increases the uncertainty and the casual ambiguity
related to the resources, skills and competences the rm must have in order to exploit
the opportunities that emerge over time.
Not all the systems have, however, the same capacity for evolving and developing;
this capacity is inuenced by the degree of stability or instability of the system. While
chaotic systems manifest a widespread inability for evolving and adapting because
they are not able to organize and coordinate their behavior; ordered systems are likely
to be conditioned by excessive rigidity and static nature.
Indeed, a system may evolve towards the order, where it remains despite the
disruption deriving from outside; towards the chaos, where it moves in an irregular
and unstable way; towards the edge of chaos, where, while it converges towards
certain attractors, sudden events may destabilize and remove it.
The hypothesis is that complex adaptive systems exist at a poised state between too
much and too little connection, the so-called edge of chaos, which gives them exibility
and adaptability. These systems (cited by Kauffman, 1991, p. 82):
[. . .] may have special relevance to evolution because they seem to have optimal capacity for
evolving.
Indeed, systems that are only sparsely connected are too static, while those that are
overly connected are inherently unstable (Carroll and Burton, 2000).
The growth of the number of relations and interaction could also increase the
complication and the complexity of the phenomenon, because it increases the amount
of information and number of variables that must be considered and interpreted.
Therefore, the complexity appears to be the result of both the interdependencies and
interconnections, which involve the system and its components, and of the system
sensitivity to the change of initial conditions (Rullani, 1989).
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The level of complexity is also conditioned by both the structure and the genesis of
the system.
First, it depends on the degree of autonomy of its components or, in other terms, on
the capacity of top management for coordinating and controlling the components.
Particularly, the more is the degree of autonomy, the more will be the complexity.
Second, it depends on the origin of the system: this can be top-down or bottom-up. It
is clear that emerging systems (those that have a bottom-up origin such as the
nancial system) usually have a higher level of complexity, especially if they lack a
common management. For this, they are difcult to manage and control. The only way
to partly regulate these kinds of systems is by imposing constraints and rules from
outside.
Furthermore, a system cannot be examined and understood as a single
phenomenon, but it should be contextualized within the framework of
interconnections and interdependences with external environment, from which the
same system derives the degree of complication or complexity of its representation
(Siano, 1997).
Therefore, the complexity cannot be comprehended as an objective and implicit
characteristic of certain systems, but also as the feature of the available representation
of the same system. Phenomena are neither simple nor complex, but they become
simple or complex because of the cognitive process of the observer (La Moine, 1995).
Particularly, complexity arises from the incapacity of the observer to build an
interpretative model; while the complication refers to the difculty in understanding
such a model (Baccarani and Golinelli, 2008). Furthermore, the complexity refers to the
functioning of the system that may be more or less understandable and predictable
because of the variety and variability of internal components and of external relations;
differently, the complication appears as a feature of the model or of the representation
of the phenomenon.
In general, the degree of knowledge determines the level of complication or
complexity of the phenomenon. At the same time, a system that is complex for an
observer could appear very simple for another because of the different background of
schemes and knowledge they hold.
The complexity acquires also a historical dimension, because what today is
considered as complex, may not be the same in the future. For this, the problem is not
the complexity itself, but the dynamism of the phenomena. We could speak of
evolutionary complexity.
What is more, the difculty in managing the nancial system appears to be due to
its nature of system of systems: it is not a single system, but an assembly of systems
that are far from each other, but at the same time they are strictly interconnected and
interdependent each other. In this way, small initial events can lead to complexity
cascades of avalanche proportions, because of latent forces. Moreover, the borders and
the relations of these systems are informal and unstable: this produces a further
increase of complexity.
In this view, the nancial system appears to be in unstable equilibrium at a poised
state between order and chaos, creation and destruction.
Such considerations explain why we use the systemic approach to the complexity to
analyse, interpret and describe the functioning of the global nancial system, giving
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particular attention on the examination of causes, circumstances and prospects of the
current nancial crisis.
3. The complexity approach to investigate the global nancial system
Our hypothesis is that market operators tend to decide by instinct and perception,
rather than by real knowledge of things (Akerlof and Shiller, 2009).
Within nancial markets, decisions can inuence signicantly the evolution of
events; from they own, changes modify perceptions and decisions of participants and
determine new unpredictable evolutions of system.
These dynamics are not always sequential, but they can act simultaneously and can
further increase indetermination and uncertainty (Soros, 2008). Rarely, these inaccurate
understandings of events start a boom-bust process, but, if simultaneously similar and
interconnected processes take roots, they can cause the crash of the system as a whole.
In this view, we can analyse the current nancial crisis which, differently from past
crises, does not concern a single segment of market, rather, starting from a sector of
market, it has activated series of hidden forces which have made global nancial
system strongly unstable, causing dangerous and long-lasting effects on real economy
(Hasman and Samart n, 2008). It has spread from the United States to the global
nancial system through insurance companies, investment funds, investment banks,
derivatives and especially through the new ICT (Tremonti, 2008; Rullani, 2004).
For this, although empirical evidences demonstrate the fallibility of regulators, it is
necessary for adequate regulation, which must be continuously adapted to systemic
changes because nancial markets do not tend to a natural equilibrium and sometimes
are not able to self-organize.
Nevertheless, the mortgage bubble and the way the crisis has developed from
subprime loans to crashes on the stock exchange, banks and insurance companies
bankruptcies, and recession prove the inadequacy of some institutional measures.
3.1 The Big Crash of 1929: the basis of the current nancial crisis
Although we have to consider that there are no signicant similarities between the
current crisis and that of 1929, as they occurred in different historical contexts, because
of opposed factors and conditions, and with different implications as a result of
unequal policies, we have to emphasize homogeneity in the underlying dynamics:
.
an initial favourable event that has given widespread expectations of prot (i.e.
the reduction in the interest rate);
.
a phase of liquidity growth, characterized by a boom of loans and a large use of
leverage;
.
a phase of increasing prots;
.
a breaking point followed by a systemic collapse (in 1929, the crash of the stock
market; in 2007-2008, the collapse of real estate see Figures 1 and 2); and
.
a phase of instability and depression (in 1929) or recession (nowadays)
characterized by panic, deleveraging and lack of liquidity.
Therefore, the understanding of the current nancial crisis requires the analysis of the
Big Depression of 1929 which started with the slump on the stock exchange and the
following bank run and liquidity drop which struck banks in the world because of both
Global nancial
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283
the credit expansion policy of the Federal Reserve System (between 1927 and 1928, the
discount rate was lowered to 3.5 percent) and the phase of speculation and growth in
share prices between 1928 and 1929. The following gure shows the trend of the
Standard Statistic Index for industrial shares, which grew from a base of 100 in 1926 to
216 in 1929. In 1933, it fell to a minimum of 43.
This was not an occasional and unpredictable event within the natural course of
nancial activities; rather, it was the obvious outcome of a long-lasting phase of bad
governance of banks, which worsened credit quality and amplied negative effects on
the global nancial system and real economy.
Between 1929 and 1933, the high opacity and riskiness of management was the
main cause of the failure of more than 5,000 banks in the world, with more than 3,000
billion dollars in deposits. Really, the high number of banking failures was due to the
structural weakness of past nancial system too, characterized by a multitude of small
independent units.
Figure 1.
Trend in share price
according to the Standard
Statistics Index
Figure 2.
Securitizations of
mortgage loans (thousand
of $ billions)
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The sharp decline of the currency quantitative that followed the collapse of the
stock market, and the inability of the banking system to gain sufcient liquidity to
meet the large and pressing demands of currencies by depositors played an essential
role in the expansion of the crisis at global level.
Moreover, there was another factor that made the situation even more volatile:
several countries (such as Germany and Latin America) were running massive current
account decits nanced by the USA. This unbalanced condition was worsened by the
surplus of export over imports (Kindleberger, 1993, p. 42). When the debtor countries
became insolvent, this special condition of the balance of payments aggravated further
the internal crisis (Galbraith, 1972).
Between 1929 and 1933, central banks, the Treasury and the Federal Reserve
System adopted a passive, uncertain and protective policy because of both the
evaluations of the economists many of them considered depression as a desirable
economic event, necessary to overcome the system inefciency and weakness and
the misunderstandings of governors (Friedman and Schwartz, 1979). Faithful to the
validity of the Orthodox remedies, they reacted to the crisis on the basis of restrictive
and deationary policies, oriented to prevent speculation and to the attainment of a
balanced budget, by increasing taxes and reducing public expenditure. This started a
vicious circle, characterized by liquidity and consumption drops, which consolidated
the downward spiral and aggravated the recession in a real long depression (Pollard,
2004).
We think that the premise for the current nancial crisis has been made in the days
after the Great Depression, when it was issued a regulatory system for savers (the
Glass-Steagall Act), which distinguished nancial institutions as commercial banks
and investment banks. The latest were not authorized to accept bank deposits and
therefore their activities were much less regulated because not exposed to bank runs
(Federal Deposit Insurance Corporation, 1933).
Although this regulation has helped to keep a certain stability of the nancial
system for almost seventy years at least until it was repealed in 1999 (by the
Gramm-Leach-Bliley Law), during the so called deregulation phase willed by
Greenspan it has allowed an uncontrolled development of investment banks, which
have gained more and more relevance by developing the same activities and offering
similar services as commercial banks, but under no regulation and control of risk.
What is more, in 2004, the Securities and Exchange Commission (SEC) gave to the
investment banks an exemption from a regulation that limited the amount of debt
known as the net capital rule. By increasing the level of debt, they were able to invest in
the opaque market of mortgage-backed securities and credit default swap (cited by
Blundell-Wignall et al., 2008, p. 4):
[. . .] prior to 2004 broker dealers were supervised by stringent rules allowing a 15:1 debt to
net equity ratio. Under the new scheme investment bank could agree voluntarily to SEC
consolidated oversight (not just broker dealer activities), but with less stringent rules that
allowed them to increase their leverage ratio towards 40:1 in some cases.
For instance, in a few months the leverage ratio at Bear Stearns rose to 33:1 (Labaton,
2008).
It has denitely (cited by Friedman and Friedman, 2009, p. 9):
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[. . .] allowed the growth of highly risky and fraudulent mortgages without recognizing the
self-destructive power of this type of mortgage lending with virtually no regulation
(Skidelsky, 2008). The Fed could have put a stop to it by using its power under a 1994 law
(Home Owner Equity Protection Act) to prevent fraudulent lending practices. It was obvious
that the mortgage industry was out of control and was allowing individuals with very little
money to borrow huge sums of money.
This has recreated the conditions of such a nancial vulnerability that made possible
the Great Depression (Krugman, 2009).
3.2 The global nancial crisis of 2007-2008
Although the reasons are many and distant in the years, the root cause of the global
nancial crisis of 2007-2008 is the growth of the bubble of real estate loans, as an effect
of too much liquidity placed on the market by strongly expansive monetary policy of
the Fed of Greenspan. Between 2001 and 2004, in order to strengthen the labour market
and the economic system, it lowered the interest rate to 1 percent. This, together with
the propensity for speculation and over-indebtedness expressed by American peoples
and fostered by generous ratings and widely optimistic evaluations of risk, led to a
dilation of mortgage loans. A high percentage of these loans were subprime and Alt-A
mortgages, namely loans of low quality (Udell, 2009).
Consumers have used debt also to nance banal purchases and durable goods, as
cars, clothes, holidays, with the result of increasing the risk of insolvency.
Such trends, supported by increasingly pushed and risky practices and encouraged
by the use of sophisticated tools of mobilization of loans, have unbalanced and
destabilized the nance of families and intermediaries which have started to get into
crisis with the growth of the interest rates, imposed by Fed between 2004 and 2006 (1.5
percent to 5.25 percent), and with the reduction in house prices in 2007 (29.7 percent)
and 2008 (215.3 percent) (Partnoy and Skeel, 2006).
In fact, the widespread conception of the real utility of innovative nance, as a tool
for banks to reduce and transfer the credit risk to another party once incorporated into
new nancial products, has lead both the banks to grant more loans, and the families to
get into more debts (the so-called irrational exuberance Shiller, 2008).
We can observe that the securitization, even if potentially effective to reduce the risk
of credit, has been used inappropriately, under no regulation and control, to nance
high volatility mortgage loans. Moreover, an analysis on the Federal Reserve Bank of
Chicago Bank Holding Company Database emphasises that the net notional amount of
credit derivatives used for hedging of loans in 2005 represented less than 2 percent of
the total notional amount of credit derivatives held by banks and less than 2 percent of
their loans (Minton et al., 2009). It means that the remaining part (more than 98 percent)
was used for speculative activities.
The only relevant outcome for banks and insurance companies from using credit
derivatives has been the multiplication and exchange of risks impossible to evaluate.
Indeed, pools of subprime mortgages have been securitized in obligations, the
Asset-Backed Securities, which in turn have been incorporated in new debt securities
(the Collateralized Debt Obligation) by other banks, insurance companies or other
intermediaries, and so on up to be transferred to the investment of savers (Onado,
2005). There has been a process of production of nance by the means of nance, due
to the orientation of nancial institutions to maximize the amount of lending and
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charges, regardless the possibility of repayment. Indeed, they have been concerned to
transfer as soon as possible the risk to a wider audience of investors (Onado, 2009).
Hence, the most of the risk has been transferred on investors who, often unwittingly,
have been pushed to buy portfolios of public and private shares, credit derivatives and
other risky products (The Economist, 2005).
This mechanism was got in crisis by the strong rise in mortgage loans and the fall
in prices of houses: for this reason, a large part of the indebted families became
insolvent (cited by Reinhart and Rogoff, 2008b, p. 4):
[. . .] The impact of these defaults on the nancial sector has been greatly magnied due to the
complex bundling of obligations that was thought to spread risk efciently. Unfortunately,
that innovation also made the resulting instruments extremely non-transparent and illiquid
in the face of falling house prices.
In such a way, it has been refuted the basic principle on which the expansion of
mortgage loans was founded: as long as the house prices have continued to rise, the
borrowers in nancial straits have been able to renegotiate the loans or sell property;
but when prices fell, the system quickly led to crisis and the percentage of insolvency
has grown to 40.28 percent for loans granted in 2006 (Reuters).
Such an event, that in a condition of less leverage would have generated low
consequences, in this case has started a process of chaotic deleveraging that has
expanded the negative effects of the crisis to the global nancial system (Iannuzzi and
Berardi, 2006).
The fall in housing prices and the consequent impoverishment of the families have
led to a sharp reduction of consumption; this has plunged the sales, and the production
system has gone into a difcult stage, that has become even worse because of the credit
crunch, which has reduced investment and caused a series of bankruptcies.
In fact, nancial institutions, to cope with losses and because of their inability for
recapitalising their nances, have been forced both to reduce the value of assets and to
ration the credit to companies and families (Spaventa, 2008). Figure 3 shows the sharp
increase in housing price ination from mid-2003 to early 2006 and the subsequent
decline. We can observe that delinquency rates and foreclosure rates were inversely
related to housing price ination during the same period (Taylor, 2009, p. 11).
Since the beginning of the crisis, the investment banks were the most affected, and
suffered heavy losses. These have been increased by their vehicles, that is, off-balance
Figure 3.
Housing price ination
and subprime ARM
delinquencies and
foreclosures the
boom-bust in housing
starts compared with the
counterfactual
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287
sheet companies used by investment banks to buy further securitized obligations
(Iannuzzi, 2004).
This has led to concern and crisis of condence, not only among investors, but also
among banks that have signicantly reduced the interbank loans in the face of a
substantial increase in the interbank rate. This has increased the fear of a credit crunch
and has worsened the expectations in terms of fall in consumption, production,
investment and employment.
Asymmetric information in the context of nancial system has accelerated the
process of feedback among contraction in asset value, reduction in nancing, liquidity
crisis, losses and lack of capital. In short, the expansion of the crisis has been induced
by the close interdependence and interconnection among the nancial markets and by
the high degree of opacity and uncertainty about the effective level of losses and the
size and distribution of the risks (Impenna, 2009).
Therefore, in the days after the collapse of the real estate market, investment banks
were the rst to get in crisis, disappearing from international nancial scenario and
suffering bankruptcies, mergers, acquisitions and nationalization (The WTO Doha
Round and Regionalism, 2009).
Moreover, the opacity and ambiguity of their balance sheets, together with the
inadequate rules, show the personal responsibility of managers, focused primarily on
their own short-run prots, rather than on the creation of the stakeholders value in the
long-term.
Nevertheless, it appears difcult to recruit the thesis of unawareness of the Fed and
central banks in what was happening. In fact, they hold the information, quantitative
surveys and the experience to provide the destabilising effects resulting from high
ination, widespread nancial speculation and continued expansion of liquidity and
credit (Pavlov and Wachter, 2009). Already in 2003, the Bank for International
Settlements did not exclude acute phases of weakness caused by the growth of debt
(Bank for International Settlements, 2003). Also Rajan emphasized weighty
responsibility of asset managers of banks, investment funds, hedge and private
equity funds, who oriented themselves to high-risk investment (Rajan, 2006).
For these reasons, no one could deny that on the markets there was optimism, but it
was clear that such an optimism was increased by the irresponsible expansive
monetary policies (Bruni, 2008).
In addition, markets became extremely sensitive and widely exposed to systemic
risk, because of the so-called policies of deregulation. Indeed, the real criticality has
been expressed in the existence of an asymmetry between highly regulated areas, such
as the Europe, and others without clear and structured rules, such as the USA. This,
combined with the globalization, the interdependence and integration of nancial
markets, has created a paradoxical mechanism, a real vicious circle: hence, developing
forms of nancial activity has been possible in a context of anomie (Tremonti, 2009).
Although the crash occurred under no regulated segments of the US nancial system,
its impact has been amplied by the heightened level of leverage, and by the structured
products and the currency crisis.
This has contributed to spread the speculation, guided by short-termism of
managers, and has made markets extremely volatile, unstable and inefcient ( Jensen,
2002).
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Decisions were based on mathematical and statistical models that should have been
better interpreted and framed (Friedman and Friedman, 2009).
Furthermore, the orientation, which induces increasing bargaining in order to
achieve capital gains even with high risky practices and insider trading , was
promoted by the pay system of managers and other nancial operators, which is still
linked to short term performance compared with those of competitors (Smith and
Walter, 2003).
4. Implications and perspectives
There are two main points-of-view concerning the causes of the current crisis and the
way to overcome it:
(1) statists many of them are politicians support the decline of the American
capitalism, based on deregulation which has fostered the degeneration of
nance and globalization (Tremonti, 2008);
(2) liberalists still assume markets as fully efcient and accuse politics as the only
guilty of the crisis (Alesina and Giavazzi, 2008).
Really, the succession of stages of expansion interrupted by moments of great
uncertainty and recession proves the substantial imperfection of markets and their
incapacity for self-organization.
Nevertheless, globalization, increasing complexity, and rapid change, make many
regulatory mechanisms ineffective in facing with the formation of speculative bubbles,
which generally precede more or less intense crises. In this sense, the current systemic
crisis has highlighted the insufciency of regulatory standards and the failure both of
the system of control of intermediaries, and of the nancial markets.
Even if it is not obvious that the strengthening of stability of the nancial system
would prevent the formation of speculative bubbles and new systemic crises, as the
Great Depression showed, there must not be adopted passive policies; the same failure
of institutional systems and rules of jurisdiction and control requires their review and
the implementation of a careful policy in order to prevent the spread of the negative
effects of crises. If it appears impossible to avoid the formation of future nancial
crises, as features of modern capitalism resulting from the interactions between
hardwired human behavior and the unfettered ability to innovate, compete and evolve
(cited by Lo, 2008, p. 1):
[. . .] their disruptive effects can be reduced signicantly by ensuring that the appropriate
parties are bearing the appropriate risks, and this is best achieved through greater
transparency, particularly in the so-called shadow banking system.
It is impossible to foresee how future nancial crises will occur; therefore, the system
requires openness, exibility and adaptability to contingencies (Schwarcz, 2008).
The growth of nancial activities and its detachment from the real economy require
a change of attitude and a review of the nancial system to better satisfy the
expectations of relevant stakeholders, such as savers, consumers and rms, by
promoting sustainable development and supporting productive investment and
innovation. This measure derives from the necessity to reduce the short-term
orientation, being aware that, in the long-term, capital gains depend on the
expectations from real economy. Indeed, the propensity to short-term prots, through
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increasing share prices, and share-out have caused a division between nancial system
and real economy. The same logic of business has led to be based on nancial leverage
that has supported debt during the expansion, while it has accentuated the collapse
during the unfavourable phase of the economic cycle (Sapelli, 2008).
However, the concept of corporate governance, as complex of various forms of
self-regulation based on ethical codes of best practices, and characterized by
independent managers is marking the moment of its decline (Gordon, 2007). The
presence of powerful independent directors, who act in a condition of substantial
collective irresponsibility, does not appear sustainable by the modern nancial
capitalism (Rossi, 2008, p. 78). It appears difcult to imagine and achieve satisfactory
results in terms of pursuit, social interest, and satisfaction of stakeholders
expectations, by basing on mere ethical codes of self-discipline, when directors are
induced to undertake high-risk investment in order to increase their own prots.
Differently, the variable part of their remuneration should be linked eminently to the
long-term performance of company and the directors should be made more responsible
by sharing not only prots, but also losses.
Also, the function of balance sheet has been changed: frominformation tool for Board
of Directors, shareholders and investors to evaluate the performance of managers and
the stability of the company, it has been degraded to a tool for transferring to the market
a continuous ow of announcements to push the share price up. In this sense, the
morphology of modern nancial capitalism is focused excessively on the short-term,
neglecting the logic of intangible assets and of the statement of assets and liabilities,
which highlight the structure, history, competences and values of the company.
Despite innovations in the instruments of risk analysis, signicant evidence from
the crisis, were the mistakes made by banks and rating agencies in evaluating the risks
(Metallo, 2007). This is due to the failure of the models of corporate governance, with
particular concern to the relationship between management and control of risk.
Moreover, the evolution of bank models, from Buy and Hold (B&H) to Originate to
Distribute (OTD), has removed the fundamental role of monitoring also because of the
conict of interest expressed by rating agencies. This new model expression of the
new equity culture of banks together with the securitization process have been not
about risk spreading, rather they have been a key part of the process to drive revenue,
returns on capital and share price higher. In other words, they have been more about
increased risk taking and up-front revenue recognition (Blundell-Wignall et al., 2008).
In such a way, the model of corporate governance has marked the strategic and
managerial weakness of big corporation that is heavily exposed to the bankruptcy risk.
For the future, before we can hope to be able to manage the risks of nancial crises
more effectively, we have to be able to dene and measure those risks explicitly.
Furthermore, the complexity of nancial markets is straining the capacity of regulators
to keep up with its innovations (cited by Lo, 2008, pp. 1-2):
[. . .] New regulations should be adaptive and focused on nancial functions rather than
institutions, making them more exible and dynamic.
4.1 Toward an international nancial system
The crash of US real estate market was only the spark of the crisis, freeing the
pervasive elements of instability that permeated the global nancial system. In this
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context, short-term debt played a critical role in amplifying the effects of the crisis,
leading nancial institutions to settle and devalue the most of their assets to satisfy
creditors, with the effect of increasing the likelihood of insolvency (Zingales, 2009).
The Government must avoid to focus on occasional and short-termpolicies, limited to
prevent nancial institutions fromfailing and depositors fromlosing their funds; rather,
they should aim at identifying the real causes of problems to implement effective and
long lasting remedies (Yeoh, 2009; US Government Accounting Ofce, 2008).
Nevertheless, we do not have to underestimate the effects of the rescue operations of
the nancial institutions by governments in terms of uncertainty, instability and moral
hazard. In many cases, governments have been forced into the role becoming new
owners of distressed nancial institutions, guarantors of loans and making regulatory
adjustment on the run; this condition inspires a series of concerns and doubts, such as:
.
further irresponsibility of the top managers, who could be induced to undertake
high-risk investment in the perspective of socializing and transferring the risks
of potential losses on tax-payers;
.
uncertainty about the weight of the State in making strategic and managerial
decisions (Barucci and Messori, 2009); and
.
conicts of interest arising from the illogical admixture of the roles of controller
and controlled.
It follows the necessity to restructure the nancial system to serve the needs of
ordinary people and families and to avoid the pursuit of personal interests (Schwartz
Center for Economic Policy Analysis, 2009, p. 12).
At the moment, the nancial system in most developed Countries has become
bloated and it is too big relative to the size of the real economy. Therefore, it is
necessary to:
.
increase transparency in operations and nancial innovations;
.
reduce asymmetric information, conicts of interest and perverse incentives
which led nancial actors to take on excessive risk (Crotty and Epstein, 2008);
.
restrict or even eliminate off-balance sheet vehicles;
.
limit the level of lending by increasing capital requirements; and
.
encourage the ow of credit to SMEs; reduce pro-ciclicality (Grifth-Jones et al.,
2008).
It is necessary to evolve from the logic of the maximization of prot and shareholders
value, to the policy of long-term strategies, investment and productivity. Furthermore,
globalization needs to harmonize the rule of individual States and to reinvigorate a
global discussion of nancial regulation (Obadan, 2006) to avoid arbitrages and
obscure risks.
The interdependence and interconnection of markets at international level impose a
greater coordination among different countries in order to counter the formation of the
shadow banking system (Draghi, 2008; Saccomanni, 2009).
Another problem is that several banks have become too big and too interconnected
too fail and to save (Stiglitz, 2009, pp. 1-4): this creates perverse incentives for excessive
risk taking (Bank for International Settlements, 2009).
Global nancial
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291
The systemic nature of the crisis emphasises the needs for a process leading to the
creation of both a System of international governance (may be the Global Legal
Standard) through the denition of common principles and regulation, and national
and supranational institutions with the role and the power of control and intervention
on the international players of markets (Federico et al., 2009).
As it has emerged from the last G-08 and G-20 summits, the orientation of
international partners is to move towards a new order, a real new international
nancial system, where the stabilization of nancial system does not pass only
through the bodies created in Bretton Woods (i.e. IMF, World Bank), but through the
endowment of new rules and structures (i.e. Financial Stability Board). In particular,
the Government of this system should aim at:
.
stabilizing the factors which have been at the basis of the current crisis and
guiding the different national and supranational institutions;
.
supranational institutions should play the function of coordinating the actors of
nancial markets and preventing systemic instability; and
.
national institutions should play the role of supervision and monitoring the
activities carried out in the different countries.
It is also necessary to establish concrete procedures for an effective international
cooperation, which enables the application of this regulation (Attali, 2009).
In this perspective, the European regulatory and supervisory reform is based on two
main pillars: the European Systemic Risk Council, chaired by the Governor of the ECB,
for macro-prudential supervision; and the European System of Financial Supervision,
composed of national supervisors and three new European Supervisory Authorities for
the banking, securities and insurance and occupational pensions sectors, for
micro-prudential supervision.
We must underline also the role of central banks as lenders of last resort, in order to
counter the crisis and stabilize the markets when this occurs. Indeed, as the Great
Depression and the current nancial crisis demonstrate, the monetary policy of the
central banks inuence duration and depth of crises (Reinhart and Rogoff, 2009).
Financial innovations have spread the vain illusion of being able to diversify and
reallocate every form of risk and, hence, to support ever-increasing nancial activities
with a small capital (DArista and Grifth-Jones, 2008). Differently, there is a need for
adequate capital requirements to support all risky investment, and nancial
institutions must be brought under adequate regulatory control that limits the level
of leverage and demands absolute transparency in operations (Apanard, 2009).
On the other hand, these measures must be dened and introduced to avoid to block
innovation and tighten up the nancial system (Shiller, 2005).
Finally, the regulatory reform must be consonant with the culture and values of the
international community (Golinelli, 2005). In other words, to achieve greater efciency
and stability of global nancial system, the rules should be adapted to the specic
contexts of markets and products to reduce the emergence of opportunistic behaviors
and other destabilising factors.
5. Conclusion
The current crisis of modern nancial capitalism concerns both the system, that
despite the experience of 1929, has proved to be not capable for creating transparent
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and precise rules, and the individuals and their system of strong believes, culture and
expectations (Barile, 2009).
The morality of managers is a critical aspect to understand the formation of
speculative bubbles and crises. Also, Adam Smith, in The Theory of Moral Sentiments,
stressed that economic growth depended on morality (Alvey, 1999). Indeed, while it is
impossible to support the idea of nancial markets tending to the equilibrium, this is
mainly due to the orientation to the self-interest, for long time theorized in the main
schools of management of the world (Ghoshal, 2005). In this perspective, Howard
speaks of tragedy of maximization to dene the adverse effects caused by the spread of
the culture of maximization of self-interest that in economic and managerial terms
means short-term maximization of prot and shareholders value (Howard, 1997).
Finally, the crisis 2007-2008 has clearly emphasized, together with the fragility of
global economic system, a crisis of social, personal and political values. Furthermore,
the widespread philosophy of the pursuit of self-interest, contrary to the past when it
was based on mere ethical and behavioral codes and on various forms of incentives for
managers, such as the stock options, requires the translation of the ethical principles
into laws, which must be clear and shared at international level.
According to the twelve table of the OCSE the global nature of the crisis imposes
to the Governments the adoption of a systemic approach. In particular, the stability of
nancial and economic system requires to re-introduce the values of property, integrity
and transparency by Governments, rms and other entities which must activate
consonant relationships based on the principles of equilibrium, transparency and
fairness (OECD, 2009).
However, more regulation is not enough by itself; it is also necessary a change of
perspective, that is a change of culture by decision makers who, inspired by the
categories of ethics and morality, should nd the balance among entrepreneurial and
personal interest and collective interest.
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About the authors
Elio Iannuzzi is Associate Professor of Business Management, Corporate Finance and Business
Innovation Department of Business Studies Faculty of Economy, University of Salerno,
Italy. His main topics of research are: viable systems approach, retail marketing and
management, corporate nance, and industrial districts. Elio Iannuzzi is the corresponding
author and can be contacted at: eiannuzz@unisa.it
Massimiliano Berardi, PhD of Business Management, Department of Business Studies
Faculty of Economy, University of Foggia, Italy. His main topics of research are: entrepreneurship,
viable systems approach, complexity theory, corporate nance, and knowledge management.
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