What exactly is the problem today with banks, financial institutions and the financial markets?
Problem #1 – Over-Leverage
During the last several years, financial institutions borrowed more money to engage in their business activities than at any point in the history of the United States banking industry.
As you can see from the illustration, if asset prices fall by just 3% ($1 in this case) the financial institution's equity in the investment asset is wiped out and they need to raise more funds to restore their 30:1 leverage ratio! When you hear about "capital requirements", that is exactly what it means. In other words, financial institutions need to raise more funds in order to meet their minimum capital requirements of having $1 of equity for every $29 of leverage. Every time asset prices fall, financial institutions need to raise more money to maintain their minimum capital requirements. Now here's the billion dollar question: where are the financial institutions going to get the money from?!
Yep. You guessed it! They are forced to sell even more of their investment assets!! If they sell off their investment assets, prices decline even further due to supply and demand. After all, prices always decline when there are more sellers than buyers in any marketplace. This creates a downward spiral in prices, causing the financial institution to sell even more assets into an already depressed market. A bad situation quickly becomes even worse and that is exactly what has been happening among financial institutions since July 2007.
There are two other ways for financial institutions to raise funds:
- Sell stock in their company or merge with a larger institution
- Borrow more money
Problem #2 – Lack of Liquidity
Financial institutions will continue to try and raise funds to meet their obligations and continue running their businesses. Although it is scary to think of the various doomsday scenarios that could result from the high leverage and the lack of liquidity, these worst case scenarios are unlikely to occur for two main reasons:- Foreign investors and governments, sovereign wealth funds and other large investors have too much invested already in the US to allow the US financial markets to collapse. If the financial markets and institutions collapse, these investors would lose enormous amounts of capital. Not only that, but their own economies would crumble because US consumers would no longer be able to afford to purchase their products. Therefore, foreign investors are likely to continue being an important source of funding for US corporations and banking institutions.
- The Federal Reserve has been very active in providing liquidity to financial institutions throughout this crisis and will likely continue to do so.
The financial industry regulatory structure in the United States is, to a large degree, over 100 years old! Various government officials have proposed certain reforms that are currently in the process of being considered and debated. Although the reform process has started, it will take several years to fully reform the regulatory structure of the US financial markets. As a participant in the CMPS Institute I have been very active in helping to reform and shape the future of the US financial regulatory structure.
