Term Paper: U.S. Financial Market. To Start

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[. . .] (The Federal Reserve Board: Remarks by Chairman Alan Greenspan)

Bankers who had avoided risks had the backup of certain lines of credit that had been made in conjunction with the Federal Reserve Bank, and these served as the backstops to the financing business. All this served to reduce the impact on the real economy of the capital market, because business could go on as usual; firms could still sustain production, and consumers and businesses did not lose the confidence in these institutions. The normal occurrence of a vicious cycle in which a major disruption would lead to major losses, and this in turn would lead to a major erosion of the financial sector did not happen at this time, and this was indeed fortunate for the financial sector and for the numerous businesses depending on the efficiency of the financial market. This incident of 1998 revealed an important principle: the numerous alternatives that exist to transform an economy's entire savings into capital investments definitely act as backups should the system fail due to any reason whatsoever. In the United States of America, the back up system was the fact that banking had managed to replace the capital markets of the country. However, it has not always been the case with the U.S.A., as this was a very recent development. (The Federal Reserve Board: Remarks by Chairman Alan Greenspan)

As seen in the remarks given by Mr. Timothy F. Geithner, the President and the CEO of the Federal bank of New York, in the year 2004, the financial system of New York is at present undergoing a transition and a change. It is now that the U.S. financial system has gained considerable strength, and financial institutions are engaged in advanced risk management behavior. However, it was not always like this, and an analysis at this point as to why the strength has increased today as compared to yesterday has to be conducted so that there need not be severe fluctuations in the market in the future. Therefore, the developments that have contributed to the success of the present stability have to be studied. It was over the past twenty years that a wide range of systemic events has in fact been affecting the stability of the U.S. Financial system. Some of the events were related to credit booms and some were related to credit concentrations, and these were the events that led to a large amount of losses to the banking sector. Losses also occurred in commercial real estate, and in the field of agriculture and energy. (Perspectives on the U.S. Financial System)

The results of these 'shocks' were very much evident in the sudden and sharp fall in the interest and exchange rates, as well as in asset prices. Macroeconomic performances were seen to be the cause of such falls, in some cases. Sometimes, the shocks were seen to be happening even during times when there was very strong economic growth, and sometimes when there were some changes in expectations of inflation or of monetary and economic policies, where the shocks would generate changes in the interest rates and also in the shape of the 'yield curve'. After the shock events, there would be a level of change in the financial conditions wherein there would be a fast rate of the growth of credit rates and a rise in asset prices. The positive changes were due to the fact that there was always present a self-reinforcing element within the events taking place, and the initial changes that would take place in both interest and the asset rates would be reinforced by the actions of the participants in the financial market events who would react to the losses in a particular manner.

The event of financial leverage would also be amplified in the face of these events or shocks. Sometimes it would be found that there was a co-relationship between the movement of asset prices and that of the credit losses for borrowers. These events led to a need for changes in the supervision of the financial market, in the practices of the risk management procedures, and in the capability of the Central Bank in containing systemic risks. Even though it is a fact that these recent events have led to the development of a certain degree of immunity to such risks in the future, and also that the overall vulnerability of the entire system to shocks of this kind has been evaluated and contained and therefore the risks have been essentially lowered, it is still true that there can be no single financial institution that can be considered invulnerable to risks and to shocks. It is a definite fact that the financial system of the U.S.A. must prepare for the future with humility and with a great degree of caution. (Perspectives on the U.S. Financial System)

Stresses and shocks must therefore be prepared for in advance so that the financial system finds itself in a good working condition at all times, especially in times of stresses and strains. Is the Financial System of the United States of America's strong and as resilient as it must be, or does the system have to be modified? The truth is that the financial system of the U.S.A. Of today is stronger than that of the previous ten to twenty years. For one, the financial institutions that are present at the very core of the entire system are both well organized as well as profitable. In addition, they are very well capitalized. The sum of the total risk-based capital ratio for the ten of USA's biggest bank holding companies shows a definite increase of 12% over the past two years, from the sum of the same for about ten years before. Almost all the banks in America were declared to be 'well capitalized' in the year 2003, and it was a mere 1% of banks - i. e. less than a hundred of the country that could not meet the regulatory standard. While it is true that in general, risk-based ratios of capital are not indicative of the capital strength of a financial system of a particular country, it still demonstrates the very strong position of the capital of the country. (Perspectives on the U.S. Financial System)

Robust capitalization and strong earnings is a must for any country if there were to be a line of defense against losses; when the capital of a country is strong, then these losses can be countered with ease. If there were indeed loss of any kind, or a negative incident of some sort, then capitalization would help restore the loss of confidence in the customers and the counter parties who would at first attempt to pull out of the institution. Therefore, it is evident that capital is capable of insuring the financial institutions against the system of 'runs', both traditional and on franchise value. The traditional run is one in which the issues at stake are those of short-term funding, and short-term liquidity, whereas for the franchise run the issues that are brought into play are those of the gradual withdrawal of customers from the financial institution on account of the loss of confidence suffered as a result of the losses that the institution has been through.

The customer in fact turns to some other institution to avail of the financial services that he feels that this institution is incapable of handling. Therefore it is evident that when consolidation takes place, the financial institutions attain more diversity as well as an increase in their sizes. The system of 'deregulation' has also helped financial institutions to broaden their scope wherein the scale and the scope and the geographic spread of all operations become better and more optimized. The result of such deregulations is in the emergence of large and diverse financial institutions that have a very high earning capacity. For example, in the year 2003, the total earning for about 18 bank holding companies and about six securities in the U.S.A. had earned more than $1 Billion, while the total earnings for five bank holding companies went up to more than the astonishing figure of $46 Billion, which made up about 40% of the total of the banking industry earnings. These figures show that in the case of any loss, they would be able to provide the various financial institutions with adequate cushioning, so that the fall would not be so painful, and re entry would be easier. In addition to the high figures providing a security blanket, it is the advancement made in risk management that would hold up the financial institutions against losses. With the current training in risk modeling and in data collection that all financial institutions are going through, it becomes easier for these institutions to manage risks. (Perspectives on the U.S. Financial System)

Now the pricing can also be based after considering the various risks that may be involved. Now financial institutions are given the option… [END OF PREVIEW]

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