The financial crisis of the sub-prime mortgage market in the United States of America (U.S), which started manifesting itself in 2007, had engulfed the entire global financial system. From what appeared to be a crisis that could be contained by the American monetary authorities, the crisis went wild while its contagion effects spread into other countries/regions of the world. The crisis started when millions of homeowners in the US who had taken mortgages started defaulting on their loan obligations in what later became the sub-prime mortgage crisis.
The impact of the financial crisis rippled across the globe, prompting concerns and eliciting responses from various national authorities. As the crisis deepened, governments in many nations had to intervene to save their affected financial systems and in some cases took over previously public liability companies. In developing countries, because of the interconnectedness of the global financial system, various governments and their respective citizens became apprehensive about the effects of the crisis on their economies.
The advent of the crisis also brought to the fore the importance and relevance of deposit insurance system (DIS) as many jurisdictions with explicit DIS revised some of the features of their systems with a view to stemming panic and restoring confidence in their respective financial systems. Worldwide, depositor protection has become an important feature of financial safety-net arrangements put in place by various countries to minimize the occurrence of financial system instability or reduce its impact whenever it occurs. Although there are several options available to all nations in their desire to protect the interest of the depositors of deposit-taking financial institutions in their domains, deposit insurance of the explicit type stands out as the preferred alternative. It is defined as a financial guarantee to protect depositors in the event of bank failure and also to offer a measure of safety for the banking system (NDIC, 1997).
This chapter examines the global financial crisis, enumerates some of its impact on various economies, including those of the developing countries, highlights major responses to the crisis, particularly those relating to deposit insurance, by some nations and draws some lessons for DIS in developing countries.
Nature, Causes and Impact of the Crisis
The root of the global crisis which started in the US began with the collapse of the American mortgage market when for several reasons the value of properties went down drastically, leading to inability to refinance individual home mortgage because the banks were reluctant to lend. Banks that had a lot of money tied up in loans to house owners who were no longer able to pay went bankrupt or near bankrupt, with that came the credit crunch. Banks and other lending institutions were no longer willing to lend. Some of the mortgage loans were sold by the banks to two giant banking institutions, namely Freddie Mac and Fanny Mae, which served as holding financial institutions for mortgage loans. The problem of the sector led to the collapse of the two giant financial institutions, which the American government reluctantly took over. Even after that, the problem persisted. The crisis manifested itself mainly in the form of banking crisis, currency crisis and stock market crashes.
There were diverse opinions on the causes of the crisis. Many had blamed the crisis on speculation based on false assumption of an unending increase in housing prices occasioned by long period of easy monetary policy. Other causes were identified to include greed, outright fraud, lax oversight/ regulatory regimes and uncoordinated and late interventions by governments. According to Zingales (2008), the roots of the crisis were sown during the real estate boom. A prolonged period of real estate increases and the boom of securitization relaxed lending standards.
During the real estate boom, delinquency rates dropped due to sustained real estate price increase. During boom years, mortgage brokers, enticed by the lure of big commissions, talked buyers with poor credit rating into accepting housing mortgages with little or no down payment and without credit checks. Also, the availability of innovative mortgage options, allowed buyers to purchase houses for which they could not sustain the mortgage payments at higher prices. The quality of these mortgages were neither adequately checked by the regulators nor the market.
Also, the massive amount of mortgage securities issuance by a limited number of players changed the fundamental nature of the relationship between credit rating agencies and the investment banks issuing these securities. As a result, instead of submitting an issue to the rating agency’s judgment, investment banks shopped around for the best ratings and even received handbooks on how to produce the riskiest security that qualified for best rating (Scorse, 2008).
The pooling of mortgages, while beneficial for diversification purposes, became a curse as the downturn worsened. The lack of transparency in the issuing process made it difficult to determine who owned what. Furthermore, the complexity of the repackaged mortgages was such that small differences in the assumed rate of default could cause the value of some tranches to fluctuate widely. With illiquidity as well as lack of adequate information on the quality and hence the value of banks’ assets, banks stopped lending and even recalled some of their loans.
The impact of the crisis and its severity varied among nations depending on the degree of interconnectedness of nations. For economies whose financial systems are dominated by internationally active banks, the impact was swift, direct and severe. Countries in this category include the USA, United Kingdom, Japan, Western European countries and some emerging economies like Taiwan and Malaysia. In developing economies with a few or no, internationally active banks, the effect has been less swift but nonetheless, potentially severe unless concerted efforts are made to ameliorate the adverse impact of the crisis on such economies. Most developing nations, particularly in Africa, Latin America and Asia fall into this category.
For the first category of countries (i.e. advanced and emerging economies with internationally active banks), the impact included, among others, declining real output growth; weakened financial systems, loss of jobs; loss of confidence in financial markets, leading to inability to carry out their intermediation role in their respective economies; and declining stock market prices. For instance in the USA, the crisis led to bankruptcy of major banks while unemployment continued to rise. The stock market in the USA fell by a cumulative 44.7% between December 2007 and December 2008. In Europe, housing prices crashed while manufacturing activities also declined. There was stock market instability across Europe as stock market declined by about 41.7% in the UK, 42.2% in France and 52.9% in Germany between end of 2007 and 2008. In Taiwan, the crisis caused a run from private banks to the state-run Bank of Taiwan. Also, Taiwan stock market a slump with banks being the main victim of the stock market crash. The situation was made worse by the pull-out of foreign investment funds. In Japan, vital export industries were hard hit by the credit crunch, as export declined by 1.7% in 2008 while export to the US declined by 15.4% and to Europe by 11.2% during the same period. The benchmark Nikkei Index lost a cumulative 63.3% between December 2007 and end of 2008. In South Korea, the crisis raised the cost of borrowing and reduced access to funds as global lending dried up. The stock market experienced significant declines with the Kospi Index falling by about 52.8% between December 2007 and December, 2008. There was a pervasive loss of confidence in the banking and capital market in the country as a result of the crisis.
Being part of the global economy and given the problems in the economies of some of their major trading partners, the economies in the second category (i.e. developing economies) could not have been insulated from the effects of the global financial crisis that rocked the US and other advanced economies. For these economies, the impact of the crisis, which has not abated, include crash in commodity (oil, tradable agricultural and mining products) prices; contraction of revenue accruing to governments since most of those commodities were the major revenue earners to their respective governments; dc-accumulation of foreign reserves with attendant pressure on exchange rates; and limited foreign trade finances for banks as credit lines either dry up or re at much higher rates. Others include capital market downturn arising from divestment by foreign investors with attendant adverse feedback effects on the balance sheet of banks; and contraction in home remittances by citizens in diaspora, among others. In Nigeria for example, the price of crude oil, the highest foreign exchange and revenue earner for the country, crashed in the international market. Oil prices fell by more than 66% from $147 per barrel peak in July, 2008 to below $45 per barrel by the end of the same year in the international market. That led to a drastic contraction in revenue accruing to the country with its attendant adverse effects on government fiscal operations. Similarly, the exchange rate of the Naira had witnessed consistent depreciation since the adverse effect of the crisis on the price of crude oil became manifest in the country For instance, between September 2008 and end of January 2009, the official exchange rate of the Naira had depreciated by about 42.24% while there was equally a slump in the capital market as the market capitalization crashed by about 67.5% between February 2008 and corresponding month of 2009. In South Africa, there was a declining growth rate while the Rand depreciated by about 41.43% within a year.
Reactions to the Crisis from Some Jurisdictions
In response to the global financial crisis, governments and authorities in various nations took various actions to stabilize arid save financial institutions in their economies. While some of the actions taken to bolster liquidity and restore market confidence in some jurisdictions included one or more of the following — state guarantee of wholesale debt obligations, recapitalization of banks/partial nationalisation; asset purchases; and central bank liquidity schemes, the focus in this chapter will be on enhanced depositor protection.
One of the immediate responses of governments in some of the industrialized nations to the ensuing financial crisis was to increase their respective DIS coverage limits as a confidence boosting measure. In an effort to address the situation in the United States of America, the Congress of the US, in addition to other measures, increased the deposit insurance coverage from $100,000.00 to $250,000.00 (i.e. 150%) up to the end of 2009. In addition, the Federal Deposit Insurance Corporation (FDIC) announced a Temporary Liquidity Guarantee Programme, which within the time set would increase the scope of coverage. The programme, expected to have the potential for strengthening confidence, would involve the following:
a. Full coverage for some categories of unsecured debt (such as promissory notes issued by banks, thrifts, and certain holding companies, newly issued on or before June 30, 2009, in the event the issuing institution fails or its holding company files for bankruptcy. The coverage would be limited to June 30, 2012, even if its maturity exceeds that date; and
b. Full coverage for non-interest bearing deposit transaction accounts (such as pay-roll accounts), regardless of dollar amount
The funding of the programme was to be sourced through special fees charged the participating institutions only. Fees of 75-basis point would be charged against the new debt issues while 10-basis point would be charged against the non-interest bearing deposit transaction accounts.
All FDIC-insured institutions were to be covered under the programme for the first 30 days without incurring any cost. After the initial period, however, institutions not wishing to participate must opt out or be assessed for future participation. If an institution should decide to opt out, the guarantees would be good only for the first 30 days.
In the UK, the deposit insurance coverage level was also increased to £50,000.00 from a maximum of In addition, co-insurance was abolished. In a swift reaction to the crisis, the EU increased its deposit insurance coverage from +20,000.00 to at least +50,000.00 in the first instance and ultimately to +100,000.00.
In Iceland, given the likelihood of failure of its financial system as a result of the crisis, the Iceland government had to declare a blanket guarantee as a way of restoring confidence in the system.
The Governments of Republic of Ireland and Greece, in reaction to the crisis also declared blanket coverage for 2 years, an indication that all depositors in those countries were fully covered in the event of bank failure.
CBN Gov., Godwin Emefiele
