Atkinson, Wigall, and Lee (2009) have also concluded that the Basel II accord on international bank regulation also opened an arbitrage opportunity for banks which led to the acceleration of off-balance-sheet activities. In the same paper, they claim that SEC 2004 decision to allow investment banks to manage there own risk was a major policy blunder. Soros puts it this way. “Since 1980, regulations have been progressively relaxed until they have practically disappeared.
Authorities could no longer calculate their risks and started relying on the risk management methods of the banks themselves (Soros 2008)” At the same time, scholars have concluded that the other root cause of the problem is traceable to the easy availability of credit. Diamond, etal (2009, p 615) argue that the policies affecting liquidity availed a lot of funds to the banks.
The 1% federal interest rate, the % interest rate in Japan, the fixed exchange rate in china and large reserves of sovereign wealth funds are listed in his paper as sources of cheap credit which fueled the economic boom in America led to an inflation of prices around the world. The claims that interest rates were low are supported by statistics which indicates that real short term interest rates were negative from mid 2001 to mid 2005, given the modest values of inflation (Yellen, 2008) The low interest rates, in turn, ignited a housing boom.
According to Grauwe (2009), the doubling of US house prices from 2000-2006 was not underpinned by real changes in the U. S economy. In the same survey, he reports that between July 2006 and July 2007 the value of Dow Jones and the S&P 500 rose by 30% while GDP increased only by 5%. Taken together, researchers have concluded that the collapse of the real estate market in 2006 was the origin of the crisis. The rising foreclosures turned the credit boom into a bust.
however, economist have at the same time stated that the severity of the housing market bust has been compound by the weakness inherent in the financial system (Calomiris, 2008; Rajan; 2009; Bookstabber, 2007) namely; use of bank deposits for speculative activities- this operation was made possible though special investment vehicles (SIV) sometimes called shadow banking; new financial innovations – derivative products like Credit Defaults Swaps (CDS) and Collateral Dept Obligations (CDO): they have been described as complex and overly opaque; failure of rating agencies to properly calculate the risks embedded in this instrument; and failures by regulators and supervisors. Some have added that the formulas used to compute the level of risk in this instrument was questionable and that the development of riskier higher order CDOs tended to magnify the systemic risk (Volcker, 2008; Veneroso, 2007; Soros, 2007; Rajan 2009 b). Sorros (2008) argues that the new types of mortgage-backed securities central to the boom were too complex and opaque to be priced correctly. Grotty (2009 p 40) also argues that these instruments encouraged fraud since most investors did not even know what they were buying.
That when the risk inherent in these products became apparent in 2007, investors pulled back from structured products in general, banks had to re-absorb the losses incurred by their off balance entities – SIV, straining there balance sheets in the process. Moral hazard problems and adverse selection worsened with time lending to a credit freeze which led to a slow down in economic activities around the world (Mishkin, 2007, Folkman etal, 2007; Dornbusch etal, 2000)
Concerning solutions, most policy makers agree that to reverse the recession, there is need for closely coordinated intervention at global level and that efforts must focus simultaneously on fiscal, monetary and financial stability policies. The underlying assumption is that restoring confidence in the prospects for employment and income and returning to balanced growth are the only way out of the recession (Draghi, 2009).