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EuroMed Journal of Business Emerald Article: Global financial crisis: causes and perspectives Elio Iannuzzi, Massimiliano Berardi

EuroMed Journal of Business

EuroMed Journal of Business Emerald Article: Global financial crisis: causes and perspectives Elio Iannuzzi, Massimiliano Berardi

Emerald Article: Global financial crisis: causes and perspectives

Elio Iannuzzi, Massimiliano Berardi

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Elio Iannuzzi, Massimiliano Berardi, (2010),"Global financial crisis: causes and perspectives", EuroMed Journal of Business, Vol. 5 Iss: 3 pp. 279 - 297

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Global financial crisis: causes and perspectives

Global financial crisis

Elio Iannuzzi

Department of Business Studies, University of Salerno, Fisciano, Italy, and

Massimiliano Berardi

279

Department of Business Studies, University of Foggia, Foggia, Italy

Abstract

Purpose – This study aims at examining the current global financial crisis, by emphasizing its main causes and perspectives to define 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 approach.

article

used

complexity theory and viable system

Findings – The findings 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, financial 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 financial system, where the stabilization of financial 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 finance to generate short-term profits and shareholders’ value.

Practical implications – The findings 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 financial crises and the way to limit them.

Keywords Financial risk, Complexity theory, World economy, International finance Paper type Conceptual paper

1. Introduction

The traditional theory of markets considers financial crises and speculative bubbles as temporary deviations from efficient 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 efficient self-organizing systems, able to allocate financial sources in a

If the research paper is the result of common reflections, 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.

The current issue and full text archive of this journal is available at www.emeraldinsight.com/1450-2194.htm Global financial

EuroMed Journal of Business Vol. 5 No. 3, 2010 pp. 279-297 q Emerald Group Publishing Limited

1450-2194

DOI 10.1108/14502191011080818

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rational way –, which has favoured the current systemic crisis by inspiring several wrong decisions – such as the deregulation of banks, the wide spread of financial innovations (Greenspan, 2004), etc. – and we can adopt an approach which considers markets as systems far from equilibrium (Pitelis, 2002). Therefore, financial markets can be thought as Complex Adaptive Systems (CAS), that are systems on the edge of chaos, so, while tending towards certain attractors, they

  • 280 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 influence 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 financial crisis, focusing on its main causes and perspectives, in order to define 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 difficult 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 finance to generate short-term profits and shareholders’ value.

2. The complexity approach

The complexity approach is not a scientific 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 defined 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

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 flexibility of the system. For this, the system is defined as adaptive and the more numerous are the factors that influence 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 firm’s 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 definable 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 firm 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 influenced 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 flexibility and adaptability. These systems (cited by Kauffman, 1991, p. 82):

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[...]

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
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is clear that emerging systems (those that have a bottom-up origin – such as the

financial system) usually have a higher level of complexity, especially if they lack a common management. For this, they are difficult 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 difficulty 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 difficulty in managing the financial 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 financial 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 financial system, giving

particular attention on the examination of causes, circumstances and prospects of the current financial crisis.

Global financial crisis

3. The complexity approach to investigate the global financial 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 financial markets, decisions can influence significantly 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 financial 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 financial system strongly unstable, causing dangerous and long-lasting effects on real economy (Hasman and Samartı´n, 2008). It has spread from the United States to the global financial 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 financial 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.

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3.1 The Big Crash of 1929: the basis of the current financial crisis

Although we have to consider that there are no significant 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 profit (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 profits;

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 financial 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

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Figure 1.

Trend in share price according to the Standard Statistics Index

Figure 2.

Securitizations of mortgage loans (thousand of $ billions)

EMJB 5,3 284 Figure 1. Trend in share price according to the Standard Statistics Index Figure
EMJB 5,3 284 Figure 1. Trend in share price according to the Standard Statistics Index Figure

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 figure 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 financial activities; rather, it was the obvious outcome of a long-lasting phase of bad governance of banks, which worsened credit quality and amplified negative effects on the global financial 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 financial system too, characterized by a multitude of small independent units.

The sharp decline of the currency quantitative that followed the collapse of the stock market, and the inability of the banking system to gain sufficient 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 deficits financed 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 inefficiency 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 deflationary 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).

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We think that the premise for the current financial 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 financial 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 financial 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).

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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.

  • 286 This has recreated the conditions of such a financial vulnerability that made possible

the Great Depression (Krugman, 2009).

3.2 The global financial crisis of 2007-2008

Although the reasons are many and distant in the years, the root cause of the global financial 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 finance 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 finance 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 (2 9.7 percent) and 2008 (2 15.3 percent) (Partnoy and Skeel, 2006). In fact, the widespread conception of the real utility of innovative finance, as a tool for banks to reduce and transfer the credit risk to another party once incorporated into new financial 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 finance 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 “finance by the means of finance”, due to the orientation of financial institutions to maximize the amount of lending and

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):

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[...]

The impact of these defaults on the financial sector has been greatly magnified due to the

complex bundling of obligations that was thought to spread risk efficiently. 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 financial 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 financial 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 difficult stage, that has become even worse because of the credit crunch, which has reduced investment and caused a series of bankruptcies. In fact, financial institutions, to cope with losses and because of their inability for recapitalising their finances, 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 inflation 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 inflation 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

charges, regardless the possibility of repayment. Indeed, they have been concerned to transfer as soon as

Figure 3.

Housing price inflation and subprime ARM delinquencies and foreclosures – the boom-bust in housing starts compared with the counterfactual

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sheet companies used by investment banks to buy further securitized obligations (Iannuzzi, 2004). This has led to concern and crisis of confidence, not only among investors, but also among banks that have significantly 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,
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investment and employment.

Asymmetric information in the context of financial system has accelerated the process of feedback among contraction in asset value, reduction in financing, 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 financial 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 first to get in crisis, disappearing from international financial 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 profits, rather than on the creation of the stakeholders’ value in the long-term. Nevertheless, it appears difficult 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 inflation, widespread financial 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 financial markets, has created a paradoxical mechanism, a real vicious circle: hence, developing forms of financial activity has been possible in a context of anomie (Tremonti, 2009). Although the crash occurred under no regulated segments of the US financial system, its impact has been amplified 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 inefficient (Jensen,

2002).

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 financial operators, which is still linked to short term performance compared with those of competitors (Smith and Walter, 2003).

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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 finance and globalization (Tremonti, 2008);

(2)

liberalists still assume markets as fully efficient 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 insufficiency of regulatory standards and the failure both of the system of control of intermediaries, and of the financial markets. Even if it is not obvious that the strengthening of stability of the financial 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 financial 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 significantly 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 financial crises will occur; therefore, the system requires openness, flexibility and adaptability to contingencies (Schwarcz, 2008). The growth of financial activities and its detachment from the real economy require a change of attitude and a review of the financial system to better satisfy the expectations of relevant stakeholders, such as savers, consumers and firms, 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 profits, through

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increasing share prices, and share-out have caused a division between financial system and real economy. The same logic of business has led to be based on financial 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

  • 290 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 financial capitalism (Rossi, 2008, p. 78). It appears difficult 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 profits. 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 profits, but also losses. Also, the function of balance sheet has been changed: from information 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 flow of announcements to push the share price up. In this sense, the morphology of modern financial 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, significant 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 conflict 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 financial crises more effectively, we have to be able to define and measure those risks explicitly. Furthermore, the complexity of financial 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 financial functions rather than

institutions, making them more flexible and dynamic.

4.1 Toward an international financial 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 financial system. In this

context, short-term debt played a critical role in amplifying the effects of the crisis, leading financial 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-term policies, limited to prevent financial institutions from failing and depositors from losing 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 Office, 2008). Nevertheless, we do not have to underestimate the effects of the rescue operations of the financial 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 financial 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

conflicts of interest arising from the illogical admixture of the roles of controller and controlled.

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It follows the necessity to restructure the financial 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 financial 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 financial innovations;

reduce asymmetric information, conflicts of interest and perverse incentives which led financial 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 flow of credit to SMEs; reduce pro-ciclicality (Griffith-Jones et al.,

2008).

It is necessary to evolve from the logic of the maximization of profit and shareholder’s 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 financial 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).

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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 definition 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

  • 292 international partners is to move towards a new order, a real new international

financial system, where the stabilization of financial 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 financial 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 financial crisis demonstrate, the monetary policy of the central banks’ influence 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 financial activities with a small capital (D’Arista and Griffith-Jones, 2008). Differently, there is a need for adequate capital requirements to support all risky investment, and financial 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 defined and introduced to avoid to block innovation and tighten up the financial 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 efficiency and stability of global financial system, the rules should be adapted to the specific contexts of markets and products to reduce the emergence of opportunistic behaviors and other destabilising factors.

5. Conclusion

The current crisis of modern financial capitalism concerns both the system, that despite the experience of 1929, has proved to be not capable for creating transparent

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 financial 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 define 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 profit 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 financial and economic system requires to re-introduce the values of property, integrity and transparency by Governments, firms 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 find 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 finance, 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 finance, and knowledge management.

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