¶ … Liquidity and Loan Quality: the Impact it is having on Bank Health
Since the 1980's, there has been an emphasis on deregulation within the banking industry. Part of the reason for this, is because of shifts in the economy (thanks in part to globalization) as the markets and products have changed. This has forced many different governments around the world to reduce regulations to include: liquidity and loan quality standards. As a result, the underlying risks at many financial institutions have increased exponentially. In this research project, we will show how these reduced standards have contributed directly to: the financial crisis and stagnant economy. Once this takes place, it will provide the greatest insights as to how these two factors will determine the strengths of different of financial institutions. At which point, we can present specific ideas about how to effectively address these challenges in the future.
Introduction
: Background
Over the last several years, the issues of loan quality and liquidity have been increasingly brought to the forefront. Part of the reason for this, is because the total number of bank failures is currently sitting at 365 financial institutions. According to the FDIC, this amount is expected to increase, with the government taking over 40 banks so far in 2011. This accounts for over $660 billion in assets that the FDIC has seized since the beginning of the financial crisis in 2007. ("FDIC Failed Banks," 2011) This is significant, because it is illustrating how the overall amounts of liquidity and the quality of loans have threatened the economic viability of many institutions.
Further evidence of this can be seen with a study that was conducted by Thies (1993). He determined the total number of bank failures was directly tied to the quality of the loans that were underwritten. As it revealed that between 1921 and 1932, financial institutions began to take on large amounts of risk. This is because, the lack of regulation made it easy for them to create a number of different mortgage products. (Theis, 1993, pp. 109 -- 114) Over the course of time, this meant that the total amounts of loans increased exponentially. However, some of weaker banks began to also reduce their liquidity standards and offered even greater numbers of mortgages. Once the economy began to slow and unemployment was rising; these loans set off a wave of defaults that shook the financial industry. The hardest hit during this time was state banks. This is because they were the institutions that had: the least amounts of liquidity and the highest number of poor quality loans. By the 1932, these risks were having an adverse effect on these entities, setting off a wave of foreclosures. This caused a number of financial institutions to fail leading to: bank runs and a lack of confidence in the system. The only way to deal with the situation was through: the implementation of the New Deal and various financial regulations (such as the Glass Steagall Act along with the Banking Act). (Theis, 2008, pp. 3 -- 4) These different laws are important, because they would place strict regulations on: the kinds of activities banks could become involved in, the quality of loans that they were underwriting and their levels of liquidity.
However, improvements in technology have meant that the kinds of loans and liquidity standards have become less stringent. The reason why, is because many financial institutions are arguing that these Depression era laws are making it difficult for them to compete globally. As a result, these standards and the enforcement of the different regulations were severely reduced. This caused the total quality of mortgages and the levels of liquidity at a variety of financial institutions to decrease. Over the course of time, this would lead directly to the current financial crisis and economic implosion. This is significant, because it is illustrating how the overall amounts of liquidity and the quality of the loans can have a direct impact on the health of variety of financial institutions.
1:2: Hypothesis
The different challenges in the banking sector are indicative of a negative trend that has been occurring since deregulation began during the 1980's. This has lead to series of financial crisis that are based upon same problems most notably: the quality of loans and liquidity. These two factors have been the root causes of: the Savings and Loan Crisis during the 1980's and the recent financial crisis. As a result, they underlying amounts of deregulation have meant that the risks many banks are taking are rising exponentially. Once this begins to occur, it can cause the economy to go through extreme boom and bust cycles. This leads us to introduce the following hypothesis:
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