[보도] Understanding the U.S. financial crisis

Commercial banks raise money by attracting deposits from their clients. They then lend the money to those in economic activities after screening out the applicants for the loan based on various standards. The money flows into commercial banks through savings and then moves into those who need it in the form of loans. During this course, savings become liabilities for banks and loans become assets. This is how the indirect financial system, also called institutional finance, works. The government usually provides a safeguard to protect the depositors, which can serve as insurance for the bank against liabilities, entailing a high risk of moral hazard.

Direct finance is another major area, with companies or individuals using the capital market system to raise funds. Under this financial system, a market should exist to trade securities such as bonds and stocks or derivatives. A company can fund itself by issuing shares or bonds and selling them in the market. Investors buy those shares or derivatives, with the proceeds flowing into the firm.

Direct finance is a system of financing by means of securities and derivatives. Investment banks play a crucial role in direct financing by providing various services such as brokering, undertaking, advising, entrusting and collective investments. As investment banks' activities are based on the transaction of bonds or shares under the direct finance system, the financial markets are vital to their success.

What has brought on the U.S. financial crisis?

The United States has been staggering from one of its worst-ever financial challenges, ending its decades-long global leadership in the direct financial market with some of its once-mighty investment banks suffering a disgraceful failure or forced sale. Latin American countries fell into a crisis in the 1980s when loans heavily extended by commercial banks in the euro-dollar market defaulted. The Asian financial crisis in the late 1990s was also triggered by banks overstretching their loans beyond borrowers' payment capability.

The United States appears to be in a different situation. The U.S. financial crisis is closely related to the entire financial sector, including commercial banks and investment banks. The usual business for commercial banks is to extend mortgage loans and receive principals and interests. But the U.S. commercial banks created mortgage-backed securities by selling the rights to the principal and interest.

Investment banks came to be involved in the securitization of the loans. They enjoyed huge commissions by making and selling securities backed by mortgage loans. Through the securitization, the commercial banks could receive the money and lend it again. Whenever this cycle repeats, the financial companies can make more money. In short, the commercial banks and investment banks have been overstretched in this business.

When the asset-backed securities were sold, the proceeds were lent again and again, with the loans snowballing and reaching to sub-prime borrowers. An excessive amount of capital was used as mortgage loans. Then the housing market unexpectedly stopped its years-long boom and burst, sending all the mortgage loan-related financial companies into distress.

Commercial banks who lent the mortgage loans, investment banks and hedge funds who raked up asset-backed securities and collateralized debt obligations, and the monocline insurers who insured assets held by those banks all fell into a whirlwind of trouble. The mortgage insurers Freddie Mac and Fannie Mae were taken over by the government, Lehman Brothers filed for bankruptcy and Merrill Lynch was forced to sell its assets. The world's top investment bankers, Goldman Sachs and JP Morgan, decided to turn themselves into a commercial bank. With a $700 billion bailout plan for the financial sector passing through the U.S. Congress, all eyes are now focused on how to contain and end the financial crisis.

It's absolutely not a failure of liberalism.

What is more frustrating is that the skepticism over capitalism and market economics has gained ground in during this crisis. The gist of neoliberalism, the most dominant modern economic theory, can be seen in what is called the Washington Consensus. The consensus calls on governments to limit spending, reduce its size, liberalize the capital market and open the foreign exchange market. It also calls for lower tariffs, the privatization of state-run industries, allowing the acquisition by foreign investors of local companies, an easing of regulations and the reinforcement of the protection of property rights.

We need to learn hard lessons from the current turmoil and step up government supervision to ensure the prosperity of the financial industry. But this does not mean that neoliberal policies are fundamentally wrong. South Korea is still under the duress of excessive regulations and overstretched government functions. It will be risky to conclude that we should keep the regulations intact after looking at the fall of the U.S. financial system. It remains to be seen whether the world can overcome this crisis or not. While closely watching the developments, we also have to continue to ease regulations that overly suppress the creativity and autonomy in the private sector.

Some have said the U.S. financial crisis shows the failure of financial capitalism, but I believe this is a hasty conclusion. The U.S. government's plan to save the ailing financial companies with taxpayers' money has met with sarcastic responses.

But how was our nation a decade ago? The South Korean government pumped 167 trillion won into banks and other local companies in the wake of the 1997 foreign exchange crisis, which amounted to about 35 percent of the nation's GDP. The rescue package helped financial companies clean up their balance sheets and regain financial strength quickly. The Korean government was lucky, as it could raise such a tremendous amount of money thanks to insignificant fiscal debt. The past governments' efforts to keep a balanced fiscal budget made a considerable contribution to the nation's fast recovery from the crisis.

Although the United States runs a sizable fiscal deficit, the proposed $700 billion rescue is equivalent to only about 5 percent of the nation's GDP (about $14 trillion). This is not a staggering amount compared with South Korea's 1997-98 rescue plan. U.S. Fed Chairman Ben Bernanke is a leading economist who has intensively studied the Great Depression. He once insisted that the Great Depression was prolonged due to the central bank's tightening policy. The latest U.S. decision to rescue financial companies appears to be affected by Bernanke's conviction and South Korea's handling of the currency crisis.

Given our history of pouring public funds worth 35 percent of the nation's GDP into the financial sector, it would be foolish to criticize the U.S. move to spend about 5 percent of its GDP on a similar rescue plan and simply announce that the liberalism has failed. After overcoming a severe financial crisis with public funds just a decade ago, we should refrain from any hasty and thoughtless criticism.

Financial industry development requires deregulation.

The capital market consolidation law will finally take effect next year after long, painful delays. Under the new law, financial investment companies will be allowed to engage in multiple businesses from brokering, entrusting and advising to collective investment management. They will also be allowed to sell a wider range of financial instruments and products. The law will require a function-oriented financial supervisory system and introduce various measures to protect investors.

As investors shoulder all the entailed risks under the direct finance system, the market can absorb investment-related risks without relying on the government. Furthermore, the direct finance system can deliver what a banking system is not able to offer by promoting free transactions of stocks or bonds. When used properly, the direct finance system has considerable benefits. It will be useful for the national economy if we can develop the system further to facilitate national economic growth. In this sense, we have to proceed with the capital consolidation law and continue our efforts to nurture the financial investment industry.

When a panic quickly spreads through the entire market as seen in this crisis, the government can contain it by quickly coming to its rescue and correcting serious market failures. I believe the government can intervene in the financial markets when they face an unexpected and temporary failure. Some financial companies are turning this catastrophe into a free-for-all by purchasing relatively sound assets at giveaway prices, planning to sell them later at huge profit margins once the crisis passes. While many financial companies are on the verge of collapse, some see others as attractive investment opportunities.

It seems premature to write the eulogy for the investment banking business model.

Latin America was forced to declare a debt moratorium due to excessive lending, but few would call for the abolishment of the commercial banking business model revolving around deposits and loans. Both investment banks and commercial banks are two wheels of a wagon. The two businesses should go along together and neither can be rendered useless. Even though we have little experience in the investment banking industry, some are opposed to the idea of creating a South Korean investment bank, pointing to the high risks involved.

But I believe we should not abandon ourselves to despair. If the capital market consolidation law is well exploited with strong and sound risk management practices, the financial industry will prosper. We should refrain from hasty criticism over this financial crisis. Korea must proceed with its reform drive to remove unnecessary regulations, thereby strengthening the long-term global competitiveness of its financial companies.

By Yoon Chang-hyun