WHAT markets, overly complex credit products and irrational




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JULY 24, 2018

1.0. Primary Causes of the Global Financial Crisis
As posited by Reinhart and Rogoff’s (2009), some features are common to all financial
crises: a fragility in financial systems with a breakdown in effective intermediation that otherwise
matches assets with liabilities; amplifying factors such as an inefficient market, herd behavior,
high leveraging; and a sudden large loss in value of one or more financial institutions or assets that
leads to problems in liquidity and the possibility of contagion. Whilst the specific root cause of
the 2008 financial crisis was unique, the path from disproportionate and unwarranted risk-taking
to financial turmoil is one that is familiar to all past crises. It resulted from a wide array of market
behavior that built up over time and led to an explosion in the US credit market, and later the rest
of the world: the under regulation in financial markets, overly complex credit products and
irrational behavior in the mortgage market.
The Banking Act (1933) (Glass-Steagall) that regulated banks after the 1929 stock market
crash was repealed in 1999 by The Gramm-Leach-Bliley Act. This new regulation allowed banks
to once again invest depositors’ funds in unregulated derivatives. Shortly afterwards, the US
Federal Reserve’s (FED) reaction to 9/11 was to reduce interest rates to 1% to protect growth in
the economy. This coincided with an influx of new money from China (and the Middle East), as
the country took advantage of its position as a new WTO member to flood the world with cheap
exports whilst keeping the Yuan very low. Together, these resulted in the notion of ‘cheap money’
and a wealth of available credit in the US. Investment banks, looking for returns above the FED
level, saw the warming US mortgage market as an opportunity and this led to a real estate boom
from 2002 to 2006, with property values tripling.
Surplus leverage is, by definition, at the heart of all financial crises. Minksy (1992)
suggests that throughout history, long periods of prosperity have inherently led to financial

instability because borrowers and lenders have been encouraged to behave with more and more
abandon. The madness of Lehman using Repo and commercial paper markets to fund real estate
holdings serves as just one example of liquidity mismatches that were rife in this era. There was
no viable reason for an investment bank to be speculating on buildings with the implicit support
of taxpayers. Lehman were not alone. Mortgage providers sold the packaged loans to investment
banks that in turn negligently and disingenuously re-categorized their risk and sold them as
financial derivatives to investors around world, thus transferring the risk from mortgage sellers,
through investment banks to investors. Provided that homeowners did not default on their
payments, the risk was deemed acceptable. There was no transparent accounting treatment for such
dangerously hidden leverage, so mitigating against it through regulation was as difficult and
complex as it is today.
As the number of credit worthy applicants began to dwindle, more and more risky
incentives were used to attract subprime applicants with the rationale that rising property prices
would mitigate any risk of default. Higher than expected subprime default rates led to an excess
of property supply over demand as investment banks were left holding too many homes. As house
prices began to decline, subprime mortgage holders were further incentivized to default on their
negative equity leaving over leveraged investors with vast loans and houses that they couldn’t sell
as new mortgage applicants had been exhausted. The default and foreclosure driven unravelling
of the securitization process resulted in massive losses for holders of securities. The securitized
obligation market dried up in haste and the risk premiums on them swelled. The short-term money
markets were, in essence, frozen as interbank lending ceased, and, as has happened in all previous
financial crises, cash became a prized asset. Although governments around the world intervened

to improve liquidity, this was accompanied by a substantial and pervasive decline in asset prices,
particularly in equity markets (Ramadhan, 2018).

2.0.Regulatory Considerations in Financial Markets
Government intervention in financial markets during and post crises come in the various
forms, including bailouts and regulations. The regulation consideration feature before, during and
after the crises. Though financial markets may seem like they are regulated with much more
severity and concern than other industries, but, that said, the consequences of failures in financial
markets can have much more devastating consequences to the wider economy. There are two
broad drivers of market failure that have attracted the attention of regulators: asymmetric
information and social externalities.
The most pertinent asymmetry is that between buyers and sellers of financial products. In
other markets, the market functions best with repeat purchases when it is easy to identify the
quality of the product and to switch to a substitute if quality is poor. It is not that easy in finance
as sales volumes are low and buyers only discover the quality of the product after a long time and
when it is likely very difficult to remedy. It is therefore necessary for regulation to balance the
needs of unsophisticated buyers with the interests of much more sophisticated sellers.
Social externalities occur when the consequences of the actions of a private company are
not entirely captured by such private parties. The Financial Crisis displayed consequences far
beyond those for the shareholders of accountable financial institutions, for example. Regulators
attempt to mitigate social externalities through government led depositor insurance and the
requirement for banks to carry greater capital than they would normally want to in order to avoid
moral hazard behavior of insured banks. This does not address the endogenous risks that come

from the collective and interconnected nature of banking activity, but instead it seeks to secure
each individual component of a complicated system.
Just prior to the Financial Crisis, some commentators aired concern that a more painful
recession would follow a bigger boom. Generally, however, regulators viewed managing the crisis
in recession as something that would be easier to do than it would to burst a bubble with unknown
dimensions. It goes without saying that there has been a paradigm shift in this view, with crises
best avoided or dampened rather than managed (Warwick, n.d.).

3.0.The General Response of Policy Makers and Regulators to the Global Financial Crisis
The lax regulatory policies and weak prudential and regulatory oversight (see Lin, 2009)
which led to the crisis caused a number of policymaking and regulatory responses. Following the
Reserve Bank of Australia (RBA, 2014), we classify these reforms and their intended effects into
four core areas:
Building More Resilient Financial Institutions: Basel III was introduced in response to
the financial crisis to strengthen prudential regulatory standards of financial institutions. Through
higher capital ratios, redefinition of capital and new liquidity requirements banks’ ability to
withstand losses have been improved under Basel III.
Addressing the “Too Big to Fail” Problem: Supervisory intensity has been increased and
principles-based regulatory frameworks developed for systemically important financial
institutions (SIFIs) across the banking, the insurance and investment industries. Also, cross-border
crises management groups have been established to address cross border contagion risks from
these institutions.

Addressing The Shadow Banking Risks: The Financial Stability Board (FSB) and the
International Organization of Securities Commissions (IOSCO) have developed policy
recommendations (targeted towards risk management, enhanced disclosure requirements and
reduced banks’ interactions with shadow banks) to strengthen oversight and regulation of non-bank
entities associated with credit intermediation and maturity/liquidity transformation.
Making Derivatives Markets Safer (Though Stronger Financial Market
Infrastructures): To boost the transparency of derivatives markets and to mitigate the scope of
contagion arising from counterparty exposures, an international policy consensus has emerged for
the greater use of centralized infrastructure (trade repositories, central counterparties and trading
platforms) in OTC derivatives markets, with higher capital requirements for non-centrally cleared
The overarching objective of these reforms was to strike the right balance between prudent
risk taking and economic growth (RBA, 2014). While poor regulatory framework was a major
contributor to the global financial crises, stronger risk management frameworks, improved
disclosure and regulatory oversight, which have been enacted after the crises, are intended to
reduce systemic risk and information asymmetry while boosting investor confidence in financial

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