WHAT markets, overly complex credit products and irrational


[email protected] JULY 24, 20181.0. 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 The Banking Act (1933) (Glass-Steagall) that regulated banks after the 1929 stock market crash was repealed in 1999 by The Gramm-Leach-Bliley Act.

We Will Write a Custom Essay Specifically
For You For Only $13.90/page!

order now

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 financialinstability 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 intervenedto 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 comefrom 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 contracts. 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 markets.References Amadeo, K.

(2018, May 23rd). Dodd-Frank Wall Street Reform Act. Retrieved from: https://www.thebalance.com/dodd-frank-wall-street-reform-act-3305688 Guynn, R.D. (2010, November 20th). The Financial Panic of 2008 and Financial Regulatory Reform.

Harvard Law School Forum on Corporate Governance and Financial Regulation. Retrieved from: https://corpgov.law.harvard.edu/2010/11/20/the-financial-panic-of-2008-and-financial-regulator-reform/ Jarvis, J.

Vivien Yeow (2012, July 23rd). The Causes and Effects of the Financial Crisis 2008 Online video. Retrieved from: https://www.youtube.com/watch?v=N9YLta5Tr2A Klein, A. (2017). Setting the Scales: Dodd-Frank’s Balancing Act on Big Banks.

Vanderbilt Law Review. Vol. 70. Pp269-272. Lin, J.Y. (2009).

Policy Responses to the Global Economic Crisis. Development Outreach. Washington DC. The World Bank Institute.

pp 29-33. Minksy, H.P. (1992). The Financial Instability Hypothesis. Levy Economics Institute. Working Paper No. 74.

The Jerome Levy Economics Institute, Bard College. Retrieved from: http://www.levyinstitute.org/pubs/wp74.pdf . Ramadhan, Mohammad ; Naseeb, Adel (2018).

The Global Financial Crisis: Causes and Solutions. Retrieved from: https://www.researchgate.net/publication/265235519_The_Global_Financial_Crisis_Causes_andSolutions . Reinhart, C. M.

; Rogoff K. S. (2009). This Time Is Different – Eight Centuries of Financial Folly. Princeton: Princeton University Press.Reserve Bank of Australia (2014).

The Regulatory Response to the Global Financial Crisis, Financial System Inquiry. Retrieved from: https://www.rba.gov.

au/publications/submissions/financial-sector/financial-system-inquiry-2014-03/regulatory-response-to-the-global-financial-crisis.html Selmil, N. ; Hachicha, N.

(2014). Can Bank be a Cause of Contagion During the Global Financial Crisis? International Journal of Economics and Financial Issues, 4(2), pp. 353-362. S.R. (2016, Sept 9th). What causes financial crises? Retrieved from: https://www.economist.com/the-economist-explains/2016/09/08/what-causes-financial-crises.


I'm Mary!

Would you like to get a custom essay? How about receiving a customized one?

Check it out