The Main Causes and Underlying Drivers of the Recent Global Financial Crisis - Essay Example

? [BEHAVIOUR FINANCE AND MARKET EFFICIENCY] Behaviour Finance and Market Efficiency Date: November 18, 2013. Section A: Behavioural Finance The Main Causes and Underlying Drivers of the Recent Global Financial Crisis The recent global, financial crisis spread from the source crisis country to other countries, and consequently, across global, financial markets. It commenced from the United States’ subprime mortgage market and spread across global, financial markets (Gonzalez-Hermosillo, 2008, p, 3). Conditions in global, financial markets affect international investors’ risk appetite. Changes in international investors’ risk appetite may be responsible for the spread of the original shock across, global, financial markets (Gonzalez-Hermosillo, 2008, p, 3). In this report, the main causes and underlying drivers of the recent global, financial crisis are explained. Also, comparison and contrast of behavioural and non-behavioural explanations commonly provided by finance academics have been made. The main causes behind the recent global, financial crisis include deregulation by financial institutions, accompanied by rapid financial innovation, which stimulated powerful financial booms. As the financial institutions became flawed, leading to the financial crises, governments responded to such crises with bailouts that allowed new expansions to begin (Crotty, 2009, p, 563). First, the integration of modern day financial markets with the era’s light government regulations, which is also referred to as the New Financial Architecture (NFA) led to the global, financial crisis (Crotty, 2009, p, 563). It should be noted that the New Financial Architecture is based on light regulation of commercial banks, lighter regulation on investment banks and little regulation on the shadow banking system. The shadow banking system represents hedge and private equity funds and special investments that are created by banks (Crotty, 2009, p, 563). Minimal regulation of financial institutions led excessive risk taking by numerous financial institutions because of the existing incentives in the market, without fear of restriction or limitation. The assumption that rational investors can make optimal decisions, and that only those who could handle risk, could take it is based on poor theoretical foundations, with no convincing empirical support (Crotty, 2009, p, 563). On the contrary, many investors and financial institution took excessive risk, which they could not manage. Consequently, the global, financial crisis had to arise when the potential losses associated with high risk occurred. Separately, it should be noted that perverse incentives affect key personnel of vital financial institutions such as commercial banks, insurance companies, investment banks, hedge and private equity funds, as well as, mutual and pension funds to take excessive risk when financial markets are buoyant (Crotty, 2009, p, 563). For instance, the provision for no return of fees for securities for mortgage loans, if the securities suffered large losses made most market participants to take loans, as much as the loans may have not been viable or sound (Crotty, 2009, p, 563). Problems arose when the loan takers failed to service or repay the loans because their investments could not profit due to the prevailing market conditions. Financial innovation contributed to emergence of recent global, financial crisis because it led to the creation of financial products that are so complex that they are not transparent (Crotty, 2009, p, 563). This means that such financial products cannot be priced correctly. They are also illiquid and are not sold on markets. In the current financial market, there is a higher value of securities that are not sold on the markets than the existing securities (Crotty, 2009, p, 563). The fact, that sale of securities derivatives is mostly carried out by an investment bank negotiating with customers over the counter, led to imperfect information. It is therefore, not true that risk is priced optimally in competitive capital markets, and as a result, investors can make erroneous decisions (Crotty, 2009, p, 563). Another cause of the recent global, financial crisis is that banks neither distributed their risky assets to capital markets nor hedged everything that remained, as claimed (Crotty, 2009, p, 563). As a result, no loans were sold to capital markets. This means that banks still kept Mortgage Backed Securities and Collateralised Debt Obligations to reduce moral hazard, and to convince investors that these securities were safe. Banks had incentives to hold Collateralised Debt Obligations because Collateralised Debt Obligations could be held off- the-balance sheet, with no capital reserve requirements (Crotty, 2009, p, 563). It took a longer time between a bank’s receipt of mortgage and sale of Mortgage Backed Securities or Collateralised Debt Obligations, leading to banks having custody of the security for long. Banks also decided not to sell Mortgage Backed Securities and Mortgage Backed Securities when prices were low, keeping the riskiest products that they created as an incentive of generating high profits later (Crotty, 2009, p, 563). Financial institution regulators contributed to the global, financial crisis by allowing banks to hold assets off-the-balance sheet, with no capital requirement to support them (Crotty, 2009, p, 563). In actual sense, Regulators and supervisors failed to restrain excessive taking (Kolb, 2010)79. This led to the accommodation of excessive risk by banks. Also, giant banks were allowed to measure their own risk and set their own capital requirements, leading to excessive risk taking (Crotty, 2009, p, 563). Excessive risk taking among financial institutions led to the global, financial crisis. The provision of the New Financial Architecture for increased borrowing lead to the growth of a dangerous high system of wide leverage among financial institutions (Crotty, 2009, p, 563). In addition, financial innovation led to the creation of complex, financial products which were relied on heavily, leading to systematic risk (Crotty, 2009, p, 563). It was presumed; through deregulation that every investor was to hold a risk that s/he was comfortable with, but most companies failed to follow their own risk management procedures. The creation of marginal assets whose viability depended upon continued, favourable macroeconomic conditions also contributed to the global, financial crisis (Laeven, Claessens, Igan, & Giovanni, 2010, p, 5). Financial institutions loaned borrowers who had limited credit and employment histories meant that repayment and debit servicing were subject and vulnerable to economic downturns and changes in monetary and credit conditions (Laeven, Claessens, Igan, & Giovanni, 2010, p, 7). This credit expansion was concentrated in the subprime mortgage market of the United States (Laeven, Claessens, Igan, & Giovanni, 2010, p, 5). The underlying drivers of the recent, global financial crisis are rooted in financial market and investor behaviour. Most investors have cognitive conceit and overweening belief in own intuitive abilities. They are overconfidence in their judgements, but forecasts are subject to changes as they are not perfectly related to their actual outcomes. This means that managers, investors and financial analysts can be biased in their judgement, thus making decision errors, which might have contributed to the financial crisis. On the other hand, it should be noted that market practitioners are imperfect decision makers, and can make cognitive errors because they are loss averse and have imperfect control. This is because they employ intuition and psychological factors in making investment decisions. Investors make satisfying decisions, rather than optimal decisions. As potential loss was made unconscious while excitement or gain was made conscious, investors took wrong investment decisions knowingly. Banks refused to lend each other, investors were unable to determine what was good or what was bad, leading to the economic crisis as investors sought for exceptional performance, while potential loss was ignored. Also, there were numerous bankruptcies and government bailouts of major banks and other financial institutions. Behavioural and Non-Behavioural Explanations Commonly Provided by Finance Academics According to finance academics, markets generate genuinely random price behaviour, as investors make self attribution bias in interpreting the events that are consistent with actions. Investors also interpret events that are inconsistent with actions due to external factors. Secondly, long horizon returns have the same indicator as announcement period returns, similar to conservatism where investors revise their beliefs slowly in response to earnings announcements. Third, the genuinely, random price that markets generate, give the appearance of regular pattern, as can be seen in behavioural explanations where there is representative heuristic, and investors believe they see patterns in earnings changes that are random. On the other hand, behavioural explanations state that there is a medium price momentum in earnings, which investors belief are temporary become permanent, unlike the genuine, random price behaviour. Also, there is a long-term price reversal because investors make assumptions about a long run sequence of goo or bad earnings news, and later find out that their forecasts are invalid. In non-behavioural explanations, markets are taken into account while behavioural explanations take investors into account. Investors are normally overconfident, as they overestimate the precision of private and information that is not private. Investors interpret events that are consistent with actions as conforming ability. They also interpret events that are inconsistent with actions due to external factors, while non-behavioural explanations provide that markets offer real information. Mutual fund operators believe that past performance is associated with future results while non-behavioural explanations deal with current information. It should be noted that past performance is not associated with future results, and that investors are prone to representativeness and fallacies of gamblers. Behavioural explanations depend on the rationality, competence of investors while non- behavioural explanations do not. Behavioural finance states that decision making is done under uncertainty (Tuckett & Taffler, 2007). Section B: Market Anomalies Form of the Efficient Market that Represents the Tougher or Highest Hurdle that Must be Met for the Stock Market to be Regarded as Perfectly Efficient The strong form efficient market represents the tougher or highest hurdle that must be met for the stock market to be regarded as perfectly efficient. The strong form of efficient market states that both public and private information is available to the market (Harder, 2010, p, 6). It further contains that even profits are impossible on private information, meaning that insiders cannot capitalise on private information to make abnormal profits. With full public and private information to all market participants, investors are expected to make rational decisions that will lead to a perfect and efficient market. In reality, information is never available to all market participants, at the same time. For instance, access to private information is may not be easily possible to all market participants. In addition, insider information may leak and be taken into share price (Harder, 2010, p, 6). This may be regarded as insider trading. The premise that the strong form of efficient market includes all information, which is known to any market participant, renders it unrealistic because it is difficult to prove or reject this form of efficient market because private information is difficult to specify. Information is worthless today, if it is not reflected in tomorrow’s price (Gardes & Prat, 2000, p, 77). Therefore, investors may fail to take a signal into account, based on private information. Market operators ignore current, private information, when it has not become common knowledge. It should be noted that collection of information consumes time, making it costly. Therefore, private information cannot be available freely to all market participants, as claimed by the strong form of market efficiency. Therefore, private information cannot be freely available to all market operators. When information is accessible to every market participant, it is no longer private information and may not have the private value in a speculative activity (Gardes & Prat, 2000, p, 77). The strong form of efficient market assumes that private information is available to market participants, but still remains private. This premise is faulty because the definition of private information is ambiguous. It is ambiguous whether information contained in forecasting or tipping services should be classified as private information (Williams, 2005, p, 149). It is difficult to determine how information that is not available to the public can be incorporated in the market. This is because incorporation of information that is not available to the public in the market can contribute to insider trading. It may be possible to have empirical evidence to prove an efficient capital market hypothesis but there is no way of proving market efficiency by use of the strong form of market efficiency. There are infinite types of public information and ways to use them. Therefore, it can only, be rejected that the market is not efficient by use of evidence (Ho & Yi, 2004, p, 24). It is vital to note that uncertainty is introduced into individual calculation by new information. When new information that prospects have changed is available, then economic agents buy and sell until prices change in line with their changed expectation of reality (Tuckett & Taffler, 2007, p, 392). The strong form efficient market assumes a perfect market, which may not be realistic. In reality, information cannot be freely available to everyone in the market at the same time (Smith, 2012). Also, in an efficient market, prices adjust rapidly to new public information, which is contrary to the premises of the strong form efficient market. Also, it should be noted that dissemination of new information takes time and stock prices move to new equilibrium at a gradual manner, hence stock prices move in trends that persist (Smith, 2012). Since information that is known to any market participant is reflected in the market prices, then not even an insider can earn abnormal returns, based on any private information. Even uninformed investors are expected to rely on the price information of the securities they buy (Gabor, 2013, p, 131). Given that the strong form of market efficiency is reliant on both private and public information, it should be noted that private information may create adverse selection and decrease the welfare of all market participants because it reduces the hedging effectiveness of the market (Vives, 2008, p, 145). Also public information may lead to the same effect because of the destruction of insurance opportunities. Therefore, having more information may yield inferior outcomes, as far as, efficient markets are concerned (Vives, 2008, p, 145). Above Average Returns earned by Legendary Investors such as Warren Buffett and the Efficient Market Hypothesis As much as the efficient markets hypothesis implies that not all the participants in the market ought to know the optimal forecasts, a few savvy investors such as Warren Buffett can drive the price to the optimal forecast by exploiting opportunities for profit (Burton, Nesiba, & Brown, 2010, p, 154). However, it is impossible to maintain an above average return for a long period of time, as implied by the efficient market hypothesis. Companies can capitalise on bubbles, and investments based on insider information, as well as, market overreactions to new information to make above average returns (Burton, Nesiba, & Brown, 2010, p, 154). Companies analyse the current financial market trend and purchase assets that are most likely to sell for more in future periods (Rapp, 2009, p, 1). Such companies also work hard to increase and project to attract more new buyers. As buyers of assets increase, they ensure further increase in returns. Therefore, the more the customers are attracted, the more they buy, and the increase in returns continues, leading to above average returns. In this case, the momentum of an asset’s selling price is determined by self speculative building (Rapp, 2009, p, 1). Companies can also earn above average returns by following standardised trading rules. This means that companies like Warren Buffett seek to get better price from the trading venue than the posted best bid in a market. They then use some different trading rules to ensure that there are improvements in their earnings to guarantee above average earnings (Williams, 2011, p, 357). In some cases, such companies use the promise of price improvement and deviate from standard trading rules of the market so as to use their own standardised trading rules. Such companies may make use of technical analysis to get above average returns. According to Kurth (2011, p, 5), an analysis of the stock market based on short intervals such as daily, monthly or weekly, shows that stocks with above average returns in different intervals increases the likelihood of further above average returns in the subsequent periods. Also, the companies may be monopolies that have access to inside information, which they use to increase their profitability. For instance, some specialists on major security exchanges in the United States have monopolistic access to information which could be used to formulate profitable trading rules (Williams, 2005, p, 49). However, it should be noted that any use of private information because of monopolistic access to information to make a systematic abnormal return is evidence of strong form market inefficiency (Williams, 2005, p, 49). Companies that earn above average returns use their insider corporate information. Such companies use insider corporate information to protect minority shareholders, and treat creditors equally in bankruptcy so as to protect their holdings of corporate bonds (Balling & A?lvarez, 1998, p, 49). Since insider trading leads to more diffusion of information in the market, savvy organisations manage their risks efficiently through agents who share information to improve returns. Consequently, asset prices increase and returns go up, as the cost of capital goes down. Lower information acquisition costs are incurred by outsiders when private information is available in the market (Barucci, 2003, p, 384). This leads to market efficiency because it encourages efficient investment decisions by firms. Recent studies have analysed technical rules and trading horizons widely (Frydman & Goldberg, 2011, p, 206). Conditions in global, financial markets affect international investors’ risk appetite. The main causes behind the recent global, financial crisis include deregulation by financial institutions, accompanied by rapid financial innovation, which stimulated powerful financial booms. Changes in international investors’ risk appetite may be responsible for the spread of the original shock across, global, financial markets (Gonzalez-Hermosillo, 2008, p, 3). These studies claim that rules based on intraday horizons can generate above average returns after risk has been accounted for (Frydman & Goldberg, 2011, p, 206). There are also fixed parameter models that company economists use to estimate asset returns and report stable patterns that could be used to earn above average returns, after accounting for risk. However, according to the efficient market hypothesis, all such trading rule profits and patterns should be quickly arbitraged away (Frydman & Goldberg, 2011, p, 206). References Balling, M., & A?lvarez, A. I., 1998. Corporate Governance, Financial Markets and Global Convergence. Dordrecht : Kluwer Academic Publishers . Barucci, E., 2003. Financial Markets Theory: Equilibrium, Efficiency, and Information. London: Springer Finance Press. Burton, M., Nesiba, R., & Brown, B., 2010. An Introduction to Financial Markets and Institutions. New York: M.E Sharpe Press. Crotty, J., 2009. Structural Causes of the Global Financial Crisis: A Critical Assessment of the New Financial Architecture’. Cambridge Journal of Economics, pp. 563-580. Frydman, R., & Goldberg, M. D., 2011. 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