How Can Financial Innovations Lead To Financial Crisis - Assignment Example

How Can Financial Innovations Lead To Financial Crisis? Introduction Global financial crisis intensification has caused the current financial and economic problems facing the world in the global financial systems and the central banks owing to different contributing factors. However, globalization of the financial markets is deemed to be the principal contributing factor to the financial crisis. Following the trade liberalization and the revolution of information, globalization in of financial markets through integration has been made a reality through modern e-communication (Kimbrough & Wu 2006, p. 394). Globalization is associated with benefits such as diversification of portfolio risk, increased market size and cost efficiency. Nevertheless, lack of supervision and regulations account for the negative side of integration of financial markets. Owing to the global financial markets deregulations, financial managers used creativity in spreading risks with ignorance that the same virtue will have adverse effects on the world economy (Llewellyn 2009 p.55) How can financial innovations lead to financial crisis? Explain specifically the role of securitization of the mortgage market. Financial globalization attributed to growth in size of financing markets leading to cross-nation misbalance which caused financial crisis. The developing countries are disadvantaged on the global financial systems. The collapse of the U.S mortgage market revealed the bottlenecks of the global financial markets with complex financial products lowering trust on the whole system. Currently, the global financial crisis is done through innovative investment instruments for instance securitization, derivatives and auction rate securities which were designed through quantitative techniques by mathematicians in an effort to eliminate risk. Securitization is the structured financial process where risks of banks are distributed by pooling loans into sellable assets. This was one of the greatest financial innovation in the 20th century where loans were being converted into securities with the buyer receiving regular payments and the banker disseminating the risk. Banks borrowed more money for lending to create more securitization for loans as they engaged in buying, selling and trading risks believing they have effectively spread the risks only to end in a financial crisis (Keys, Mukherjee ,et al, 2007 p.67) The mortgage defaults were caused by the tightening of the monetary policy triggering disturbances in the financial institutions worldwide. The escalating subprime mortgage defaults led to a significant fall in house prices causing a severe liquidity crisis. The risks associated with subprime mortgage crisis involve the credit risk, which is borne by the lending financial institution representing the potential that the issuers of debt security might fail meeting the obligation of making remitting periodic payments and interest to investors. The second risk is known as the asset risk price which deals with valuation of mortgage business. It is arrived at by computing the chances of subprime mortgage against the viable market for assets. Thirdly, liquidity risk prevails due to decliner of liquidity in the market and as a result of credit risk and asset price risk. Lastly, counterparty risk is as a result of associated parties impacting on the brutal circle of subprime crisis. Derivatives was another investment innovative instrument used for hedging and managing risks. This innovation made the problem worse through its proliferation by making the economy grow faster than expected. The risks were shifted with the designer and the buyer failing to comprehend the risks and their implications. Derivatives increased the market risk instead of decreasing it in order to make more money in addition to the fact that regulation was done poorly. Derivatives do not cause financial crisis, but accelerates it due to the interlinking with the mortgage investment business. The credit default swap, a new innovated financial instrument is also believed to contribute to the financial crisis. These are insurance-like instruments that covers losses on certain securities in the event of default with applications limited to municipal bonds, corporate debt and mortgage securities. This market is unregulated hence posing risks to banks with the fear of going down. Auction rate securities are also linked to the financial crisis. It is a long term borrowing mechanism without having to pay high interest rates resulting to offering investors assets as good as cash. Investors have lost confidence in their liquidity with the banks preventing that due to the collapse of the subprime mortgage market. Faith and trust of the investors in the financial system has been undermined by the financial crisis since the liquidity of the financial instruments innovated do not function as expected. How were adverse selection and moral hazard contributing factors in this crisis? A financial crisis is causing disruption to the financial markets where adverse selection and moral hazards problems worsen the ability of financial markets of channelling funds to investors efficiently. The asset manager’s incentives and bonus schemes encourage them to undertake large risks and also risk their positions. The incentive imbalance presents a moral hazard for the asset manager which can also be attributed to the net result of abandoning fiduciary relationships. Deposit insurance contributes to the moral hazard faced by the banks and depositories. Owing to this deposit insurance, depositors care less of what risks the banks take and they allow them take high risks because they are protected. There is a hazard when there is no incentive for depositors to select their banks because poor bank performance and unleveraged state do not have an impact on the capital they receive. The problem of moral hazard is reinforced by the fact that market models are false in themselves as they focus on normal market conditions by undervaluing risk. Thus, instead of risk management reduces the risk it magnifies it. Regulators must thus take moral hazard serious and factor its impact on regulation. Did the unprecedented level of government intervention in the economy prevent an even more severe economic downturn than what actually occurred? Is this affecting a moral hazard problem in the future? The financial crisis in 2007 pointed the failing role of the government in designing macroeconomic policies to safeguard financial stability leading to a severe global recession. The extreme negligence of the regulators and the financial banks in abusing financial innovations made the financial system to be highly leveraged with moral hazard ruining corporate governance and the financial innovations increasing the financial risks (Milan and Sufi 2007, p.89) However, the unprecedented level of government intervention and bailouts during the financial crisis helped to prevent the worst financial and economic outcome by injecting money massive amount of liquidity into the financial system. The investment banks offer support to the firm and the governments also contributes by offering money through issuing and selling securities in the capital markets whether equity or not. The government also offers advice on transactions. The investment banks in collaboration with other financial institutions have assumed a significant role in credit derivative transactions to create certainty in the market. What will be the long-term impact of the government’s intervention, particularly the ballooning of the national debt? The government’s intervention to avert the financial crisis demonstrated an act the government to ensure survival of the firms and corporations. This shows the short term and long term consequences and positive outputs. For the long term the benefit of the government is from the interest rate received from banks, but from bailouts it may result in negative short term effects such as for example high taxes and lower salaries. The ballooning national debt increases adds more burden to the taxpayer by increasing the burden of paying interest. The government intervention showed lack of leadership and preparedness on the political side. The rise in national debt limits the fiscal policy independence for countries. The price of bonds and investment increases with the ballooning national debt, thus limiting new investment ventures (Taylor 2008, p. 109) Conclusion The financial crisis that affected the world economy did demonstrate the loopholes of the financial systems and the government to control the crisis. The government has a vital role to play in the financial system by developing the necessary monetary and fiscal policies that should guide the operations of banks and other financial systems in their respective countries. Thus government’s intervention can help restore sanity in the financial sector, especially in the financial crisis experienced in 2007. References Keys, B., Mukherjee, T.,et al, 2007,” Did securitization lead to lax screening? Evidence from subprime loans” Working papers, University of Chicago GSB. Kimbrough, S., & Wu, D. J. 2005. Formal modelling in electronic commerce. Springer E-Books. Berlin, Springer. Llewellyn, D.T 2009, The economic rationale of financial regulation.” Occasional paper No. 1, Financial services authority, London. Milan, A. and Sufi, A. 2007, The consequences of mortgage credit expansion: evidence from the 2007 mortgage default crisis, working paper, University of Chicago. Taylor John B. 2008,“The financial crisis and policy responses, An empirical analysis of what went wrong, November 2008. This essay is an example of Read More