Table of Contents
- Current financial crisis
- Price for an Essay
- Nature of moral hazard
- Subsidized risk-taking
- Misguided policy intervention
- The failure of financial risk management
- What is liquidity risk?
- Liquidity risk and asset prices
- Liquidity and the current crisis
- Lessons for the future
- Related Free Economics Essays
The current banking and financial crisis is regarded by many financial analysts and economist as the worst financial crisis since the Great Depression. Preliminary reports find the current crisis to be triggered by a liquidity shortfall n the US banking sector a situation which resulted to the collapse of giant financial institutions. The government intervention by trying to bail some institutions did not help much as a result of a world downturn in the stock market. The current crisis is an all rounded crisis which has contributed to the failure of key businesses, a decline in consumer wealth and a decline in economic activities.
Current financial crisis
The current financial crisis has sent shockwaves in the financial sector over financial policies and their implementation. In most countries, there has been continued panicking by governments to try and regulate financial policies and institutions hence reduce the effects of the financial crisis. Most governments have responded to the financial crisis by introducing bailouts policies and re-introducing no-holds barred Keynesianism. According to Frost, "banks and other financial institutions are very different commercial animals than manufacturing and other financial-companies" (Frost, pp.532)
Some financial analysts argue that moral hazard is overrated. They say that moral hazard has a weak role in the banking and financial sector .However, one Lawrence K. warns against the previous perception about moral fundamentalism. His approach is that moral hazard had a prominent role in the current financial crisis. I believe moral hazard played a pivotal role in the events leading to the current financial crisis.
Nature of moral hazard
A moral hazard can be describes as a situation where one party is responsible for the interest of the other. However in moral hazard, one party has the incentive to put his/her own interest first. Some financial moral hazard situations are such as;
a. I sell you a financial product with perfect knowledge that it was not your intention to buy it.
b. I reward myself with excessive bonuses from the funds that I manage on your behalf,
c. I take risks that you have to bear
Examples of financial moral hazard situation such as these are very persuasive and inevitable in the current financial system as well as the general economy. The central challenge for most financial systems is how to keep such moral hazard situation under reasonable control. Controlling such situations reasonably is one of the principles of institutional design.
Most of moral hazard situations have increased risk taking. Inadequate control of moral hazard situation leads to recurrent and excessive risk taking which is a significant characteristic of the current financial crisis. In the past, banks were very careful at identifying who to sell or grant a mortgage. This is because if the mortgage holder defaulted in payment, it was the bank that suffered financial loss.
However with current trends in the financial sector, this incentive of screening individuals before granting a mortgage is greatly weakened. Most of the banks and financial institutions are not concerned whether an individual defaults the mortgage or not. What really concerns them is the payment they get form originating the loan. This has brought a situation whereby originating banks are more than willing to lend to almost anyone and this puts us in an unsound situation where mortgages are being granted with little or no concern on the risks involved. Banks disregarded the credit culture which according to Stuart is "the term used to describe the banks general approach to managing credit risks" (Stuart, pp. 532)
The greed game is the next characteristic of moral hazards contributing to the current financial crisis. In this, the partners of private equity and hedge funds would make an investment plan on their backers' funds on a compensation mutual agreement that would give them 20% gains. In case of financial loss, backers alone were left to shoulder the loss. In these plans, investments were leveraged by enormous borrowing.
"If a private-equity firm or a hedge firm generates a capital gain of 1 billion pounds, and in the boom conditions of the past few years, that wasn't unusual, the partners in the relevant fund would pocket 20% or 200 million pounds. In case of financial loss, only the backers would suffer the financial loss" (Peston, 2008).This led fund managers and bankers take more risk than they would have done had their money been at stake. With none of their money at risk, and the speculative illusion of earning huge bonuses, fund managers and bankers were seduced to a systemic game that would extensively hurt the financial sector at the long run,
Misguided policy intervention
We put into consideration some policy failures that directly or indirectly contributed to the current crisis. The misguided intervention by the federal government in the US housing sector led to an irreparable damage in the sector that in one way or another contributed to the current financial crisis. According to Milner, this intervention by the government was as a result of continuous desire by the government to increases home ownership especially in low income households (Milner, 2009).
This desire to increase home ownership led bankers to come up with affordable lending terms to accommodate low income earners. The government also established massive mortgage enterprises such as Fannie Mae and Freddie Mac to expand the ability of both financial and residential mortgage. Such policies had the primary objective of increasing home ownership but ended up pushing house prices up and the growing house bubble which is one of the main contributors of the housing bubble and the subprime mess.
The failure of financial risk management
When we think about what really happened to the financial risk management in the wake of the financial crisis, the answer is that modern financial practitioners and quantities financial managers all make inadequate assumptions in the financial sector. Many risk models today fail to consider both outcomes of financial strategies and ignore strategic and systemic interaction. For example, it's not all financial models are bad; there might be a good financial model that is abused by those who use it.
A major concern with regards to moral hazard is the 'too big to fail' syndrome. The presumption that an institution is massive and connected that the possibility of its failure is almost non-occurrence is what led to the failure of some of the world's largest financial institution. The fall of the giant insurer AIG according to Casu is attributed with inappropriate fiscal policies in an institution operating under the policy of revenue increment rather than profit-loss evaluation model (Casu, 2006)
What is liquidity risk?
What really is meant by liquidity risks has two different approaches with regards to liquidity. There are two different kinds of liquidity that are; market liquidity and funding liquidity. Market liquidity risk can be described as a situation where market liquidity worsens in the occurrence of trade. Funding liquidity on the other hand refers to the situation where a trader is unable to fund his position and is forced to unwind. An example of this is when a levered hedge loses its access to borrowing and is forced to sell its securities.
Liquidity varies with regards to the difference in time and markets. The current banking and financial crisis is experiencing extreme liquidity where dealers make no bids. This is commonly being experienced in the asset backed securities and the convertible bonds. The current capital shortfall on banks has brought about banks scaling down their trading activities as well as reduces the lending activities to other key financial drivers such as hedge funds. This means that if banks cannot fund themselves, they cannot be in a position to fund other clients.
Prior to the crisis, banks had begun giving more loans to potential home owners in the US. This was accompanied by the banks encouraging home owners to take up considerably high loans overlooking the interest rates. There was also the issue of financial innovation where banks and other financial institutions developed financial products tailored for a specific clientele group. Some of the examples pertinent to this crisis were adjustable rate mortgage, mortgage backed securities and collateralized debt obligations.
Liquidity risk and asset prices
A security that is not liquid tends to have a higher required return so as to compensate the investors for the expenses accrued from the transaction. Based on the fact that the market is unpredictable and may deteriorate in the future, investors increase market liquidity so as to compensate for the costs. An increase in the required return leads to a decline in asset prices. This is with regards to the liquidity-adjusted capital asset pricing model.
Liquidity and the current crisis
The central force behind the bank and financial crisis was the bursting of the housing bubble. The levered financial institutions made the situation worse due to the high level of their exposure in the crisis. This eventually led to great financial loss by banks and other financial institutions that were characterized by funding liquidity problems. This caused a financial systemic problem where the banks and other financial institutions responded to their deteriorating balance sheets by hoarding cash asset selling in an attempt to reduce their exposure to the crisis.
The result of this is that risk management tightened and the interbank funding market was greatly affected. The funding liquidity problems spilled on other investors particularly those who rely on leverage such as hedge funds as a result of the unwillingness of banks to lend. When investors saw a looming problem of giant banks such as Bear Sterns and Lehman falling, they withdrew their capital and unwind positions in an attempt to avoid losing their capital or having it frozen in case of bankruptcy.
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This funding liquidity problem eventually developed into a more complex market illiquidity characterized by bid-ask spreads widening in most markets. The market illiquidity situation led the investors become scared dropping prices specifically for illiquid assets with high margins. The crisis then spread to other asset classes and markets globally. This has been continuously been experienced in countries with weak currencies where investors unwind carry-trades and have little faith on weak currencies.
This current situation of increased risk and illiquidity has sparked volatility that has led to higher margins. There is also greater co-relation in the asset market as a result of most assets trading under liquidity. Home owners and other asset owners now experience asset deteriorating prices as well as consumers experiencing reduced access to credit facilities.
Lessons for the future
What is obvious about the current financial crises is that state intervention in the financial systems is a failure. It is however not right to assume that unregulated financial systems are a success. Moral hazards should be taken seriously and individuals should not be led to believe that moral hazard has little or no effect in financial systems. Financial policies should be tailored in such a way that the question behind their formation and introduction should be; does this increase or reduce moral hazard? The bottom line is that when an individual or a financial institution take risks, they are responsible for the said risks but when they take risks at the expense of another party, that's a moral hazard simply because there is no such thing as free risks.
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Market liquidity on the other hand is an important driver in security prices, risk management and speed of arbitrage. What mainly determines market liquidity is the funding liquidity of banks and other financial institutions. The overall effects of market liquidity are increased margins, tight risk management and an increment in market volatility. This leads to liquidity becoming liquid demanders which leads to price drops and rebounds. According to Heffernan, the overall lesson from this is that trading through organized exchanges with centralized clearing is much better than trading on over the counter derivatives since trading derivatives leads to an increase in co-dependence, complexity and counterparty risks in the financial sector.