Key Sources of Financial Fragility-Free-Samples-Myassignmenthelp

Questions: 1.Describe three key sources of Financial fragility that led to the Financial Crisis 2.Discuss about the Central Banks response to the Crisis. 3.What is the relationship between financial development, growth and volatility? Answers: 1.The beginning of the US financial crisis can be traced back to 2008 following the collapse of Lehman Brothers Investment Bank. This was then followed by the 2009 EU Debt crisis which affected many European countries and finally the global economic downturn. In this essay, I describe the three main sources of the financial fragility that led to the above sequence of events. Securitization According to Diamond and Raghuran (2009), one of the reasons for the financial crisis can be blamed on securitization of assets. Following an increase in demand for housing and low interest rates, many banks began investing in mortgage based securities. A mortgage based security is a type of derivative whose price is based on the value of its mortgages used as collateral. The banks would then sell these securities to investors like hedge funds, pension funds, commercial banks and other institutions. In the process, they were also transferring their credit risk to these investors. As a result, these securities were deemed more profitable to banks and they opened up a new source of funding from traditional ways. As profits grew, demands of the bank and investors to invest in these securities also grew. As a result, banks began lending loans to anyone including subprime borrowers who had a higher risk of default. When the property bubble began to burst and mortgage prices started to fall, the price of the mortgage based securities became volatile and decreased in value. By then, most banks had these securities listed on their balance sheets. The drop in value made these securities worthless and banks were faced with liquidity problems as they were unable to borrow against them. Some went to the extent of becoming insolvent. To prevent the entire system from collapsing, big financial institutions had to be bailed out by the Feds and other governments. Short Term Debt The second reason provided by Diamond and Raghuran (2009) for the financial fragility was the heavy reliance by financial institutions on short term debt capital structures. In good times and periods of low interest rates, short term debt is favored by most institutions as it is cheaper than long term debt. However, as pointed above, a lot of these banks were holding mortgage based securities which were dependant on the value of real estate. Consequently, there was a maturity mismatch as the assets backing the short term debt were long term in nature. Furthermore, during the economic downturn, it was impossible to liquidate property and real estate in the short term. Thus banks were again faced with the risk of illiquidity and potential insolvency. Regulatory Failure and Deregulation The third reason for financial fragility is regulatory failures. There were many regulatory failures that led to the current crisis. For example, there was no strict regulation that existed on the transactions between the banks and other investors when selling the mortgage based securities that proved fragile under stress. These resulted in numerous layered transactions and almost every institution ended up holding these securities, either directly or indirectly, on their balance sheets. In addition, the numerous layers involved in the selling of these securities complicated the supervision process by the regulators. According to Kroszner and Melick (2009), the tools and approaches used for financial regulation prior to the crisis had not evolved along with the changes and sophistication of the financial system. As a result, they proved inadequate. Additionally, other regulatory failures included a decline in credit risk underwriting procedures. Traditionally, the process of offering loans was stricter but with the securitization, it became more relaxed. Furthermore, there was poor oversight by rating agencies on the lending process. In summary, we have observed that the emergence of sophisticated financial instruments coupled with short term debt structures were the key sources of the financial fragility that led to the crisis. This is evident from the way many US banks were moving away from traditional roles of just lending and investing in derivatives like mortgage based securities which they perceived to be more profitable with less strict underwriting procedures. The financial crisis also revealed weaknesses in the original supervisory structures of banks which proved to be inadequate and out of date. Consequently, it generated a need to strengthen the existing framework by tackling existing problems while identifying and preventing possible future threats to the system. 2.The central banks role is to maintain prices and stabilize inflation. According to Bernanke (2009) speech, the central bank (fed) did the following in response to the crisis. Ease monetary policy by cutting down the discount rate- In an effort to improve the economy and reduce inflation, the discount rate was brought down to its lowest rate of 1% over seven months. Provide short-term liquidity to financial institutions that are sound- This allowed institutions to borrow from the bank against the less liquid collateral. By providing liquidity they were reducing systematic risk. Directly provide liquidity to market players in specific credit markets. The aim of providing liquidity was to reduce concerns of rollover risk in cases where a borrower couldnt repay maturing commercial paper. Increase banks portfolio investment in long-term securities- The aim of this is to improve conditions in the mortgage markets by placing a downward pressure on the long term interest rate. 3.Theoretically, financial development should support economic growth as it allows for proper allocation of capital and resources. However, in reality, this may not always be the case as evidenced by the 2008 financial crisis. We observed that financial development came at a cost in terms of volatility. The new sophisticated instruments and multiple layers of transactions made the system vulnerable and fragile to shocks consequently leading to a downward spiral of the economy (Kroszner, 2012). On the other hand it can also be argued that financial development may reduce volatility through risk sharing and diversification. However, this effect may probably be more visible in less developed markets than mature markets like in the west. References Kroszner, R. (2012). Stability, Growth, and Regulatory Reform. Paris: Banque de France. Diamond, D., Raghuran, R. (2009). The Credit Crisis: Conjectures about Causes and Remedies. Cambridge: National Burea of Economics Research. Kroszner, R., Melick, W. (2009). The Response of the Federal Reserve to the Recent Banking and Financial Crisis. Rome: Brugel Institute and the Peterson Institute of International Economics. ernanke, B. (2009, January 13). The Crisis and Policy Response. Retrieved August 5, 2017, from www.federalreserve.gov/newsevent/speech/bernanke20120413a.htm Kroszner, R., Melick, W. (2009). The Response of the Federal Reserve to the Recent Banking and Financial Crisis. Rome: Brugel Institute and the Peterson Institute of International Economic.