The Financial Crisis Flashcards
What are the objectives of financial regulation?
- maintain confidence in the financial system
- financial stability
- consumer protection
What is the rationale for bank regulation?
- banks have a pivotal position in the financial system
- potential systemic dangers of bank runs
- adverse selection and moral hazard risk
What are the main systems of financial regulation in the UK?
- Prudential Regulatory Authority (PRA)= monitors the financial stability of financial institutions
- Financial Policy Committee (FPC)= intervenes to ensure liquidity in the banking system
- Financial Conduct Authority (FCA)= ‘financial watchdog’ regulates firms providing financial services to consumers
What is financial innovation?
Act of creating new financial instruments, technologies, institutions and markets (e.g. hedge funds, private equity).
- product innovation (credit cards)
- Process innovation (payment systems)
- Organisational innovation (product specialist’s)
Why is financial innovation needed?
- Fill gaps in products and services
- Reduce market frictions
- Make financial services more useful, accessible and efficient
What are the advantages of financial innovation?
- Creation of new securities, markets and institutions
- Helps economic growth
What are the disadvantages of financial innovation?
- Can amplify economic cycles
- Can increase debt
- High costs
- Systemic risk
What is systemic risk?
When the failure of one institution has repercussions on others, threatening the stability of whole financial markets.
How did new methods of securitisation and collateralised debt obligations contribute to the financial crisis?
Securitisation led to new securities like mortgage backed securities and collateralised debt which made lending on the subprime market possible. The increased supply of loans to subprime lenders increased systemic risk.
How did structured investment vehicles contribute to the financial crisis?
A pool that borrows money in the short term and invests it in long term securities. This allowed money to be borrowed and invested into mortgage backed securities and collateralised debt obligations- fuelling demand for these securities. Its risk was hidden from the public.
How did the development of credit default swaps contribute to the financial crisis?
Credit default swaps are instruments that allow the swapping of one cash flow for another. It gave investors who had purchased mortgage backed securities and collateralised debt obligations insurance against default. It was not regulated.
In general, how did financial innovation contribute to the financial crisis?
Financial innovation (securitisation, collateralised debt obligations, structured investment vehicles, credit default swaps) fuelled the asset bubble, hid the risks and failed to insure people against the risks.
What is a financial crisis?
Major disruption in financial markers characterised by a sharp decline in asset prices and the failures of many financial and non financial firms. It disrupts the normal functioning of the economy.
What were the main causes of the 2008 financial crisis?
- Financial innovations in mortgage markets
- Agency problems in mortgage markets
- Asymmetric information in credit rating agencies
What was the impact of the 2008 crisis?
- Impact on residential house prices
- Deterioration of the balance sheets of financial institutions
- Decline in global financial markets
- Failure of high profile firms