Things that increase the risk of a financial crisis Flashcards
Overoptimism
believing asset prices will continue to rise
banks do have departments that assess their risk, but they sometimes fail to realise how risky some practices are
MBS
mortgage backed securities
these are several mortgages bundled together, shares of which get sold
this was popular because it gave the illusion of diversification (if one household can’t pay, the others will keep paying)
but people thought it was safer than it was and it wasn’t true diversification because a shock affecting the housing market affected all of the houses involved
credit rating agencies
these are agencies that assess how risky assets are for investors
they gave unreasonably high ratings to mortgage backed securities (because they were perceived to be safe)
change in models for banks that are the “originators” of debts
shift from “originate and hold” to “originate and distribute”
in the past, banks would screen and monitor with rigour
however, nowadays banks are more relaxed when it comes to screening because they are likely to sell debts on and so the likelihood of a borrower defaulting is no longer the bank’s concern. With this model, banks don’t even bother with monitoring at all
asymmetric risks
bankers get huge bonuses when they perform well at work and no negative impacts when they perform poorly
this makes them less likely to be cautious
implicit bailout guarantees
governments are willing to bail out banks in order to prevent them from causing problems with the economy
this is particularly true for large banks
but large banks may therefore feel that they’re “too big to fail” and behave recklessly
Culture
short-termism: there is more of a focus on short-term risks and rewards than long term ones
banks are also trying to grow (and merge) as much as possible, so that they become “too big to fail”. But when banks become too big, it’s difficult for CEOs to control what they do
