Elements that make innovation possible also increase the possibility of market instability because financial players tend to come up with products that less susceptible to competition but new to investors (Sanchez, 2010). This was the case that preceded the global financial crisis in 2008.Some of the innovations that contributed to the crisis include expanded the role of banks, development of securitization, development of structured investment vehicles, the creation of Collateralized Debt Obligations (CDOs), and Credit Default Swaps(CDS).
Superior role of Banks
The demise of the investment bank model allowed banks to abandon their traditional roles of acting as agents of borrowing and lending. For instance, Dwyer (2011) explains that banks created subsidiaries and bought long term assets that were financed through the issuance of asset-backed commercial papers. These subsidiaries paid reduced interest rates because the credit risks associated with the loans were not transferred to them by mother banks (Acharya, Schnabl, & Suarez, 2013). As a result, a huge appetite for borrowing was created. This trend strained the market liquidity as the housing prices plummeted to record lows in 2007.
Securitization of Loans
Securitizing of loans also played a role in fueling the crisis. Illiquid assets were converted into securities under an opaque process where sellers of the created securities enjoyed the advantage of having information regarding the riskiness of these securities (Acharya, Schnabl, & Suarez, 2013). This information asymmetry meant that investors could not make informed about their investments (Sanchez, 2010; Dwyer, 2011). Since the exchange of this illiquid assets continued without scrutiny (Pinto & Sobreira, 2010), dishonesty became widespread as financial intermediaries rushed to make profits from the housing market boom.
Structured Investment Vehicles
Structured Investment Vehicles (SIVs) are financial instruments that are geared at generating profit from the difference between long-term returns and shorter borrowing rates (Dwyer, 201). These instruments sought to take advantage of the incentive of lower-income ownership launched by the US federal government. This created the risk in the sense that these instruments are not reflected in the balance sheet and, therefore, little information is available to investors (Acharya, Schnabl, & Suarez, 2013; Sanchez, 2010). As a result, excessive risk was absorbed, resulting in liquidity problems when the housing market crashed.
Collateralized Debt Obligations
As indicated earlier, banks created new structures and arrangements in lending and borrowing. In this regard, structured securities such as CDOs were created and backed by subprime mortgage assets. It is worth to note that CDOs do not create risk but aid in spreading risk (Sanchez, 2010, p.26). Before the crisis, insolvency of borrowers occurred, and expectations from the housing boom could not be fulfilled and as such, the overpriced CDOs caused a credit crunch which spread to other sectors of the economy (Dwyer, Tabak, & Vilmunen, 2012).
Credit Default Swaps
Swaps are credit guarantees that seek to eliminate risk in the issuance of bonds/loans. The introduction of CDS made banks to abandon the tradition of including a risk premium on loans and also holding capital to cushion themselves against default risk (Sanchez, 2010). The advent of this instrument led to wanton lending to meet the demand from the housing sector as banks risks were transferred to other players in the new financial structure(Llewellyn, 2008, pp.1-3). When banks do not shoulder the credit risk, they tend to reduce efforts to control credit quality and also mitigate default risks (Sanchez, 2010, p .28; Llewellyn, 2008, pp.2-3). In effect, banks offered highly risky loans which resulted in liquidity problems in the financial sector.
Remedies to Systematic Financial Risks
Tighter regulation on new products can provide the opportunity for the market to experiment the effect of innovated products on efficiency and long-term profitability of the market. It may not be prudent to regulate innovation, but evidence from the 2008 crisis suggests that more regulation in the creation of the new financial products would have averted the crisis. For instance, the CDS were overpriced due to opaque methods of valuation among players (Sanchez, 2010, pp.28-29).In retrospection, a tighter but conducive regulatory framework would have countered risky activities of sellers especially those that were at the heart of the shadow banking system.
Some scholars have proposed structural reforms to banks bookkeeping as another mechanism of circumventing systemic financial risks without necessarily affecting lending (Pazera and Rossi, 2011, p.312). Declaration of these financial innovations on balanced sheet can enhance awareness among investors .The institution of the mentioned mechanism would engender transparency and accountability towards investors (Sanchez, 2010, pp-27-31).A major issue with the new financial instruments is that they were new to investors. But the lack of transparency especially in the exposure of information regarding instruments such as SIVs means that dealers in these products mainly focused on short-term profits at the expense of the investors interests. Ideally, the presence of accurate information to investors would have affected investors confidence which, in turn, would have resulted in more responsible lending. The situation was aggravated by the complexity of the new securities in terms of creation and trading. According to Pazera and Rossi, revision of banks booking would enhance market discipline as it would control wasteful appetite for credit risks (2011, p.312).
Acharya, V. V., Schnabl, P., & Suarez, G. (2013). Securitization without risk transfer. Journal of Financial Economics, 107(3), 515-536. doi:10.1016/j.jfineco.2012.09.004
Dwyer, G. P. (2011). Financial Innovation and the Financial Crisis of 2007-2008. Federal Reserve Bank of Atlanta University of Carlos III, Madrid and CAMA.
Dwyer, G. P., Tabak, B. M., & Vilmunen, J. (2012). The financial crisis of 2008, credit markets and effects on developed and emerging economies. Journal of Financial Stability, 8(3), 135-137. doi:10.1016/j.jfs.2012.03.001
Llewellyn, D. T. (2008). Financial innovation and a new economics of banking: Lessons from the financial crisis. Financial Innovation in Retail and Corporate Banking, 1-38. doi:10.4337/9781848447189.00007http://frank-oertel-math.de/Financial_crisis_and_new_economics_of_banking_Aug_2009.pdf
Pinto, F., & Sobreira, R. (2010). Financial innovations, crises and regulation: some assessments. Journal of Innovation Economics, 6(2), 9. doi:10.3917/jie.006.0009
Sanchez, M. (2010). Financial Innovation and the Global Crisis. International Journal of Business and Management, 5(11). doi:10.5539/ijbm.v5n11p26
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