The 2008 financial crisis came along with stunning events that exposed financial institutions and other independent agencies to the woes of illusions. The lives of many Americans got destructed by the events of the financial crisis and the questions below will explore the events of the crisis according to Arnold Kling, a renowned economist.
According to Kling, the 2008 financial crisis got fueled by key illusions that got held by participants in the financial market before the occurrence. The renowned financial executives in the United States were overly confident in the existing mathematical models of risk calculation CITATION Arn09 \l 1033 (Kling, 2009). Additionally, the executives mentioned above believed so much in financial engineering and the AAA designation held by the credit rating agencies. Financial executives ignored the pertinent regulatory policies and presented a distorted view of history by asserting that there was a breakdown in the market discipline. Also, financial regulators thought that the dispersal of risk into the shadow banking system would make the financial system safer. Financial regulators were also of the illusion that securitization depicted a superior form of mortgage financing. The mentioned illusions as appertains financial market caused a disruption in the credit markets, and the housing market suffered a great deal.
According to Kling there exists a framework that enlists four elements that vividly define the financial crisis. The four elements of the financial crisis include bad debts, excessive leverage, domino effects, and the 21st-century bank runs. The four elements help in the understanding of how the illusory policies contributed to the financial crisis. Bad debts entail the speculative investments that fueled the housing bubble (Kling, 2009). Excessive leverage indicates how banks and other financial institutions assumed significant risks without keen attention on capital reserves. The Domino effect element entails the connections in the financial system that made it hard for the confinement of the crisis to firms that had only made the bad debts. The Domino effect element elaborates how the healthy financial and investment institutions could suffer as a result of the collateral damage brought about by the actions of the unhealthy institutions.
According to Kling, in the traditional bank run, the depositors that have the interest of accessing and withdrawing money from an uninsured bank may end up finding that the bank lacks the funds when they reach the teller. The depositor, therefore, gets forced to run to the bank for him to be first in line and this explains the traditional bank run. On the contrary, the 21st-Century bank run explains the financial stress that gets created by a situation in which the first creditor that makes an attempt to liquidate its claim gains an advantage over the rest of the creditors. In the event of trouble sign for an uninsured bank, the available contingency measures entail the withdrawal of funds by depositors leading to failure of a bank. Kling gives an example of the AIG Insurance to elaborate the 21st-Century bank run that got caused by credit default swaps (Kling, 2009).
Excessive leverage hugely contributed to the financial crisis by introducing a flaw in the financial institutions. Excessive leverage perverted the nature of capital regulations in the financial market economy. The capital mentioned above regulations received implementation to encourage risk-taking by financial institutions instead of constraining the leverage. The major financial institutions received a go ahead to pile on the mortgage credit risk in the presence of very little capital. The available commercial banks portrayed an off-balance-sheet entity that allowed for the holding of large amounts of mortgage risk with little capital (Kling, 2009). The pile up on mortgage credit risk played a pivotal role in the financial crisis. Failure to appreciate the innovations that came about with excessive leverage by regulators led to the skyrocketing in the financial crisis.
The domino effects and bank runs contributed significantly to the financial crisis and policy makers took extensive measures in the annihilation of the effect. The financial institution fell victim to bad debts and excessive leverage leading the government to raise emergency response measures. The government emergency response aimed at preventing the loss of confidence in correcting the bad equilibrium in financial institutions. The actions of the government in response to the crisis put more emphasis on loss of confidence than on bad decisions as relates to domino effects and bank runs (Kling, 2009).
Kling outlines five policy areas that link to the elements mentioned above of the financial crisis concerning causal relationships. Kling describes the five policy areas as the housing policy, the capital regulation for banks, the competitive boundaries in financial intermediation, response to financial innovation, and finally the monetary policy. Kling assigns weights to each policy area along with the cause, and an order gets created in matrix form explaining the most and the least contributor policy to the financial crisis. Kling believes that Capital regulations entail the most important policy area in causing and explaining the financial crisis. Capital regulations encouraged financial institutions to make bad debts and thereby setting up financial structures that were subject to domino effects. The second most important factor regarding policy areas entail the housing policy because the policy consistently encouraged more home ownership and a subsidized system of mortgage indebtedness. The housing policy hugely contributed to an unsustainable speculative upsurge in the purchase of homes hence the financial crisis (Kling, 2009).
The Obama administration and a majority of individuals believe that the domino effects and bank runs got caused by changes in the financial industry structure, but Kling holds a differing opinion. Kling dissents from the analysis of the shadow banking system that amounted to trillions of dollars due to portfolio investments in banks and off-balance sheet entities. Kling argues that the shadow banking system emerged in response to the capital regulations. The fragility of the financial system offered a reflection of risk allocation created by structured transactions and leverage at individual institutions. Contrary to Obamas administration belief that the financial structure contributed to bank runs and the domino effect, Kling opines that the capital regulations set up the stage for the two elements. Kling believes that the capital regulations skewed the incentives away from the traditional mortgage lending towards securitization. Kling dissents further by the claim that if an alternate history regarding capital regulation that did not favor securitization and off-balance sheet entities got conducted, then shadow banking system could not arise (Kling, 2009).
Kling claims that other than the practices that received development for the regulation of capital arbitrage, financial innovation played a role in the crisis. A majority of financial innovations that emerged in the past forty years did not get implicated in the crisis, and only a few were at the center of the turmoil. The replacement of mortgage credit replaced the human underwriting, and this led to the automation of mortgage application thereby making the processing routine. The mortgage credit scoring changed the approach to credit risk in the market. The scoring approach made it easy for the formerly unqualified borrowers get accommodated for a mortgage at appropriate interest rates. Credit scoring got adopted when there was no major imbalances in the housing markets and the late 20th-century slump in housing led to the shooting of housing prices everywhere. Investors became overly optimistic on the effectiveness of credit scoring thereby leading to the housing crisis. The innovation of the credit default swaps elevated the financial crisis since it acted as a form of insurance against the default of security. The protection of credit default swaps allowed for the selling of mortgage securities to institutions that were reluctant to hold securities. The downfall of AIG insurance that was an insurance seller for billions of dollars of credit default swaps on the presumed safe securities played a major role in the financial crisis. Mortgage credit scoring explains an autonomous innovation that got created for reasons other than regulatory capital arbitrage. The overconfidence in the credit scoring helped fuel the bad debts in mortgage lending (Kling, 2009).
Mortgage interest deduction falls into the category of the policies that encouraged home ownership in the past decade thereby contributing to the housing bubble. The mortgage interest deduction had a great impact when the marginal tax brackets and nominal interest rates escalated than the present rates. According to Kling, the mortgage interest deduction played a little role in the encouraging of the surge in home ownership. A majority of the marginal home buyers had low-income tax rates, and for the home buyers in high tax brackets, the deduction caused a likely increase in the demand for larger and high-quality homes (Kling, 2009). The mortgage interest deduction reduced the incentive for homeowners to pay off or pay down their mortgages.
Mortgage securitization got deemed as the greatest financial innovation and the financial crisis put the blame to the innovation as a creation of financial companies. Mortgage securitization emerged as a by-product of mortgage credit scoring that grew out of financial innovation schemes. Mortgage securitization brought about changes in the approach to the credit risk in the market. The financial innovation of credit scoring facilitated the securitization of mortgages that gave the purchasers of mortgages pools of objective data that got used to measuring the credit risk of underlying mortgages. Mortgage securities received innovation in response to the major imbalances in the housing markets. The rise in the prices of houses is causing regional imbalance caused investors to be overly optimistic on the effectiveness of credit scoring thus mortgage securitization. Securitization allowed for the turning of illiquid assets of the available individual mortgage loans into marketable securities that can easily get bought (Kling, 2009).
The Basel accord came up with a concise definition of bank capital and through that there was the set-up of a minimum risk-based capital adequacy applying to all banks and governments in the world. The Basel accord provided for the measuring of risks as individual assets rather than treating assets as a portfolio.
Financial innovation, regulatory rulings, and legislation include the aspects worked to erode the competitive boundaries in the banking industry. Erosion of competitive boundaries adversely affected the structure of the banking system. The erosion of boundaries led to banks becoming larger and more complex. The Non-bank financial firms became critical to the functioning of the financial system and closely intertwined with banks. The complexity and interconnectedness of the banking system brought about by the erosion of boundaries made the financial system vulnerable to domino effects and bank runs. The interconnected of banks across states caused by the erosion of boundaries made it difficult to confine the financial crisis to the banks that experienced bad bets. The growth of banks meant that the depositors increased and in the wake of the crisis, individual depositors cr...
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