What are the key illusions held by financial market participants that led to the financial crisis?
Among key illusions that caused the financial crisis, one can note that the participants in the financial market were excessively confident in mathematical models of risk along with financial engineering, relying on credit rating agencies and the regulatory community.
What are the four elements of the financial crisis?
According to Kling (2009), bad bets, domino effects, excessive leverage, and 21st-century bank runs are the four elements of the financial crisis.
Compare and contrast the traditional bank run with Kling’s “21st century bank runs”.
A traditional bank run assumes that depositors are waiting to withdraw their funds from an uninsured bank can encounter the bank’s default because the bank can be out of funds. In its turn, Kling’s “21st-century bank runs” supposes that the first creditor attempting to liquidate his or her assets has an advantage over those who wait.
Excessive leverage led to what feature (flaw) of large financial institutions?
Excessive leverage led to declines in asset values that made the large financial institutions unable to sustain the value of mortgage-backed securities.
What did the government emergency response attempt to prevent?
The government emergency response aims at preventing unprecedented financial bailouts, in particular, at forestalling bank runs along with domino effects.
What are the five policy areas and which one does Kling believe is most important in explaining the crisis? Which is second most important?
The five policy areas explaining the causal factors of the financial crisis include housing policy, capital regulation for banks, industry structure and competition, autonomous financial innovation, and monetary policy. From the matrix presented by Kling (2009), it becomes evident that the first important factor is capital regulations, while the second is financial innovation making banking more resilient.
Many, including the Obama administration, argue that the financial industry’s structure is to blame for the domino effect and bank runs part of the crisis. Why and how does Kling dissent from this opinion?
Kling (2009) dissents from the opinion that the domino effect and bank runs are caused by the financial industry’s structure because the author considers that the phenomenon of “shadow banking,” resulting from the two factors mentioned above, is caused by capital regulations. He claims that in case capital regulations prevented securitization and off-balance-sheet financing, there would be no “shadow banking” and subsequent crisis.
What financial innovation underlies much of the issues that led to crisis?
Financial innovation is a significant reason that led to the financial crisis. It focuses on money market funds and mortgage securitization that impact customers’ deposits as well as their mortgages. In the context of automation, mortgage credit scoring was implemented to replace traditional handwriting. The private-label mortgage securities according to which the private investors restrained the credit risk were initiated. Among other innovations, structured finance, off-balance-sheet entities, and credit default swaps may be noted.
According to Kling what did the mortgage interest deduction do and what did it not do?
Kling (2009) states that mortgage interest deduction is one of the policies that encouraged homeownership in the last decade, making the mortgage more affordable. At this point, consumers with low-income tax rates were marginal home buyers while buyers with higher tax rates experienced an increased demand for larger homes. However, home mortgage interest deduction did not include personal loans.
Was mortgage securitization and organic development (private innovation) or was it a by-product of policy decisions? Briefly explain the cause. (i.e. to what was securitization a response to?)
Mortgage securitization, an advanced form of mortgage finance, was a response to domino effects and bank runs caused by capital regulations. Therefore, the author believes that securitization is a by-product of policy decision rather than a private innovation. Nevertheless, in spite of this measure that was initiated to weaken the financial crisis, mortgage securities became the “toxic assets” with exotic initials.
As succinctly as possible (one sentence if you can) explain how the Basel accord changed the risk nature of banks.
The Basel Accord is a set of regulations that changed the risk nature of banks by making an agreement on standard rates of venture capital adequacy ratio for commercial banks.
What did the erosion of competitive boundaries in banking do to the nature of banks? Which two parts of the “four effects” did this impact and how?
The nature of the banks is rather sensitive to the erosion of competitive boundaries in banking. The policymakers believed that it would enhance the competitiveness that, in turn, would benefit consumers. Primarily, the structure of banks became larger and more complex. The non-bank organizations became interconnected with the banks that, in combination with complexity, made the banks more prone to domino effects and bank runs.
Furthermore, erosion of competitive boundaries in banking makes it more challenging to maintain the sustainability of the banks. However, the positive effect of this phenomenon is that it is likely to lead to soundness and security. In any case, the regulators have to encounter the following dilemma: on the one hand, “shadow banking” can grow if regulators would restrict expansion in previously forbidden areas; on the other hand, supervisors can experience the lack of necessary skills to assess the risk effectively.
Kling argues that it may be the case that financial institutions are naturally prone to instability. What features cause this?
Financial institutions are inherently exposed to instability due to waves of euphoria and pessimism. It is caused by their high vulnerability to domino effects and bank runs. In order to understand the volatile nature of financial institutions, it appears appropriate to compare financial and non-financial sectors. In particular, the latter prioritizes short-term and riskless assets while the first one focuses on long-term and risky liabilities. This explains the natural vulnerability of financial institutions to instability.
According to Kling, better policy may be to make a system that is easier to fix (I.e. the fall out of financial crisis is less.) How does he recommend we achieve this? (Hint. Two things.)
Kling (2009) recommends achieving a system that is easier to fix by the implementation of equity financing instead of higher leverage in the context of the financial policy. Another way to provide an easier system is likely to come as a result of creating small institutions with weakly correlated risk rates. It goes without saying that it is easier to identify weakly correlated risk rather than annual risks.
According to Kling, what are the most useful steps regulators could take to prevent crisis in the future?
The regulators can take the following steps to prevent the financial crisis in the future: reconsider mortgage interest deduction and divert policy away from debt finance.
Reference
Kling, A. (2009). Not what they had in mind: A history of policies that produced the finanicial crisis of 2008. Arlington, VA: Mercatus Center.