Financial Institutions

Home Assignment

BY
ADEEL AHMED KHAN
CIIT/DDP-SP11-BBA-001/LHR

Q1.
How can financial innovations lead to financial crisis? Explain specifically the
role of securitization of the mortgage market.
Financial crises are considered to be a major disruption in the financial markets.
Financial crises often results in sharp declines in the prices of the assets and also
leads towards failures of many financial and non-financial organizations. When we
talk about financial innovation we often refer to the advancements and emergence of
new techniques that take place in the financial market. Study suggests that financial
liberalization often leads towards financial innovation and thus creates an
environment that is less controlled by restrictions. This elimination of restrictions also
means lower level of monitoring on investments taking place in a financial market.
This also means that the financial intermediaries and other parties are now in a
position where they can take drastic steps to get hold of the major chunk of the
investments available in the market. Though innovation in financial markets is
considered to be a positive thing but studies suggest that certain innovations have
resulted in emergence of complex financial instruments and issues like adverse
selection and moral hazard problems. These complex financial instruments have led
towards credit expansion which has resulted in financial crises.
Securitization is one of the processes that also emerged due to the innovation in the
financial markets. In simple terms it is the process of creating securities by pooling
together various cash-flow producing financial assets. Securitization is termed by
many as the main cause of the recent financial crises that hit U.S. Securitization in
the mortgage markets unrestricted by any government regulations motivated the
banks and other involved intermediaries to make riskier investments and to use the
securities for earning more and more. This all landed them ultimately in a situation
where they were unable to recover the loans. The crises that was actually built by
financial innovation like securitization was actually a result of an ineffective role
played by the government, the rating and other monitoring agencies and most
importantly by the investment banks and other intermediaries. All of these parties
failed to realize the downside of the actions that were taking place in the name of
greater financial liberalization and the ultimate result was the bust in the housing
market and the downfall of the financial market.
Q.2.
How were adverse selection and moral hazard contributing factors in this
crisis?
In case of the recent financial crisis, moral hazard and adverse selection issues
raised due to various factors that lead towards poor investment decisions and thus
resulting in a financial crisis. One of the reasons for possibilities of adverse selection
and moral hazard was the conflicting role played by the rating agencies that made

them to issue good ratings even when the reality was otherwise. These rating
agencies apart from playing the role of credit rating also advised financial
intermediaries on making financial decisions. This all encouraged them to issue
misleading ratings and thus was the cause of wrong financial decisions made by
investing entities. Similarly greater liberalization of the financial markets also meant
that the government was not keeping its close check on the activities of the financial
market and this all also allowed the intermediaries and financial institutions to issue
misleading information that often resulted in adverse selection and moral hazard
problem. However the real reason that leads to adverse selection and moral hazard
problems was the practices and new investment techniques that involved a third
party investment situation. In such situations banks opted to go for riskier
investments while at the same time introduced practices like securitization. This
created a situation where lenders and investors were less aware about the
borrowers and this lack of awareness or lack of information lead to the situation what
possibly caused the problems of adverse selection and moral hazards.
Q.3.
Did the unprecedented level of government intervention in the economy
prevent an even more severe economic downturn than what actually
occurred? Is this affecting a moral hazard problem in the future?
In order to counter the effects of great recession the government took drastic steps
and many are of the view that this government intervention avoided what could have
been a more severe economic downturn. The U.S. government took steps to expand
the money supplies and to avoid the risk of deflationary spiral. Further the U.S.
Federal Reserves revised liquidity facilities allowed the central bank to fulfil its
lender of last resort role in a more effective way and similarly largest liquidity
injection into the credit market in the history was introduced during this time.
Similarly government took various other steps that allowed it to control the effects of
financial crisis. However there is a counterargument to this intervention of the
government. Few analysts are of the view that the involvement of the government
allows the financial market entities to take riskier investments as they know that
government will be there to save them if they land themselves in a situation of crisis.
This often results in careless investment decisions and can thus result in a situation
of moral hazard. Therefore it is advised that government should enter only when
there is no other solution for survival and in other cases the government should work
for avoiding any possibilities that can lead towards a situation of crisis.

Q.4.
What will be the long-term impact of the governments intervention,
particularly the ballooning of the national debt?
The intervention by the government has resulted in lowering the impact of the
financial crisis on the economy of the country. This will allow the U.S. economy to
return to its normal position in due course of time. However one aspect of this
intervention can be that the intermediaries and the parties involved can continue to
invest in riskier investments with a belief of getting saved by the government unless
stricter checks and regulations are not introduced. However the real negative impact
that has already been exposed and is expected to make negative impact on the
economy is the ballooning of the national debt. The injecting of greater money
supplies by the government has been done at the cost of incurring greater debts on
the country this means that today the debt on the U.S. government has increased
into several trillions of dollars partially due to the preventive measures that it took to
counter the impact of the financial crisis. If this situation is not controlled, than this
can result in another financial turmoil for the economy.