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To start with, the need and sole contributor to financial sector development revolves
around financial crisis. The term financial crisis is implied broadly to a variety of
situations in which some financial institutions or assets suddenly lose a large part of
their values. Financial crises have been an unfortunate part of the industry since its
beginnings. Bankers and financiers readily admit that in business so large, so global
and so complex, it is naive to think such events can ever be avoided.
A brief look at a number of financial crises over the last 30 years suggests a high degree
of commonality: excessive exuberance, poor regulatory oversight, dodgy accounting,
herd mentalities and, in many cases a sense of infallibility. William Rhodes has been
involved in the industry for more than 50 years and has lived through nearly every
modern-day financial crisis, many of which are detailed in his book, Banker to the
world. As he puts it, there is a common theme of countries and markets wanting to
believe that they are different and that they as not as connected to the rest of the
worlds economy. In his view, many aspects of the Latin American debt crisis of 1982
have been repeated a number of times and there is much from this crisis which we can
apply to what is currently in Europe, Africa and beyond.
This crisis developed when Latin American countries, which had been gorging on
cheap foreign debts for years, suddenly realised they could not repay it. The main
culprits, Mexico, Brazil and Argentina, borrowed money for development and
infrastructure programmes. Their economies were booming, and banks were happy to
provide loans to the point where Latin American debt quadrupled in seven years.
When the worlds economy went into recession 1970s the problem compounded itself.
Interest rate on bond payments rose while Latin America currencies plummeted. The
crisis officially kicked off in august, 1982 when Mexicos finance minister Jesus Silva-
Herzog said the country could not pay its bills. Rhodes recalls it as a tense period, but
says that strong political leadership enable them to get through the crisis. He laments,
however, that the lessons of the crisis werent heeded.
While the solution to the Latin American crisis was being put together, a domestic one
was happening right in front of the United States regulators. The so-called savings and
loans took place throughout the 1980s and even into the early 1990s when more than
700 savings and loan associations in the US went bust. These institutions were lending
long term at fixed rate using short term money. As interest rate rose, many became
insolvent. But thanks to a steady stream of deregulation under President Ronald
Reagan, many firms were able to use accounting gimmicks to make them appear
solvent. In a sense, many of them resembled Ponzi schemes. The government
regulated with a set of regulations called the Financial Institutions Reform, Recovery
and Enforcement Act of 1989. While the act tightened the rules on S&Ls, it also gave
Freddie Mac and Fannie Mae more responsibility for supporting mortgages for lower-
income individuals.
And other crises like: Junk Bond Crash-1989, Tequila Crisis-1994, Asia Crisis-1997/98
and Dotcom Bubble-1999 to 2000 etc.
To crown it all, below are few highlighted types and causes and consequences of
financial crises:
In the 1970s, the United States position as the unchallenged colossus of the capitalist
world was suddenly threatened from multiple directions: rising international
competition, spiking energy prices, declining productivity and profitability, and soaring
In East Asia, the major countries liberalized in the 1980s, though at different times
and to different degrees. For example, Indonesia, which had liberalized capital flows in
1970, liberalized interest rates in 1984, but the Republic of Korea did not liberalize
interest rates formally until 1992. Low inflation generally kept East Asian interest rates
reasonable in real terms, however. In most countries, connected lending within
industrial-financial conglomerates and government pressures on credit allocation
remained important.
In the transition economies, financial liberalization took place fairly rapidly in the
1990s in the context of the reaction against communism (Bokros, Fleming, and Votava
2001; Sheriff, Borish, and Gross 2003).
The earliest policy changes generally focused on interest rates. In many instances
governments raised interest rates with a stroke of the pen to mobilize more of the
resources needed to finance budget deficits and to enable the private sector to play a
greater role in development. (Some interest rate increases, designed to curb capital
flight, were intended more for stabilization than for liberalization.) New financial
instruments were introduced that had freer rates and were subject to lower directed
credit requirements.
In response to the reduction of such financial crises and risks managers of financial
institutions became more alert to financial innovations by the introduction of new
financial instruments to better control and manage the risks and crises they faced.
Mishkin (2006) is even more adamant that derivatives are new financial instruments
that were invented in the 1970s. He suggests that an increase in the volatility of
financial markets created a demand for hedging instruments that were used by
financial institutions to manage risk.
Does he really believe that financial markets were insufficiently volatile to warrant
derivative trading before the 1970s?
Starting in the 1970s and increasingly in the 1980s and 90s, the world became a riskier
place for the financial institutions described in this part of the book. Swings in interest
rates widened, and the bond and stock markets went through some episodes of
increased volatility. As a result of these developments, managers of financial
institutions became more concerned with reducing the risk their institutions faced.
Given the greater demand for risk reduction, the process of financial innovation
described in Chapter 9 came to the rescue by producing new financial instruments
that helped financial institution managers manage risk better. These instruments,
called derivatives, have payoffs that are linked to previously issued securities and are
extremely useful risk reduction tools." (Mishkin, 2006, p. 309)
The widespread ignorance concerning the history of derivatives is explained by a
dearth of research on the history of derivative trading. Even economic historians are
not well informed about the long history of derivative markets. A review of three
leading economic history journals - the Journal of Economic History, the Economic
History Review and the European Review of Economic History - has yielded not a single
article after 1990 with a title that would indicate that it deals with some aspect of the
history of derivative securities. Similarly, the Oxford Encyclopaedia of Economic
History (2003) gives short shrift to derivative markets; it includes an entry on
commodity futures in the United States in the nineteenth century and options are
The history of derivatives has remained unexplored because there are few historical
records of derivative dealings. Derivatives left no paper trail because they are private
agreements that have been traded in over-the-counter markets for most of their
history. Even today, the international commodity and financial markets, which have
always been a primary focus of derivative dealings, remain beyond the reach of
national statistical offices. Another reason why historical records of derivatives are
scant is conceptual. A forward contract has no market value when it is set up,
although its notional value may be large. Thus, how should a forward contract be
recorded when it is set up? There is naturally no point in recording a zero value. This
problem is even more acute with futures contracts whose market value does not
deviate much from zero during their entire life. At the end of each day, the value of a
futures contract is set back to zero by crediting or debiting the daily change in value to
a margin account. The Triennial Central Bank Survey of the Bank for International
Settlements, which was first published in 1989, for the first time addressed the
conceptual and practical difficulties of recording derivative dealings in international
over-the-counter markets.
Financial derivatives
These are financial instruments that are linked to a specific financial instrument or
indicator or commodity, and through which specific financial risks can be traded in
financial markets in their own right. Transactions in financial derivatives should be
treated as separate transactions rather than as integral parts of the value of underlying
transactions to which they may be linked. The value of a financial derivative derives
from the price of an underlying item, such as an asset or index. Unlike debt
instruments, no principal amount is advanced to be repaid and no investment income
accrues. Financial derivatives are used for a number of purposes including risk
management, hedging, arbitrage between markets, and speculation.
The most vital financial instruments that managers of financial institutions normally
used in their various markets to minimize such risk include:
1. Forward contracts
2. Financial options
3. Financial swaps contract
4. Financial future contract
1. FORWARD CONTRACTS:
A forward contract is an unconditional financial contract that represents an obligation
for settlement on a specified date. At the inception of the contract, risk exposures of
equal market value are exchanged. Both parties are potential debtors, but a
2. FINANCIAL OPTIONS:
Advantages of swaps
Parties with informational advantages who to eliminate interest rate risk may
suffer loss of information advantages
It involves a substantial transaction cost when balance sheets are rearranged
Disadvantages of swaps
References:
o Financial Derivatives
Prepared by Statistics Department International Monetary Fund (IMF)
o Mishkin Fredrick S. (2000) The Ec0n0mics of money, Banking and Financial
Markets
6th Edition updated.
Addison Wesley, World student services.
o A short history of Derivative Security Markets
By Ernst Juerg Weber
The University of Western Australia
o Google engine