Causes of Financial Crisis 2008

The financial crisis has raised many issues relating to the regulation of the financial system and what needs to be done to prevent recurrences of asset bubbles.

(a) Consider what may have been major causes of the financial crisis, explaining the way in which each of them may have contributed; (17 marks)

The current financial crisis originated with a liquidity crunch in the United States is caused by (1) the global macro policies affecting liquidity, (2) the financial market factors and (3) the poor regulatory system and (4) the inherent systemic risks.

(1) The global macroeconomic factors

1. The excessively low interest rates in major economies including US and Japan,

2. The flood-in of foreign capital to the US finance market;

3. The accumulation of foreign funds due to huge trade deficit as a result of currency manipulation and the high oil price.

(2) The financial market factors

1. The origination and distribution of the new financial products, including MBS, CDO and CDS, is in such a fashion that passing all the risks to the next group down the line.

2. The excessive off balance-sheet financing;

3. The increasing financial sector concentration that the failure of just one of the big firms would pose a systemic risk.

4. The inaccurate credit rating by the rating agencies;

5. Inadequate quantitative methods to evaluate the new products;

6. The poor due diligence process and the weak underwriting standards,

(3) The poor regulatory system

1. The regulatory framework failed to keep up with trends in finance;

2. The over-reliance on the self-regulatory virtues of markets

3. The failure to regulate the shadow banking system

(4) The systemic risk

1. The conflict of interest among market participants;

2. The inadequate incentive structures and compensation schemes in the industry that encouraged the excessive risk-taking;

(b) The purpose of capital is to protect against unexpected loss; consider the conflict between high levels of...