A financial crisis is underway and the situation is dramatic. The crisis has long since reached the financial markets and the real economy in many countries. Explanations of why there has been a crisis vary, and different factors are emphasized differently. Then it is no wonder that the measures also receive varying support. In this issue of Where does it happen ?, which is a continuation of No. 21, A financial crisis in the making, we try to highlight a broad set of explanatory factors. Hopefully, it will be able to inspire readers to more in-depth information gathering.
- How can the crisis be explained?
- What could be the effects of the crisis?
- What measures is the crisis facing?
- How can the crisis affect big politics?
2: Overestimated financial innovations
According to besteducationschools, both lenders and investors as well as public opinion have difficulty understanding the scope of technological innovations. In retrospect, we can say that they have all shown a tendency to overreact and overestimate the effect of innovations.
Significant increases in the price of securities have often coincided with the emergence of a widespread idea that we are moving into a “new era” where the importance of a new technology is being praised . Reference to a new era is then used to justify and be able to claim that traditional ways of valuing and credit rating are outdated.
Many would say that over the last ten years, progress has been made (better value hedging, increased predictability) in the ability to manage financial risk. The question is, however, whether the importance of these new financial instruments has been overestimated. Has confidence in the rise of the internet, newer computer and information technology and online business models been too great? However, have the players not assessed the risk well enough?
Among other things, the then Governor of the United States, Allan Greenspan , stated in 2005 that the banking and finance sector had been “fundamentally changed by advances in information technology.” This enabled the lenders to “very effectively assess the risk of each individual loan application”. It was pointed out in 2007 that the rapid increase in lending to low-credit households was largely driven by lenders’ “widespread use of statistical assessment models”. In retrospect, it may seem that the enthusiasm for new technology and the belief that we had entered a “new era” was exaggerated.
The same Greenspan stated in 2008 that “he was wrong when he consistently opposed the regulation of a certain type of financial instruments (derivatives)”. He also said he was shocked by “the serious shortcomings of the free market that the financial crisis has revealed”. At the same time, it was Greenspan that set the extremely low interest rate in the US in the years after the so-called dotcom bubble in 2000–2001.
If it were the case that many banks due. Newer technology and better models thought they were better able to assess risk than posterity has shown they were and are, they also provided some loans with greater risk than they should have done. Too easy access to credit seems to have largely contributed to the price of real estate, housing and securities rising sharply during the period.
3: Several explanatory factors
In addition to the already mentioned: risk diversification, subprime, excessive confidence in new technology and new instruments, and opaque and complex financial tools are also a set of other explanatory factors that recur in the exchange of words about the financial crisis:
- The reward systems in parts of the financial industry have had too short a time horizon (next quarter or year) and have thus invited excessive sales activity and risk-taking. Bonus and option schemes with a short time horizon provided strong incentives to “trade” and take risks. If you make many millions now, it does not matter much if you are fired in the next round for misinvestment or circumvention of regulations. Some top managers had an annual income of up to NOK 500 million.
- Excessively favorable bonus schemes have fueled the greed of some players – both in top management and among brokers.
- Deregulation – less regulation and supervision, a belief that the market had the ability to self-regulate and market discipline – an ability that can be questioned in retrospect. When the banks were also free to lend many times their equity and their reserves, it gave an extra boost to the bubble spiral.
- The increasing complexity of the new financial instruments – derivatives , hedges, – helped to make the risk more difficult for investors to understand. The meaning of derivatives was i.a. to reduce the risk of future sales (for example of raw materials or other) or value development (a currency). It could be a farmer’s sale of a grain crop or an export company’s desire to predict the ratio between the krone and the dollar half a year into the future.
In recent decades, sales of various derivatives have grown to many times the world’s total gross domestic product. This includes not only the players’ desire for predictability and risk diversification, but also speculation and greed. In any case, some derivatives – especially so-called credit derivatives – have contributed to making the markets more confusing . Some believe that there is a huge bubble here, separate from the subprime loans, but also as an amplifier of the financial crisis. One of the richest people in the world, Warren Buffet, has referred to derivatives as “financial weapons of mass destruction”.
- Some would say that the often confusing company structure helped to reduce transparency and the opportunities for access to accounts for investors, supervisory authorities and others. The organization of companies in a number of sub-companies makes it – together with cross-ownership – difficult to get an overview of how “healthy” an investment object – a company or a company – really is.
- Increased impenetrability – accounts and annual reports became difficult to oversee. 75% of all hedge funds had addresses in tax havens.
- Shadow banking systems – in addition to the regular banking system, car salesmen, bartenders, etc. could run lending activities. More importantly, several banks established subsidiaries in tax havens. Among other things, they got away from the home country’s authorities, supervision and requirements for self-coverage when lending.
- Several believe that the so-called rating agencies (valuation agencies ) – which specialize in assessing the risk associated with banks, investment objects and securities – occasionally underestimated this. Objects were therefore perceived as far less risky than they actually were. In the exchange of words, questions have been raised about how agencies could have the highest valuation (AAA) – ie high creditworthiness – just before a company went bankrupt (including Lehman). Criticism for mixing roles and conflicts of interest – difficult to give a downgrade to someone who pays you for valuation – is part of the exchange.
The emphasis on the various explanatory factors will vary between researchers and between other analysts. With different emphasis, the medication – the measures – can easily split, possibly only be able to gather around a minimum common multiple. Regardless: In order to restore confidence and counteract negative real economic effects, the authorities in many countries are now trying to contribute with various measures – both national and international cooperation.