Reasons for the Financial Markets Existence Finance Essay

The statement in question is also one of the features and probably a very important function of the global financial system. If the system aligns the need of the deficit unit with the surplus, then the systemic failings of global magnitude are presumed to be “unlikely”. This is probably why there are certain methodologies of operations adopted in the system which would holds the statement true and would help prevent any unforeseen event. However, the past decade has proven otherwise. It has challenged all assumptions and brought about a change in the system which would have never been imagined. The recent financial crisis has taught many lessons which have been transformed into thousands of books offering different explanations to one simple question, what went wrong? There are two distinct groups in an economy.

Firstly, the one who have surplus funds more than their expenditure and the other whose expenditure are more than their sources of income. The former are known as surplus agents while the latter as deficit agents. These two groups are critical factors in an economy. The surplus agents comprises of firms and individuals whose motive to save funds is to meet future needs or come out best during any unforeseen circumstance. Even the investment decisions made by the surplus agents would be in a product which provides them a suitable combination of liquidity, returns and protection again inflation (Pilbeam, 2005). On the other hand, Deficit agents comprises of individuals, firms, government agencies whose motive for borrowing funds are diverse and wide.

The investment made by the deficit agents takes a longer time to yield profits for the firm hence they require long term funding for their investments. The investments made by deficit agents are particularly risky hence, many firms are keen to raise finance through the means of equity whereby shares are offered to the public for subscription and the return to the holders of the equity depends upon the profitability of the firm.

Individuals borrow to fund expenses which are above their current sources of income. The need of deficit agents is met by the surplus agents through financial intermediaries. The primary role of the financial intermediaries is to assist in transfer of funds from the surplus agents to the deficit agents. During the process of transfer there are several economic functions that the intermediary undertakes (Pilbeam, 2005). Transformation of Risk A financial intermediary pools together the funds from the surplus agents and allocates them to deficit agents. Effective risk reduction and cost effectiveness is achieved when the process is carried through a financial intermediary. Provisioning Liquidity High degree of liquidity if required by the surplus agents.

Provisioning of liquidity is one of the important functions carried out by the intermediary. Provisioning the mechanism of making payments Financial intermediaries like bank and non bank financial intermediaries facilitate transfer of cash between the agents. Effectiveness of the payment systems is important for the sound health of the modern economy. Maturity transformation A financial intermediary like a commercial bank would be involved in converting short term liabilities into long term loans for deficit agents from surplus agents. Diversifying the fund allocate reduces risks and allows predictability of inflow and outflow of funds. Reducing costs Surplus agents lack adequate resources to look for deficit agents and analyse their financial history. Entering into contractual obligations can cause considerable economies on scale for the surplus agents. Hence, they look upto the financial intermediary who have the specialized knowledge and skill to serve the surplus agents.

Mishkin and Eakins (2006) discuss that financial intermediaries can substantially reduce transaction costs that can be defined as the time and money spent in performing financial transactions for instance the exchange of assets, goods or services. For the sound functioning of the modern economy, Financial Intermediaries play a very important role. Through the medium of the intermediary, transfer process is carried out in cost effective and a secured manner. Though with the advent of modern technology, the benefit of cost saving that an intermediary provides has become redundant, it’s still the market expertise and knowledge base that make the role of a financial intermediary ever so important. The recent financial crisis which was termed which was probably the worst crisis since the great depression bought out several weaknesses in the financial systems that existed. Even though, there were early warning signs, the savings and loan disaster which resulted in over one thousand banks failing due to bad economic policies.

After which the dot com bubble which bought out just how irrational investments by the financial institutions can cost dear. During the year 1998, a company called Long Term Capital Management which had equity of just $5billion; borrowed over $125 billion demonstrating how one fund can put an entire financial system at risk. Is it right to blame the financial intermediaries or the regulators or the government for the mess that had a propelling effect all over the world? During the meeting in 2004 between the regulators, Security Exchange Commission in the US and five major investment banks, a demand was made from the banks to gain exemption from the limitation on debt that they could have on their balance sheet, this demand was then accepted which resulted in investment in a riskier investment called the credit default swaps or CDS. Companies took on huge amount of debt. Bear Stearns had a leverage ratio of 1:34 (Kolb, 2010) which meant that it held $1 equity for every $34 of the debt. The mortgage industry was eventually not under the control of the fed and allowed borrowing to individuals with little money. The term coined for this kind of arrangement was “NINJA” loans (No Income, No Jobs or Assets). CDS was introduced initially to insure investors against bind risk but then it became a speculative instrument which became “Toxic” on the balance sheets of all major banks which were caught in the financial turmoil. Insurance was bought and sold for a fraction of an amount by the investors like the hedge funds only for speculative purposes.

Insurance contracts were sold by banks and reported as income while there did not exist any regulatory oversight for the risk which was been taken by the banks. The risky activity of the bank bought about a southward pressure on the CDS while affected its pricing.

When the prices of the CDS went own, hedge funds bought it at a cheaper rate one word which could describe the financial crisis in “Paradox” (Marthinsen, 2010). The trigger for the crisis was the subprime mortgage defaults. This was because funds were given to borrowers who were not creditworthy and had high probability of default. Low interest rates and huge inflows of funds into the country made it easy for the borrowers to borrow and lenders to lend. When more people borrowed money to buy houses, the demand of property increased. As mortgage was given against the property and there was increase in property prices, agents were asked to find potential buyers so that more money can be disbursed.

Loans were given to people who had high probability of default and were deemed as “Sub Prime Loans”. Greed at this period of time had spread like wildfire. Since the prices of homes continued to increase, many homeowners refinanced their debt by taking on new debts (Refinance their house) with lower interest rates and attractive conditions even when they knew interest rates might rise after an initial period. However, the bubble bursts as the inventory of house were just too many and this eventually led to decline in the property prices. Homeowners were unable to refinance and began defaulting on their loans which were reset to high interest rates and payment amounts. Homes were worth less then their mortgages. This led to foreclosures.

This further reduced the prices of the property and real estate market in America went down. This was just not the local problem of United States. Had this process remained between lenders and borrowers then it would have been a local problem. Sub Prime lending was a very lucrative business as interest earned on loans made under this category gave 2% interest higher than normal loans would and in the event borrower default then the lender could on the assumption sell the property at higher rate.

The stock markets were booming and there was enough liquidity in the system to attract investors as this business model was lucrative and it seemed that nothing could go wrong with this. Big American and European investment banks and institutions heavily bought these loans called as Mortgage Backed Securities (MBS). Now, the problem was not just confined to US but spread almost across the globe. Ideally this investment vehicle was lucrative till the time house prices soared and remained at higher levels. But when the property prices started declining and loan interest rising, borrowers could not manage the second mortgage on their house and eventually led to defaulting on payments which then led to foreclosure. The loan amount exceeded the value of the property.

There was no option remaining but to write of these loans. The problem became worse when prices of CDO’s of American and European Investment banks started to fall.

Banks’ capital was destroyed and portfolio was eroded. Banks like Lehmann brothers, Merrill Lynch, Bank of American suffered heavily during the crisis and had to be bailed out. Mortgage issuers require funding themselves to give money to borrowers. Funding can be achieved through external borrowing of maturity which is variable. Financial institutions were facing shortage of short term funds before and after the crisis due to diminishing liquidity in the financial position.

Another source of funding is the funds from retail banks who receive the money from customer who deposit into the bank for earning interest. Such funds can be withdrawn by the customer with minimum notice. This is what happened when many customers of northern rock withdrew money from the bank when there was media hype about northern rock approaching the bank of England for short term loan facility. Northern rock had troubles in the money market where it needed money to fund its short term obligations. The global banking communities became very risk averse because of the crisis and were pulling out of assets which were even remotely considered risky.

The banking inter bank market froze the world over. Liquidity was frozen and the crisis became not just memorable for all the above reasons but for the fact that such huge proportions of losses and events were never imagined. Decades earlier a run on the bank was characterized by customers physically lining up outside the bank to withdraw money. The run can be plugged by government an initiative which requires lot of money to be pumped into the system. The same is discussed briefly in the next section. The US economy is a mixed economy where certain regulatory functions are performed by the government.

Banks are different in this concern. The bloodstream of the economy is provided by the bank where people deposit their savings and expect help from the bank for individual needs or purposes. US had learned a lesson from the crisis in 1930’s that an adequate measure needs to be taken by the government when people are losing their savings. There lies a moral risk when the government rescues the bank as some believe that this gives bank a free hand to take undue risk which is beyond their capabilities. But the governments usually have adequate measures to make sure that the same mistakes don’t happen again as US government had during the most recent financial crisis. One of the measures that the US government facilitated the take over of bear sterns by JP Morgan. In another example the government offered $100 billion bail out package to AIG insurance group at a very high interest rate.

They have also taken over 80% of shareholding in the company, more like punishing the shareholders for getting it all wrong. Freddie Mac and Fannie may were taken over even though they were considered to be US government agencies as it became necessary to protect millions of house owners in the US. The question then arises is whether why was Lehmann brothers allowed to fail while other given the support. May be because its situation had been worse for quite some time now and this way plenty of warning was given to institutions with which it had dealings.

The rescue plan that the fed had introduced was to make the banks come in a position where they could generate higher level of lending. The US treasury formulated a three step process for assessing the banks hit during the crisis. All the banks had to undergo a “Stress Test” where it would be seen if the banks had adequate capital for them to continue lending. This test was carried out to ascertain if the banks could remain solvent if the situation worsens from the current situation they were in. Under the Capital Assistance Program, treasury would take position in the bank in terms of equity in the form of preference shares in the banks which were receiving money under the CAP. Fund Managers would then look after the trusts which have been placed by the treasury. The main motives behind lending can be summarized as follows: Get the toxic assets out of the balance sheet of the bank and getting it up and running again Restore flow of credit again by boosting lending to businesses and consumers Monitoring the money which have been pumped into system and make sure it is used for the purpose it is intended for Prevent foreclosures and make flexible terms for borrowers with higher mortgages so that they could afford payment without facing any financial burden. Home Affordable Modification Program (HAMP), an initiative by Obama is one of the measures was introduced to help borrowers make payments and save their homes. Improving small business lending and community bank lending The recent financial crisis challenged the rules of a free economy and capitalism.

Rule books were re written after understanding and learning from the mistakes which were committed by certain greedy institutes which were the reason behind the mess. Even though, the economy today seems to improving from the downtrend it noticed, there are many more lessons to be learned into the course. Emerging economies like India and China were probably the silver lining in the sky during the crisis and still continue to perform at phenomenal growth rates which the rest of the world reels under negative growth numbers. The economy of the future would be more sensitive to risks as the age of tax havens and regulatory arbitage would have been passed. But for the time being, the economies which were seriously affected during the crisis are at the end, are away from being an economy where were driven by unstable bubble and unsustainable bubble after another. From the above, it can appropriately summarized that the statement of unlikely failures if the surplus and deficit units are aligned together cannot be taken on face value as there are many factors and conditions that can cause an influence.

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