Financial Crisis and its Impact on Financial Institutions and Markets

The financial crisis that began in 2007 has been reviewed by a number of researchers, many of whom have offered up conflicting interpretations of events and of factors that led to the crisis in the first place (Healy, Palepu & Serafeim, 2009; Laux & Leuz, 2010; Young, 2008). While mainstream journalists like Lewis (2010) focused on the more sensational narrative of players orchestrating a big short in the housing market bubble through credit default swaps (CDS), others have focused more intently on the role that mark to market accounting played in the exacerbation of conditions that ultimately fueled a collapse of financial institutions like Bear Stearns and Lehman Brotehrs (Flegm, 2008). This paper will examine the causes of problems for financial institutions during the financial crisis, discuss the impact of the crisis on financial market liquidity, and address the issue of whether sound risk management was demonstrated by those who participated in the market for mortgage-backed securities (MBS).

Causes of Problems for Financial Institutions during the Financial Crisis

The background causes of the problems faced by financial institutions during the financial crisis are complex. Not only had the groundwork for a housing market bubble been set by a relaxation of lending standards under the Clinton administration (in a political show of solidarity with the working class aimed at getting more home owners and thus promoting the idea of an American Dream still existing), but the Financial Accounting Standards Board (FASB) had given the green light to fair value accounting, i.e., mark to market accounting, which allowed firms to adjust the book value of assets based on current market prices. It has been argued that this opened the door to financial shenanigans that exacerbated the marketplace and led financial institutions into regulatory traps due to unforeseen market panic when demand for previously highly liquid assets like collateralized debt obligations (CDO) dried up and demand for CDS soared (Flegm, 2008; Healy et al., 2009; Posen, 2009).

Underlying Causes of Problems Experienced by Financial Institutions

Regulation of the financial industry is meant to reduce the risk of instability among financial institutions. Ensuring that financial institutions have adequate capital to manage stress is one of the objectives of the Federal Reserve. Yet systematic regulation of financial institutions with regard to capital adequacy may have actually had the same effect on financial markets as forest fire prevention has had on forests: by over-regulating what should be more of a natural process with manageable risk to the downside, regulators create an environment in which downside risk becomes explosive when unnatural market conditions prevail and then burst all at once (Prosner, 2014).

The demand for yield brought about by low interest rates caused investors to buy up risk assets like CDOs in the run-up to 2007 and equities at all-time high valuations in the run-up to the COVID collapse of 2020. A combination of fair value accounting practices of firms and financial institutions and regulatory requirements regarding capital adequacy put certain constraints on institutions once the markets turned down in both cases. A dramatic shift in sentiment in 2007 and in 2020 was followed by crashing valuations, which in turn forced institutional selling, which in turn begat more selling as investors sought to escape a collapsing market at any price. Financial institutions saw a liquidity crisis coming in 2019, and the Federal Reserve intervened at the time by injecting liquidity into REPO markets.

How These Problems Might Have Been Avoided

Though regulations are meant to ensure quality in the market, Posner (2014) has argued that they hurt more than they help because they handcuff institutions...

…which is why a liquidity crisis appeared in 2019 in the REPO market. Regulations actually simply end up pushing smaller firms out of the market since they cannot meet the capital requirements that large firms can meet, and regulators thus protect the monopoly that persists in the marketplace (Posner, 2014). Regulation has not done anything to prevent market collapses. The Savings and Loan crisis, the dotcom bubble collapse, the housing bubble collapse, and the COVID collapse are all instances of rinse-and-repeat phenomena for market players like BlackRock, which controls over $7 trillion in assets and is certainly the too-biggest-of-them-all-to-fail. When such institutions are caught wrong-footed or are at risk of holding the bag of shares in various Fortune 500 zombie corporations, they must induce the Federal Reserve (either directly or indirectly) to intervene. Regulation does not factor into the matter other than to prevent smaller players from taking market share away from the big players. Regulation does not protect small or retail investors from risk-on appetites of big firms; it simply prevents small financial institutions from competing in the market since they cannot meet the capital requirements set by regulators (Posner, 2014).

Conclusion

Regulation could be changed to limit excessive risk-taking by simply going away altogether. Allow small institutions to compete with large ones in an unregulated marketplace, and allow the so-called too-big-to-fails to fail when they engage in excessive risk-taking and are caught wrong-footed when the market turns against them. Let institutions pay for their mistakes. To consistently reward the largest firms with bailouts spoils the idea of a free market and creates an environment of moral hazard that persists to this day. Actions should be seen to have consequences, regardless of how it affects pension funds, mutual funds, insurance companies and the like. If the entire financial/economic system were to collapse,…