Was the crisis of 2007 a systemic failure of market-based finance?

Academic Paper, 2018

19 Pages, Grade: 1,4 / 69


Table of Contents

Table of Figures

List of Abbreviations

1. Introduction

2. Comparison of market-based finance and bank-based finance

3. Explanation of the GFC

4. The Effects of the GFC in market-based systems and bank-based systems

5. The relationship between market and bank-based finance and the GFC

5. Policy Advice

6. Conclusion


Table of Figures

Figure 1: S&P/Case-Shiller U.S. National Home Price Index

Figure 2: Unemployment in Japan, Germany, UK and USA

Figure 3: GDP per capita in Japan, Germany, UK and USA

Figure 4: Average Individual Income in Japan, Germany, UK and USA (Based on the National Income) per Year

List of Abbreviations

Abbildung in dieser Leseprobe nicht enthalten

1. Introduction

The financial system played a leading role in the global economic crisis 2007-09. The list of possible explanations is long: “stupidity and greed”, as said by Timothy Geithner (Reuters 2012), deficient regulatory structures, conflicts of interest, economic deterioration of middle- income families, a wrong monetary policy, incorrect economic models etc. (Davies 2010). By discussing the causes of the global financial crisis 2007-09 (GFC), are we neglecting a more profound question? Is it possible that the GFC is evidence of the failure of a whole financial system? This essay will analyse if the GFC represents a systemic failure of market- based finance.

The thesis statement of this essay is that the GFC does not represent a systemic failure of market-based finance.

First, I will compare market-based finance and bank-based finance. Subsequently, the GFC will be explained. I will then give an overview of the effects of the GFC in market and bank- based financial systems. Next, I will discuss the relationship between market-based finance and the GFC. Finally, the resulting policy implications will be stated.

In market-based financial systems resources are allocated through financial markets; household savings are channeled to the corporate sector through the purchase of stocks or bonds. The stock market allows investors to identify risk and return opportunities. Proponents of market-based financial systems argue that a more efficient allocation of resources is possible in this system given its higher liquidity and transparency due to the availability of information (Levine 2002, 400).

Furthermore, a market-based system enhances corporate governance by easing takeovers. Besides, through tying the salary of a manager to the share price, he has an incentive that the company performances well. Also, through the opportunity of the investor to always sell its shares, he can exert pressure on management. Via shareholder meetings, the investor can influence directly the future of the company through his voting behaviour. (Jensen and Murphy 1990). However, supporters of bank-based finance make the counter argument that liquid markets lead to a reduction of corporate control since investors can sell shares inexpensively anytime which diminishes their incentive to exert corporate control (Bhide 1993).

According to Allen and Gale (2000, 10-11), market-based systems expose households to more risk than institutions do in bank-based systems, because of the volatility of asset values. Intermediaries eradicate the risk through intertemporal smoothing which offers a safety net for the investor who would otherwise be forced to dissolve assets at injurious prices.

In bank-based financial systems, banks dominate the allocation of resources in the corporate sector. Because banks have divisions which are specialised in monitoring and relationship management, they have the ability to gain mass information about firms and their managers, optimising capital allocation. Additionally, they can improve corporate governance by disciplining the management through monitoring (Diamond, 1984; Ramakrishnan and Thakor, 1984).

Boot and Thakor (1997, 695-696, 702-704) argued that banks can better monitor firms than uncoordinated markets because of their lower acquisition cost and specialisation. Through exploiting economics of scale, they can ameliorate moral hazard more effectively. Monitoring can also be improved in bank-based systems by diminishing asymmetric information distortions through forming long-run relationships (Levine 2002, 400).

Another advantage of bank-based systems is the mutual commitment. If the firm ends the relationship with the bank, it casts a poor light on the bank and vice versa. This reciprocal commitment is strengthened through cross-shareholdings and can serve as mutual monitoring (Onetti and Pisoni 2009). Regarding the corporate governance, it has to be considered that powerful banks with few regulatory restrictions can impede efficient corporate governance by colluding with creditors which have higher regulatory standards (Wenger and Kaserer, 1998).

While there are academic contributions concerning growth enhancing effects for both systems (Bencivenga and Smith 1991; de la Fuente and Marin 1996; Greenwood and Smith 1997), growth theory has been largely silent on the “bank versus market” debate. It emphasises the importance of either banks or financial markets (Chakraborty and Ray 2006, 2). Levine (2002, 423-424) concludes that his broad cross-country examination does not provide evidence for bank-based or market-based finance. While it is not conducive to differentiate countries by their financial structure, it helps to distinguish them by their overall level of financial development to elucidate differences in economic growth.

3. Explanation of the GFC

The effects of the GFC were far-reaching: the damage was severe, both financial and human. The increase of the suicide rate in 2009 in Europe and America was higher than expected if earlier trends had continued (Chang et al. 2013). The GFC cost the U.S economy at least 40 to 90 percent of one year’s total goods and services (Atkinson et al. 2013, 19). The world GDP decreased from 2008 to 2009 about 5,19 % (World Bank 2018a).

The Federal Reserve (FED) lowered its funds rate from 5,24 % (July 2006) to 1,98% (May 2008) (FRED 2018a) to boost the economy. Accordingly, more US-citizens were able to raise a mortgage and did so. Banks accepted real estates as collateral because house prices increased since the beginning of the 1990’s (figure 1). Numerous mortgages were granted to people with small repayment ability. These were commonly referred to as subprime mortgages (Acharya and Richardson 2009, 196-198).

Figure 1: S&P/Case-Shiller U.S. National Home Price Index

Abbildung in dieser Leseprobe nicht enthalten

Source: Own Diagram. Data: FRED 2018b.

Banks securitised the mortgages which were rated. Securitised mortgages with different ratings were mixed together and bundled up in collateralised debt obligations (CDOs). Many of these CDOs which include a large variety of different mortgages were rated “AAA”.

In fact, the realistic rating of a lot of these CDO’s were worse (Cominskey and Madhogarhia 2009, 271-272). The misallocation of triple A ratings were the result of modeling failures and conflicts of interest generated by a system which allowed rating agencies to be paid by their principals (Acharya and Richardson 2009, 196). Furthermore, it is questionable if rating agencies understood the complex CDOs (Cominskey and Madhogarhia 2009, 272).

Banks sold top rated CDOs to different investors (institutional investors, hedge funds etc.) globally, especially to US and European investors. Doing so, they also passed the credit default risk. Instalments of borrowers were then flowing to the buyer of the CDO. CDOs seemed to be highly profitable for banks and investors. Consequently, the demand rose (Ibid., 271-272).

The demand for mortgages was saturated after some time, while the demand for CDOs continued to rise. Therefore, banks begun to lower their credit approval standards even more by giving mortgages to people with very low creditworthiness. The number of borrowers who defaulted increased (Ibid.). Consequently, they had to endorse their houses to banks. Additionally, the demand for real estates decreased since a considerable part of the housing demand was already covered. Meanwhile, banks recognised being too lax and insisted of a more thorough documentation of income and assets which reduced the number of house- buyers (Baker 2008, 80). Besides, the FED tried to prevent inflation from rising by raising interest rates from mid-2004 to mid-2006. The rates of adjustable-rate mortgages rose, so many subprime borrowers could no longer make their mortgage payments. Following foreclosures depressed housing prices even more (Ibid., 272).

The more the value of real estates decreased, the greater became the loss for owners of CDOs. Thus, they tried to sell them – without success. At this point, several financial institutions (FIs) already owned loss generating CDOs. Hence, FIs began to distrust each other and banks reduced their extension of credit (Earle 2009, 788). FIs were dependent on these credits, especially after their losses through CDOs. Several FIs did not have enough equity deposits to countervail these losses. As a consequence, many became bankrupt or were nationalised such as Lehman Brothers or AIG (Mishkin 2011, 52-53).

4. The Effects of the GFC in market-based systems and bank-based systems

Economic literature distinguishes the United States of America (USA) and the United Kingdom (UK) as typical market-based financial systems and Japan and Germany as typical bank-based financial systems (Freixas and Rochet 2008, 103). In the following, I will give an overview about the effects of the GFC in these countries by illustrating the developments of the following measures: Change in unemployment, change in GDP per capita and the change in the average individual income.

Figure 2: Unemployment in Japan, Germany, UK and USA

Abbildung in dieser Leseprobe nicht enthalten

Source: Own Diagram. Data: World Bank (2018b).

Figure 2 elucidates that the rise in unemployment in UK and the USA was significantly bigger than Ger inmany and Japan. From 2007 to 2010 the total number of unemployed people increased in the USA about 108 %, in UK about 48%, in Japan about 32 % and it even decreased in Germany by 20 %.


Excerpt out of 19 pages


Was the crisis of 2007 a systemic failure of market-based finance?
1,4 / 69
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ISBN (Book)
Financial Crisis, 2008, Market, Finance
Quote paper
David Höhl (Author), 2018, Was the crisis of 2007 a systemic failure of market-based finance?, Munich, GRIN Verlag, https://www.grin.com/document/465436


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