Financial markets refer to the markets in which the security trading takes place. Some of the securities traded in financial markets include bonds, derivatives, and equities. Financial instruments represent financial contracts between two parties. Because of the trading, the financial markets provide an avenue in which money flows from the lenders to the investors efficiently through either direct or indirect financing. Hence, the trading in the financial markets affects economies in that it leads to the productions of goods and services (Kaplan, 2014). However, the concept of the financial market is not that developed and dubious traders, more so in developing economies, may exploit it. In this report, we explore how financial markets affect the economy of a particular nation. The paper also looks at whether the new financial instruments such as the mortgage-based securities exacerbated the risk for the global recession in 2007/2008. Besides, the report looks at whether the activities of banks and financial institutions should be regulated to prevent another global recession.
Effects of Financial Markets on the Economy
Well-developed and functioning financial markets often lead to the efficient performance of the economy. There exists a strong correlation between well-developed financial markets and the economic performance of a particular country. Financial markets provide an avenue for the traders to control the flow of savings and investments in an economy effectively in a manner that allows capital accumulation and the production of the goods and services in the economy. The financial markets thus satisfy the needs of both investors and borrowers in the economy. The financial market provides avenues to institutions such as banks through which they can specialise in particular markets and diversify risks.
In the 21st century because of the vast array of financial instruments present in the financial markets, the effects of the financial markets on the economy are profound. Primary markets have offered companies and financial institutions different ways of raising revenue and hedging against risks (Bolton, Santos and Scheinkman, 2016). For example, before the financial crisis of 2008, many financial institutions issued mortgage-based securities in the form of derivatives to the traders, which were geared at safeguarding the institutions against the risks, faced presented by the subprime mortgage loans. Hence, through the derivatives, the banks were able to spread the risk of default of the subprime loans to other parties. Moreover, the financial markets have brought with them a concept of hedging which has grown in relative importance in the 21st century. Hedging allows firms to be able to spread their risks such that in the event of an unfortunate occurrence, the firms do no stand to lose. The risk diversification and management have acted as an incentive to these institutions to take part in other financial initiatives, which contribute to the economic growth.
Before the financial market was highly developed, money flow in the economy was limited. However, the financial markets have revolutionalised the flow of money in the economy by making it efficient between the lenders and the investors. The lenders most of them deposit their money into the banks. The banks then transfer these funds to the investors through trading in the financial markets. The result is an increase in the production of goods and services, which increases a country’s GDP. Besides, the production of products and services leads to the creation of employment opportunities and increased foreign trading. On the other hand, because of the lack of clear regulatory mechanisms of the financial markets, they have exacerbated the risks of recession, as they are prone to misuse by rogue traders.
Role of the New Financial Instruments in aggravating the Risk of the Financial Crisis in 2008
The global financial crisis of 2008 is often attributed to the bust of the housing market and the highly integrated economy. However, one aspect that is not widely recognised is the role of the financial instruments in increasing the risk of the crisis, specifically derivatives. Derivatives are financial instruments, which obtain their worth from the value of the underlying asset. Derivatives are often used to hedge and guard against risks and are founded on other securities and commodities. Because derivatives are traded based on the value of the underlying assets, therefore this means any significant fall in the value of the underlying asset will lead to the crash of the derivatives. Subprime mortgages were mortgages issued to the USA to those who did not have either adequate credit or savings. Most of the derivatives in the USA derived their values from this sub-prime mortgages. Thus when the housing markets began collapsing in 2007, the values of the derivatives dropped simultaneously. In this regard banks such as the Lehman bank that had borrowed heavily because of their exposure to the subprime mortgages securities collapsed with the fall of the housing market in the USA.
The new financial instruments aggravated the risk for the global financial crisis because the derivatives provided an avenue for the banks to be highly leveraged. Derivative trading induced these banks to take excessive risks. The result was that the banks had liabilities, which were greater in value than their assets. The considerable difference between the assets and liabilities would camouflage the financial performance of these banks. Thus, from 1999, it appeared as if such banks were experiencing rapid financial growth; which was not the case since this was based on an increase in liability. The derivative trading allowed financial institutions to borrow indirectly more than allowed. Hence, when the housing market collapsed in 2008, banks’ asset got depleted and the liabilities mounted; the banks were left with worthless derivatives. Only the government through bailouts and write-downs could solve the situation. Herein we note that the derivative trading increased the propensity of the banks to borrow through excessive trading of financial securities, which were based on subprime mortgages. Hence, by providing a room for excessive trading and subsequent accumulation of liabilities, the financial instruments increased the likelihood of the financial crisis in 2008.
When the Glass Steagall Act was repealed in the USA in the late 1990S, this eliminated the regulatory mechanism in the financial markets. Banks would, therefore, gamble with depositors’ funds by accumulating excessive liabilities. The lack of clear-cut regulations led to the flourishing of over the counter derivative trading instead of a clearinghouse based derivative trading. Derivative trading though OTC is devoid of the controls present through trading in clearinghouses. Hence, this makes it difficult to note dubious trading practices and clamp them (Han, 2016). The OTC trading made the derivative trading susceptible to short guns and free trading. Therefore, when the financial crisis struck in 2007, it was hard to quantify the exact size of the derivative market. Banks had to do repeated rounds of bailouts of the derivatives markets. Herein we observe that the new financial instruments were not regulated and this increased the risk of the financial crisis in 2008.
The global recession of 2007-2008 unmasked the failures of the Basel II system. There were limited disclosure and risk assessment by the banks. There was also the prevalent market indiscipline attributed to the blanket insurance of “Too big to fail”. The ‘Too big to fail’ blanket insurance led to problems when most of the big financial institutions invested in correlated risks of real estate investment. The risks became real when the real estate market collapsed, and the Central bank was compelled to bail out the banks from their insolvency. In this regard, it is apparent that there needs to be financial regulation of the banks to prevent the moral hazard problem of the ‘Too big to fail’ blanket insurance. Making it possible for banks to be bankrupt is one of the ways that can mitigate the global recession. Besides, policies aimed at restructuring the capital of banks to increase liquidity and solvency can help reduce the risks of the worldwide recession.
Should the Activities of the Banking Institutions be regulated?
One of the underlying causes of the global recession in 2007/2008 was the unfeasibility of bankruptcy in financial institutions. The central bank would often bail out banks after taking excessive risks with the depositor's insurance. Taxpayers ought to be relieved of the responsibility in aiding insolvent banks that have accumulated excessive debts. Making bankruptcy credible is a way of disciplining managerial behaviour. For banks to achieve this, they need to be of a particular size, interconnectivity and complexity that provide a room for failure. Through this, the problem of the too big to fail that led to the global recession will be evaded. Moreover making a failure, a possibility will eliminate chaos when a bank fails such as those of the Post-Lehman disaster that led to the spread of the systemic risks in the entire industry (Plantin, 2014).
Regulating the activities of the banks will also make it possible to determine the interrelationships between banks and the complexities in their operations, which further aids in the determination of the complexities of their operations. When the interrelationships between banks are known in advance, it is possible to determine the viability of the financial institutions and anticipate failure. Besides regulating, the activities of the banks will help determine the banks that are central to the operations of other banks. A central bank that is closely connected to other banks is more likely to lead to the failure of other banks in the event of bankruptcy because of the spread of the systemic risks. Hence regulating the activities of the banks make bankruptcy possible and helps identify the systemic risk and its range, which further helps prevent the recession (Berger, Bouwman, Kick and Schaeck, 2016).
Regulating banking activities leads to centralised transparent derivative markets, which makes it possible for relevant parties to access information on the risk exposures of different firms. The centralised market will assist the bank managers to understand the evolution of financial markets. It would also help them understand the risk exposure of different firms thus dictating whether they can accept more of it or not. Regulating banking activities will also lead to high liquidity and solvency requirements, which mean in the event of particular uncertainties in the market, the banks can easily convert their debt into equity easily without overlying on the central bank to bail them out. From the above we note that regulating banking activities will help control how they take excess risks, the too big to fail blanket insurance, and capital structure, all of which led to the global recession of 2007/2008.
We have observed that financial markets affect the economic activity in a country since they influence the production of goods and services through the provision of capital to the investors. We have also observed that the financial instruments exacerbated the risk of the global recession as they were misused by banks to leverage themselves. The result was an accumulation of excessive debts and liabilities. The main reason behind the excessive accumulation of the liabilities is that there were no clear-cut regulations. Hence, through this, it is essential for states to regulate the activities of the banks.
References
Berger, A.N., Bouwman, C.H., Kick, T. and Schaeck, K., 2016. Bank liquidity creation following regulatory interventions and capital support. Journal of Financial Intermediation, 26, pp.115-141
Bolton, P., Santos, T. and Scheinkman, J.A., 2016. Cream‐skimming in financial markets. The Journal of Finance, 71(2), pp.709-736
Han, M., 2016. The Global Financial Crisis: The Challenge for Central Banks. In Central Bank Regulation and the Financial Crisis (pp. 40-50). Palgrave Macmillan, London.
Kaplan, J., 2014. Financial markets and the economy. Jay Kaplan
Plantin, G., 2014. Shadow banking and bank capital regulation. The Review of Financial Studies, 28(1), pp.146-175.
