Essay on Financial Crisis Cause
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Developments in financial markets over the last twenty years have in certain aspects made the financial system more vulnerable to market shocks. Financial institutions have become increasingly more dependent on continued liquidity in securitization and other wholesale funding markets for their financing. On their own, market participants cannot identify or manage systemic risk.
In disrupted markets, banks’ actions are motivated by self-preservation and make the financial system as a whole less stable. Regulatory standards have largely been set on the basis that if each financial institution remained sound, then the system overall would also be sound. But this approach underestimated the implications for system-wide risk of innovations in financial markets.
The extension of diversification, for example through expansion in the use of securitization markets and derivatives products, increased systemic risk by creating an increasingly complex network of interconnections between banks and other market participants.
Because financial market participants were highly interconnected, a full assessment of the risks of investing in or lending to a bank