Gfc Case Study

1073 Words 5 Pages
Financial innovation
Another reason attributable to the GFC, which was regarded by David T Llewellyn as the ultimate cause of this catastrophic recession, is the emergence of new financial innovations such as CDOs, CLOs and MBSs. These financial instruments adopted to lower the risk and create a more easily accessible market for borrowers, were of extreme use, hence brought about the inverse effect. Moreover, since these innovations require the separation of different tranches of lending activities, there has been a mismatch of interest between lending and borrowing entities. Thence, perverse incentive was formed leading to the unnecessarily risk-taking behaviour and the adverse-selection problem. Banking sectors, which frequently deemed to
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Under some optimistic views, this securitized instrument were believed to diversify risk, lower cost of lending and lengthen the maturity, hence created more lending opportunities to borrowers. However, these benefits were brought at the cost of increasing lenders’ exposure to the default risk (Solomon, 2012). In particular, as the borrowers the lenders who have a final ultimate say in the decision made by firm, creditors cannot affect the firm’s investment decision if it too optimistic. Moreover, as this practice require additional party to take some assets of the sponsor off balance sheet which is independent of the sponsor’s activities.Thence, there has been a concern that this new entities can, possibly, divest creditor’s ability to claim against their assets thereby jeopardize creditor’s ability to get their debts …show more content…
In fact, 99% of the income of these entities was not come from the budget of creditors but instead from that of investment banking, there are perverse incentives for not providing accurate ratings. On that account, should CRAs provide investment banks with lower credit rating; they, the investment banks, can and will loiter around other agency who could give them a more buoyant rating. Thence, CRAs with the fear of loosing their attraction, will bias towards a more optimistic rating hence provide investor with the misleading information for making decision. Although, the impact of CRAs on GFC would have been lessened if there had not been a heavily reliance of investors on these entities or if there would have been another external entities to regulate the rating of CRAs, the fact that securitized assets are far more unpredictable and extremely intricate makes this nearly imposible. On the one hand, as most of CDOs, MBSs or CLOs are combinationsof different tranches of mortgage debts and there is also asymetric between originators and investors, it is impratical for investors to access the rating by themselves. On the other, the government was often unable or reluctant to regulate such entities in which they had no interest, CRAs can decide their rating without any hesistation. Hence, CRAs while enjoying their privileged position complicate the fincial system and lead it to the

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