Q. 1. What were the major factors that led to the recent financial crisis? How did we get here?
One of the primary factors that can be attributed as to have led the recent financial crisis is the financial deregulation allowing financial institutions a lot of freedom in the way they operated. The manifestation of this was seen in the form of:
a) Financial innovations that were not backed up with adequate risk controls and management.
b) Too much reliance on Quantitative Risk Management ultimately leading to mispricing of risk across different financial and non-financial investments that were the product of the financial innovations made feasible by financial ...view middle of the document...
S. Department of the Treasury, 8.80 million jobs were lost and $19.2 Trillion were lost in household wealth. The estimated total potential exposure from the financial rescue was estimated to b $24 trillion by the Special Inspector General for TARP in July 2009. The IMF estimated cost of the U.S. response to be $1.90 trillion. If the government had not intervened then, the final cost of the financial crisis would have been much higher than this. The U.S. GDP grew over 2% on average as a result of the comprehensive response and prevented the economy from a total collapse. According to the U.S. Department of the Treasury, a total of $245 billion were disbursed to stabilize the financial institutions and the treasury recovered $264 billion including repayments of $230 billion and $34 billion as realized income in April 2012.
3. How can we prevent this from happening again?
A look at the factors that led to the financial crisis gives an idea of what needs to be done to prevent such crisis from happening in future. These include but are not limited to:
1. There should be a limit to financial deregulation and financial innovation particularly in areas where the prevailing risks are least understood.
2. The regulatory regimes must be strengthened and their monitoring and response capabilities enhanced to levels possible subject to being too restrictive and rigid.
3. Risk management systems should be updated and made dynamic continuously to cover both qualitative and quantitative factors. The use of triggers for different responses at different levels of risk exposure should be made an integral part of any risk management systems in place.
4. The incentives in the financial system should be actively monitored and corrective actions taken when needed.
4. What would be a likely solution? Do we need some form of regulation? Do we need this regulation? Why or why not? What are the key points that regulation should address?
How appropriate of a response to the financial crisis was the Dodd-Frank Act? What is the likely impact of the Dodd-Frank Act?
The Glass-Steagall Act of 1933 that defined the roles for commercial banks, investments banks and insurance firms was over ridden by the Gramm-Leach-Bliley Act (1999) which repealed the provisions that restricted affiliations in financial institutions. Hence one solution is to overcome the incentive problem and the conflict of interests that arise when financial institutions simultaneously undertake financial activities of varied nature.
In addition to the above the internal incentive to bank should be reduced by requiring greater capital requirements as well as improving upon the definition of what qualifies to be capital. Further in line with the answer to question 3, risk management systems in financial institutions need to be redefined and strengthened to more comprehensively identify, evaluate, manage and monitor risks.
Yes we need to have some form of...