Understanding Financial Crises, Regulations & Market Structures

Posted on Aug 17, 2024 in Economy

Financial Crises Reasons

1. Consumer Misjudgment

Complexity was often mistaken for sophistication, leading consumers to believe their investments and deposits were inherently safe.

2. Increased Leverage by Financial Firms

Managers, driven by shareholder returns and the pursuit of higher ROE (Return on Equity), often took on excessive risk.

3. Risk-Taking Incentivized

Compensation schemes for senior managers often rewarded short-term gains, even if those strategies carried long-term risks.

4. Rating Agency Incentives

The demand for credit rating services surged with the growth of securitized instruments like Collateralized Debt Obligations (CDOs).

What is a CDO?

A CDO is a structured financial product that pools cash flow-generating assets (mortgages, bonds, loans) and repackages them into tranches sold to investors. These tranches have varying risk profiles, with senior tranches being safer and offering lower returns, while junior tranches offer higher returns but carry greater risk.

Architecture of International Financial Law

Key Challenges:

  1. Regulatory Arbitrage: Exploiting loopholes in regulations, often through shadow banking schemes.
  2. Regulatory Competition: Jurisdictions competing to attract business, potentially leading to a ‘race to the bottom’ in regulatory standards.
  3. Globalized Market Risks: Risks related to market abuse and systemic issues transcend national boundaries.

Short Selling Regulation

This regulation aims to establish a consistent framework and enhance coordination between member states. Key aspects include:

  1. Public disclosure of short positions exceeding a certain threshold.
  2. Ensuring parties engaging in short selling have borrowed the necessary instruments or have arrangements to borrow them to cover the deal.

Order-Driven Dealing Systems

In these systems, buy and sell orders are matched. Benefits include:

  • Increased competition in liquid markets due to a large number of traders.
  • Potentially better prices for traders due to this competition.

Level II Quotes

Level II provides a detailed view of the order book, showing ranked bid and ask prices from various market participants, offering insights into price action.

Dark Pools

These are private trading venues used by institutional traders to execute large orders without revealing their intentions. Key characteristics include:

  • Operate independently, often owned by broker-dealers or exchanges.
  • Used to hide trading activity, especially for large trades.
  • Potential for front-running (trading ahead of a large order).

Asset-Backed Securities

These are financial securities backed by loans, leases, or receivables against assets other than real estate and mortgage-backed securities. They offer investors an alternative to corporate debt.

Securitization of Mortgages

This process involves pooling mortgages and creating mortgage-backed securities through a Special Purpose Vehicle (SPV). Investors receive interest and principal payments from these securities.

Basel II

An international standard that guides banking regulators in determining capital requirements for banks to mitigate financial and operational risks.

Basel III

Builds upon Basel II, aiming to:

  • Strengthen the banking sector’s resilience.
  • Establish an international framework for liquidity risk measurement.
  • Improve the banking sector’s ability to absorb shocks.
  • Reduce the risk of spillover effects on the real economy.