Sample Law Essay Paper on The causes of financial crisis

Causes of financial crisis

As the question goes, personally, I think financial crisis could be thought of occurring due to unreal risk-weighting of assets and unreal capital valuation even though other factors might cause it. This is in relation to what transpired before the recent US recession took place.[1] Quite evidently, one can clearly see that unreal risk-weighting of mortgages in the housing sector led to the financial crisis in question.[2] In this case, banks underrated the risk factors of their customers thereby considered some risky customers as risk free customers. In other words, banks failed to consider the risk factors of some of their customers for mortgage products that in real sense would not qualify for those products.[3] By so doing, banks took too much risk than they would have taken, and this led to the recent US recession.

In particular, as a way of attracting more customers to the mortgage products, majority of the US banks were enticed to underestimate the risk factor of their customers for mortgages. This means that the banking sector overlooked some of the risk factors that it would not have overlooked in evaluating the risk of its customers. As this took place, the banking sector ended up using riskier assets in the securitization of the mortgage products.[4] On the other hand, De-Ramon and his colleagues demonstrate the need for differentiating the types of capitals in the financial sector. They claim that some capitals are loss-absorbing while others are not loss-absorbing.[5] Given that some capitals are loss-absorbing while others are not loss-absorbing, then unreal capital valuation may cause a financial crisis.[6] To show how unreal capital requirement and valuation might lead to financial crisis, De-Ramon and his colleagues cite the UK case before 2007. They claim that before this period, the UK banking industry tended to calculate the banks’ risks profiles based on the risk of individual banks. However, after the advent of the 2008 US recession, the banking industry in the UK changed this practice. The new practice was adopted after tier 2 capital failed to insulate the risk of debt holders. In relation to this fact, I believe that unreal risk-weighting of assets as well as unreal capital valuation may be thought to be the causes of financial crisis.[7]

In the past, economists and financial analysts have proposed various Basel models as the methods of dealing with financial crises. These methods have in one way or the other sought to regulate the banking industry. In particular, Basel III has recommended for the increment of the percentage of capital requirement that banks should raise for them to remain in the banking industry.[8] Basel IV, on the other hand, has recommended for the increment of the leverage ratios, disclosure of reserves and usage of standardized models in the banking industry.[9] By requiring banks to use standardized models in calculating capital requirements, Basel IV in a way demonstrates the need for using standardized measures in calculating risks in the banking industry. This recommendation may provide commercial banks with a standardized method of valuing capitals that would in return eliminate unreal capital valuation thereby curb financial crises in the banking industry.[10] At the same time, Basel IV recommends for the disclosure of reserves. This may help in the identification of possible risks in the banking industry, and by so doing; it may curb financial crises in the banking industry. Based on this understanding, I believe that unreal risk-weighting of assets and unreal capital valuation cause financial crises and that Basel IV is an ideal method of curbing it.

 

 

 

 

 

 

 

 

 

 

 

 

Bibliography

Al-Darwish, Ahmed. Possible unintended consequences of Basel III and solvency II. International monetary fund, 2011.

Brezina, Corona. America’s recession: the effects of the economic downturn. New York: Rosen publication, 2011.

Chorafas, Dimitris. The changing role of central banks. Basingstoke: Palgrave Macmillan, 2013.

Claessens, Stijn et al. Financial crises: causes, consequences, and policy responses. Washington D.C: international monetary fund, 2014.

De-Ramon, Sebastian et al. Measuring the impact of prudential policy on the macro economy. Occasional paper series, 2012.

Lawrence, Kenneth & Michael Geurts. Advances in business and management forecasting. Amsterdam: Elsevier, 2006.

Powell, Andrew. Basel II and developing countries: sailing through the sea of standards. World bank publication. 2004.

Rosenberg, Jerry. The concise encyclopedia of the great recession 2007-2012. Lanham: Scarecrow Press, 2012.

Sherman, Howard & Meeropol, Michael. Principles of macroeconomics: activists vs. austerity policies. M.E Sharpe, 2013.

Voit, Johannes. 2005. The statistical mechanics of financial markets. Berlin: Springer.

[1] Claessens Stijn et al. Financial crises: causes, consequences, and policy responses. (Washington D.C: international monetary fund, 2014). 265.

[2] Rosenberg Jerry, The concise encyclopedia of the great recession 2007-2012. (Lanham: Scarecrow Press, 2012). 495.

[3] Sherman Howard and Meeropol Michael, Principles of macroeconomics: activists vs. austerity policies. M.E Sharpe, 2013. P. 238.

[4] Brezina Corona, America’s recession: the effects of the economic downturn. New York: Rosen publication, 2011. P. 14.

[5] De-Ramon, Sebastian et al. Measuring the impact of prudential policy on the macro economy. Occasional paper series, 2012. P. 34.

[6]Chorafas Dimitris, The changing role of central banks. (Basingstoke: Palgrave Macmillan, 2013). 197.

[7] Lawrence Kenneth & Michael Geurts, Advances in business and management forecasting. (Amsterdam: Elsevier, 2006). 89

[8] Al-Darwish Ahmed, Possible unintended consequences of Basel III and solvency II. (International monetary fund, 2011). 26.

[9] Voit Johannes, The statistical mechanics of financial markets. (Berlin: Springer, 2005). 358.

[10] Powell, Andrew. Basel II and developing countries: sailing through the sea of standards. (World bank publication. 2004). 28.