How Banks Played a PART in the Financial Crisis!

The 2008 financial crisis was an “avoidable” disaster caused by widespread failures in government regulation, corporate mismanagement and heedless risk-taking by Wall Street, according to the federal inquiry. The financial crises emphasises the importance of banks, their tendency to lend recklessly, and the role that deposit insurance plays in creating moral hazard.

It all started with the Basel committee founded in 1975; with the objective bring to different national systems of capital-adequacy regulation closer together. But with the increase in financial globalistion, the FD and government’s role as regulators were not on par anymore. Bank’s find loop holes in Basel 1 and exploited it, to make more money for their own gain. Basel 1 focuses on credit risk and where credit-risk weights, which were based on very broad categories of asset. These unduly broad categories created opportunities for banks to game the system, reducing their burden of regulatory capital for any given level of risk (or, conversely, increasing their exposure to risk for any given level of capital). In any case, the idea that aggregate risk can be estimated by adding up risks in the different categories is wrong in principle. Managing a portfolio to reduce risk involves combining assets with different risks in such a way that the hazards offset each other. The accord, in effect, denies the risk-reducing benefits of diversification.
But there are other problems with Basel 2 as well. Banks will design assets to fit particular categories of risk, bending whatever connection there might previously have been between a rating applied after the fact and the level of risk.

The report finds that the New York Fed missed signs of trouble at Citigroup and Lehman, though it did not have the main. The report could reignite debate over the influence of Wall Street; it says regulators “lacked the political will” to analyze and hold accountable the institutions they were supposed to oversee. On the other hand, the report is harsh on regulators. It finds that the Securities and Exchange Commission failed to require big banks to hold more capital to cushion potential losses and halt risky practices, and that the Fed “neglected its mission.”

By one measure, for about every $40 in assets, the nation’s five largest investment banks had only $1 in capital to cover losses, meaning that a 3 percent drop in asset values could have wiped out the firm. The banks hid their excessive leverage using derivatives, off-balance-sheet entities and other devices, the report found. The speculative binge was abetted by a giant “shadow banking system” in which the banks relied heavily on short-term debt.
“When the housing and mortgage markets cratered, the lack of transparency, the extraordinary debt loads, the short-term loans and the risky assets all came home to roost,” the report found. “What resulted was panic. We had reaped what we had sown.”


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