Financial Institutions and Markets

Financial Institutions and Markets

In any well-functioning economy, financial institutions and market are two significant aspects in a well-functioning economy (Mishkin and Eakins, 2012). The two aspects normally perform the role of channelling required funds to parties associated with value creating opportunities. However, the existence of asymmetric information can adversely impair the process, when the related parties to such financial contracts are not fully aware of the risks that are involved (Mishkin and Eakins, 2012). In so doing, recipients of financial gain are limited to financial agreement exposures that are intended to prevent them from possible losses. Asymmetric information especially when increased usually has the tendency of bringing ripple effects in the financial system which sets a stage for severe hampering of money supply and productivity. This in turn affects the global economic activities and financial market.

Occasionally, financial institutions have taken the advantage of asymmetric information thereby resulting into financial crisis. This is in turn causes major disruption in financial markets that are widely contributed by decline in asset prices and firm failures in gaining capital base. The financial institutions such as banks have continuously panic on the ripple effect cause by the effect of insurgence of asymmetric information that results into the element of adverse selection (Mishkin, 1990).   Therefore, focussing of financial institutions can best explain why the 2007 financial crisis negatively affect the financial market.

In August 2007, a great financial crisis emerged within the United States economy. The immersed impact of the crisis was much worse that what had been felt since the Depression time (Jahnsen et al, 2009). This crisis which ran through 2009 was described by various monetarists as “once-in-a-century credit tsunami,” (p.20). However, the cause of 2007 financial can best be analyzed by pointing out the effects of asymmetric information which include adverse selection and moral hazard on financial markets. Through the agency theory, problems associated with asymmetric information can be analyzed as generating adverse selection and moral hazards problems (Jahnsen et al, 2009). The writer established that disruptions that are evident in financial systems of which prevents them from channelling funds effectively are usually contributed by the increase in asymmetric information. Through this, firms are unable to acquire funds effectively from financial institutions from productive investment opportunities thereby amounting into less financial turmoil.

Through increased asymmetric information, mismanagement of financial liberation sowed the seed of financial crisis that widely affected the U.S economy (Jahnsen et al, 2009). Financial liberation as it stands if effectively promoted can enhance financial development and well-run of financial system.  However, if not properly managed, it amounts to lending spree that normally prompts financial institutions in incorporating credit boom (Jahnsen et al, 2009).  Unfortunately, the inability of lenders to have sufficient expertise or incentives in managing risks may result into credit booms leading to overly risky lending. For instance, in 2007, there were many defaults in mortgage market especially for subprime borrowers (Jahnsen et al, 2009). In so doing, borrowers with weak credit records resulted into decline in financial crisis.

Usually, government safety nets that include deposit insurance at times weaken the market discipline thereby increasing the moral hazard incentive for financial institutions (Arnold, 2012). This is widely influenced by adverse selection that freezes financial markets. Depositors normally understand that they are guaranteed protection by insurance cover offer by the government. Through this they are able even to supply funds to undisciplined banks. By this, financial institutions can make risky, high-interest loan with a view of obtaining high profit. But if such loans are not repaid, taxpayers are the once who feels the hit.

In case a buyer cannot adequately assess any asset’s quality, then the market price would only reflect the expected quality as incorporated sold market assets (Mishkin, 1990). Thus, the asymmetric information between buyers and sellers generates adverse selection as the price fall, thereby, leaving only low-quality assets referred to as lemons (Mishkin 1990). This is what marked the subprime-mortgage market that led to the freezing of market during the 2007 financial crisis.

On the other hand, the 2007 financial crisis in the United States was caused by the emergence of systemic risks.  This was widely contributed by deteriorating balance coupled with tougher business conditions. Financial institutions act as intermediaries between borrowers and lenders or investors; thereby, they play a crucial role in the economy (Acharya et.al. 2009). The existence of systemic risk can widely be translated as failure of financial institutions which reduce the supply of capital to the real economy. The evident increased uncertainty concerning asset values amplified the underestimation of systemic risks and flight to liquidity that marked 2007 financial crises and were propagated by adverse selection in securities markets (Kirabaeva, 2010).

Banks have traditionally been used as main providers of credit to the economy (Kirabaeva, 2010). However, the emergence of shadow banking systems that include market-based financial institutions, such as money-market mutual funds, mortgage brokers, and investment banks, have brought up securitization. For instance, securitization resulted into new information asymmetries due to its complexity and lack of transparency among investors (Kirabaeva, 2010). Therefore, structured products, such as collateralized debt obligations (CDOs), were developed; market mortgage portfolio and assets, such as credit cards, corporate bonds, and auto loans that were only based on their ability to absorb losses, created by underlying portfolios (Kirabaeva 2010).

Additionally, the existence of large holdings of securitized products increased systemic risk exposure to financial institutions, thereby, freezing market due to skewed payoffs (Kirabaeva 2010). This saw such institutions producing high returns during normal times, but incur substantial losses in times of crisis. For instance, in 2007 financial crisis, defaults of subprime mortgage increased significantly with a larger fraction of CDOs being downgraded. This fall in housing prices was based on the composition of assets and mortgages that supported them (Kirabaeva 2010, p.6).  Banks possibly offered subprime mortgages to financial borrowers which were less than the stipulated stellar credit records.

Moreover, the 2007 financial crisis was adversely contributed by liquidity crisis. The increase in subprime mortgage losses made banks start worrying of one another. They suddenly decreased their lending opportunities as they questioned whether borrowers were in a position to repay their loans (Jahnsen, et al, 2009). Borrowers normally have an informational advantage over lenders, since they know the kind of project they want to invest in (Mishkin, 1990). However, this informational advantage amounts to adverse selection and classic “lemon” problem.

Furthermore, financial agencies experience problem in mortgage market as they were unable to evaluate on their eligibility to repay loans. Lemon problem normally occurs in the debt market, since the lenders are troubled in determining the risk level of a borrower (Mishkin, 1990). Whether it is good meaning, its investment is reliable with a low risk or serious risk which means the investment is poor and has a high risk. Failure to assess this aspect may render the lender into giving out loan of an interest rate that reflects the average quality of both the good and bad borrowers which will amount to paying a higher interest rate that the one an investor should.  Additionally, lenders can refuse to offer loans to borrowers because of fear of being unpaid.

On the other hand, the impact of U.S 2007 financial crisis was felt worldwide.  International banks were troubled on how to raise funds (Jahnsen, et al, 2009). This caused suspense among their depositors on their solvency. For instance, when Northern Rock Bank in the UK ran out of liquid assets in September, 2007, it asked the Bank of England for loans (Jahnsen, et al, 2009). This raised the question of the bank’s solvency which led to its losing of many depositors. Thus, investors withdrew from banks rendering the financial institution as not being able to provide credit facilities required for economic uplift.

Significantly, it resulted into a moderate slowdown of global economies that were related to that of United States. For instance, when housing prices fell, it amounted to reduction in wealth consumption of which reflected the signs of trouble within the financial system (Reinhart and Rogoff, 2008). Additionally, there was a severe shortage of money or credit facilities as world financial institutions raised the cost of credit, thereby leading to economic downfall (BBC News, 2009,). “The impact of subprime mortgage crisis has been felt beyond the United States as it has resulted into credit crunch,” (p.1). This has made banks sharply decrease their lending opportunities of which have seen investors (borrowers) cut off from loans. More significant is the cut off on sales of bonds. For instance, in Australia, most firms cancelled their sales of bonds which were worth billions of dollars by citing out the impact of market conditions (BBC News 2009).

Moreover, the 2007 financial crisis led to failure of high profiled firms as they were forced to take drastic actions. For instance, in 2008, Bear Stearns, the firth-largest investment bank that had invested more on subprime securities was forced to sell itself to J.P Morgan for a cost which was 5% less than what it was worth (Jahnsen, et al, 2009).

Conclusion

In conclusion, the 2007 financial crisis in the United States had been contributed by the emergence of asymmetric information which affected key financial institutions. The inability of financial institutions to evaluate the significance and implication of asymmetric information can result into a financial crisis which declines the global economy. It is therefore imperative for financial institutions to effectively understand the impact of adverse selection in providing financial assistance to borrowers in order not to drive away potential investors. This, in turn, would ensure that the global economy is enhanced.