The proven impotency of policy responses and multiple views of number of economists and analysts over causes of Financial Crisis, has raised the root causes of global financial crisis. Although scholars and academicians cite number of soruces of financial crisis but it was the Presence of Shadow Banking, Securitization and excessive reliance on credit rating agencies that led to global downturn in financial arena.
Shadow banking is an underground banking environment where financial intermediaries create credit across global financial system. However, this system of credit creation is unregulated and also some unregulated activities of regulated institution. It is because of this reason that since shadow banking system has always escaped from the regulations many of the institutions in the financial market employed market, credit and liquidity risk without commensurating risk with capital cushions. Such banking system is said to be the one of the prime cause of 2008 financial meltdown and since then shadow banking is under increasing scrutiny and regulations.
Further, as a result of securitization, finance professionals had a reduced incentive to be prudent and primarily for huge investor demand for sub prime lending, banks and other financial institutions issued the loans and securitized them as AAA Bonds. These mortgaged backed securities were widely distributed to investors which later caused repercussions, globally, when sub prime lending went into a financial disaster in 2007. (Parkin, 2011)
Lastly, it was the credit rating agencies which during 2008, issued AAA ratings to most of the sub prime mortgage backed securities which were bundled into tranches by issuers. Later these securities were subsequently downgraded to junk status by same credit rating agencies. Thus, excessive reliance on ratings by market forces who underestimated the risk and did not used their own due diligence research before investing in MBS, led to financial crisis.(Jigling, 2010)
References:
Dr.Rakesh Mohan (2009) Rakesh Mohan: Global financial crisis – causes, impact, policy responses and lessons, London: London Business School.
Mark Jigling (2010) Causes of Financial Crisis, USA: Congressional Research Services.
Michael Parkin (2011) 'US Inflation, Unemployment and Business Cycles', in CFA Institute (ed.) Economics. Boston: Custom, pp. 168-182.
(2014) Why Are We Not Talking About America’s $123 Trillion In Unfunded Liabilities? , Available at: http://www.redstate.com/2013/02/20/why-are-we-not-talking-about-americas-123-trillion-in-unfunded-liabilities/ (Accessed: 6th January, 2014)
National Bureau of Economic Research (2014) The Effect of the Economic Crisis on American Households. , Available at: http://www.nber.org/bah/2010no3/w16407.html(Accessed: 6th January, 2014).
