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FIN302

2nd SMESTER 2022/23

Individual Assignment

Finance and Markets

Learning Outcomes

Contents

This financial crisis in year 2008 was a subprime mortgage phenomenon. Without subprime mortgages and their securitisation there would have been no crisis. Do you agree with this statement? Why?

Write  a report to  answer this  question. Please briefly  describe the  growth  of the subprime market and provide relevant theories from the news provided below, lecture notes and textbooks.

FINANCIAL TIMES

Can we predict a financial crisis? Does it matter?

Cardiff Garcia AUGUST 5 2010

A couple of new research papers have a go at the question of whether we can predict a financial crisis, and they arrive at different conclusions.

With a hat tip to Free Exchange, first up is an NBER submission co-authored by four economists.

They argue that previous studies of systemic risk have tended to focus on just one part of the financial sector, normally the banking system. For their research, by contrast, the authors used econometrics to look for predictors of systemic risk within the increasingly complex network of relationships among  hedge funds, banks, insurance companies, and brokers.

Here’s what they found (emphasis FT Alphaville’s): “… the returns of banks and insurers seem to have more significant impact on the returns of hedge funds and brokers than vice versa. We also find that this asymmetry became highly significant prior to the Financial Crisis of 2007–2009, indicating that our measures may be useful as early warning indicators of systemic risk. This pattern suggests that banks may be more central to systemic risk than the so-called “shadow banking system” (the non-bank         financial institutions that engage in banking functions). By competing with other financial institutions in non-traditional businesses, banks and insurers    may have taken on risks more appropriate for hedge funds, leading to the       emergence of a “shadow hedge-fund system” in which systemic risks could    not be managed by traditional regulatory instruments. Another possible interpretation is that, because they are more highly regulated, banks and insurers are more sensitive to Value-at-Risk changes through their capital       requirements (Basel II and Solvency II), hence their behavior may generate    endogenous feedback loops with perverse spillover effects to other financial   institutions.”

On that last bit, regarding “endogenous feedback loops”, the authors simply   mean that when internal risk measures require an individual bank to unload risky assets, it’s fine for that one bank. But if all banks then follow suit, it leads to a downward spiral of asset prices, and then it can be a problem.

The paper’s fundamental conclusion seems to be that the increasing linkages and illiquidity among the various components of the financial sector indicate a buildup of systemic risk, and the returns of hedge funds in particular can be   examined to spot it.

It’s a very dense paper, and if the reader wants a lengthier explanation that is nonetheless friendly to non-economists, FT Alphaville recommends Free Exhange’s take on it.

The second paper, posted at VoxEU and written by Andrew Rose and Mark Spiegel, starts from the premise that perhaps we know less about what       causes financial crises than we think.

The authors build on previous econometric work and look at the variables that are commonly cited as either causes of the current financial crisis or factors   that made it more severe. Here they are:

the 2006 current account (expressed as a percentage of GDP); the 2006 measure of credit market regulation estimated by the Heritage

Foundation;

2000-06 growth in bank credit (again as a percentage of GDP); the country’s trade with the US as a fraction of its 2006 trade; the 2003-06 growth in stock market capitalisation; and the log of 2006 real GDP per capita.

The authors did find that across a number of countries, stronger credit market regulation was negatively correlated with the incidence of a financial crisis.     And they found that the worse the current account deficit or the greater a       country’s short-term external debt, the more intense the crisis.

But then they took these findings a step further, and tested the variables to

see if they would have helped predict previous crises.

The answer (emphasis ours):

“Unfortunately, we find that even the best estimates gleaned from the Great Recession are not stable predictors of the incidence of global recessions at different periods of time.

Countries with large current-account deficits seemed to suffer more in the       Great Recession. The single most robust result of the Great Recession           analysis is the negative and significant effect of the credit market regulation    variable; looser credit market regulation seemed to hurt recently. But for the   two previous global recessions, this effect is often positive and significantly so in a number of the samples; it is never significantly negative. Such sample      sensitivity reinforces our scepticism concerning the value of such exercises.”

They also point out the inconsistencies in some of the other variables across countries, but the point is clear enough: the causes of the next crisis might be completely different from the causes of this one.

FT Alphaville has been on something of a Reinhart-Rogoff kick lately, so we    checked This Time is Different to see what the authors think. Real housing      prices, write the authors, top the list of indicators that a banking crisis is on the way–but they are skeptical that any indicator exists that can reliably estimate the starting date of the crisis.

And even if a reliable warning system did exist, there’s a bigger problem that economists probably can’t do much about. From page 281 of This Time is    Different:

“The most significant hurdle in establishing an effective and credible early     warning system, however, is not the design of a systematic framework that is capable of producing relatively reliable signals of distress from the various     indicators in a timely manner. The greatest barrier to success is the well-entrenched tendency of policy makers and market participants to treat the     signals as irrelevant archaic residuals of an out-dated framework, assuming  that old rules of valuation no longer apply. If the past we have studied in this book is any guide, these signals will be dismissed more often than not. ”

Source:https://www.ft.com/content/64a37773-b77a-3a75-9994-bcd917a2dbf2

Requirement

The report must be written in English, with overall length less than 400 words

excluding references and appendix.

Your analysis must be your own, demonstrating your own ideas and independent

and critical thinking (and not those of someone else).

The deadline of the assignment submission to Learning Mall Online is at 11pm

Sun 16 April 2023.

Format

Submit the soft copy in a Word file, the file name should be “FirstName

LastName StudentID”

Provide a meaningful title to the report

Report word count at the end of the report

Font: Times New Roman, size 12, line space:2; align two margins Reference properly both within text and end of reference list, Harvard reference

style