Essay on global financial crisis of 2007/08

Added on - 07 Jan 2020

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Essay on: “To what extent was the global financialcrisis of 2007/08 caused by inappropriateincentives?”
Topic:“To what extent was the global financial crisis of 2007/08 caused by inappropriateincentives?”In the present research emphasize is given on assessing the impact of inappropriateincentives leading to financial crisis in 2008. There are several banks such as investment andcommercial as well as central banks which controls the money supply and interest rates areresponsible for leading to crises situation in the market. It is because of the fact that, financialinstitution were unable to manage the funds which indeed led the huge market slump. Thus,researcher focusing on understanding how inappropriate incentives cause financial crises.In 2008, financial crisis happened because of several reasons which consist of subprimelending, growth of housing bubble, easy credit conditions, deregulations, increased debt burdenand overleveraging, inappropriate incentives etc. Herein, researcher emphasize on assessing therole of inappropriate incentives in causing financial crisis. According to the study by Pesch(2011), banking crises can be found throughout history. Herein, author argues that inconsistentincentives have cause the financial crisis. However, the roots of current financial crisis lie in thehousing bubble due to which banking has suffered from the burst of bubble doe two mainreasons: firstly, banks have been able to place assets in off balance sheet vehicles and does nothave to possess capital buffers against the institutions (Pesch, 2011). While secondly, bankscould lower their regulatory capital requirements by investing in triple “A” rate securities,mainly mortgage backs or related derivatives.Similar to this research conducted by Brek (2008) states that, it has been often argued thatthe crisis was due to the creation of pertinacious incentives in the management of financialinstitution. However, incentives, financial or otherwise are intended to promote certain behaviorthat are expected to lead to desired results, but they can also cause unwanted effects, perhapsbecause they are poorly designed i.e. improper reward system (Brek, 2008). For instance Bank ofEngland and the Federal Reserve, reward an increase in the share price in the short term ratherthan the achievement of grater value in the long term. It is because they assumed that agents areonly motivated by economic interest, so that the introduction of incentive of this nature crowdsout other possible targets such as the quality of their work or the creation of teams which areeffective in long term.It is likely that many of the inappropriate behaviors in the recent crisis are related to theexistence of perverse incentives (Malinen, 2016). For instance, the attempt to align the interest of1|P a g e
managers and analysts with those of shareholder has led to compensation systems that emphasizeshort term results, which may have led to undesirable behaviors such as excessive risk taking andmanipulation of financial results. In particular to the case of inappropriate incentives, the majorconflict is regarding interest that have arisen for instance in the rating agencies, whose incomedepended in large measure on the valuation of their clients assets. In the banking sector, a USbank incentivized employees to lend to small business and increased lending by 47%, butparallel to this defaults also increased sharply (Allen, 2009). However, as per the book publishedby Bratton (2015) researcher evaluated that, risky behavior fuelled by inappropriate incentiveshas been cited has the cause of financial crisis that began in 2008. Further author criticizing that,new pay paradigm is based on the ethical deficiencies because the practice increases employeerisk and simultaneously diminishes collective representation in pay system (Bratton, 2015). Onthe basis of this, employee risk increases as a larger proportion of pay is contingent on individualperformance which along with the growth of zero hours contracts means that earnings are far lesspredictable.Further in the article of Financial Crisis & Recession, researcher identified that, financialcrisis in 2008 occurred because banks were able to create too much money, too quickly, and usedit to push up house prices and speculate on financial markets (Financial crisis and recession,2010).(Source:Financial crisis and recession, 2010)2|P a g e
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