Financial Innovation In Banking Sector

Introduction

What is Financial Crisis? A financial crisis is when the value of a financial institutions or assets declines suddenly, where investors sell off assets or withdraw their money due to the fear that the value of the assets would drop. E. g. Of a financial crisis are:

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•  Banking Panics
•  Stock market crashes
• Bursting of financial bubbles
• Currency crisis.

What is Financial Innovations? Financial innovations are ongoing development of financial instruments designed to achieve a specific objectives, such as offsetting a risk exposure (i. e. default of a borrower) or to assist with obtaining financing. Financial innovation can either be product or process. Process are developments demonstrated by new means of distributing securities, processing transactions or pricing transactions, while product innovations embodied by new derivative contracts, new corporate securities or new form of pooled investment products.

Examples that relate to the crisis include the adjustable rate mortgage. i. e. the packing of subprime mortgages into Mortgage Backed Securities (MBS) or Collateralized Debt Obligations (CDO) for sale to investors, a type of securitization and a form of credit insurance called Credit Default Swaps (CDS), Collateralized Mortgage Obligation (CMO) The use of these products extended radically in the years prime to the crisis. These products differ in complexity and the simplicity with which they can be valued on the books of financial institutions. The purpose of this assignment is to discuss how the innovations in the financial products contributed to the current financial crisis. In this paper I also examine what these financial innovations are and how they contribute to the current financial crisis. Some of these financial innovations I will look at are CDO’s, CDS, and MBS.

Financial Innovation and the Financial Crisis

These are many factors played a part in the financial crisis and financial innovation was one of the factors but it did not only cause the financial crisis but to some degree it did contribute to the crisis due to it misuse and lack of information and the under pricing of the risk involve in some of the financial product. Collateralized Debt Obligations (CDO) Collateralized debt obligations are asset backed security that is package together in a different range of debt obligations or bank loans package into a financial security that is divided up into various tranches, each level having a different maturity and risk.

The greater the risk, the more the CDO pays. The type of CDO tranches include; Equity, Junior, Mezzanine, and Senior tranche. The equity tranche been the riskiest level and while senior tranche is the safest of the CDO. The development of CDOs resulted in more liquidity in the economy. They permit banks to sell their debt, and freed up more capital to invest or loan. Due to the additional liquidity this eventual lead to an asset bubbles in the housing market and credits crisis. So how did the CDO play a role in the financial crisis?

During the early part of the crisis CDO assets started to decrease in value due to the rise in subprime mortgage default. CDO products began to underperform, the opacity of the products with view to the character and quality of the assets that underlined their value; leading to the discouragement in the investors and also led to panic in market about exposed institutions and CDO underwriters. As a result, CDO had lets banks and other financial institutions to increase their leveraged bet on the housing market, increasing returns in the short run escalating the damage once suspicions were raised.

Investors did not know the value of the CDOs they were investing into due to the complexity of the product. Synthetic CDO increase profits on the benefit as the housing boomed however, as doubts occurs; they were use as instrument investor’s utilize to creates a short position on the disadvantage of the housing market. CDOs where use to put money in the mortgage market therefore persuading investors into thinking they were investing in a safe instruments that were establish on low quality assets. The value of CDOs helped in creating the damage of the financial crisis.

MBS create a void among the originator of mortgage risk and the ultimate holder of that risk, this void was considerably broad by CDOs. On the other hand Synthetic CDOs broke the link completely and permit investors to make an unrestricted number of bets on a key risk they did not understand. The complexity of the CDO and synthetic CDO structures was a problem. The cloudiness of the products made it hard to estimate the value thereby discouraged investors from fully understanding the risk that come with CDO investments. (Class Note by Joe Naughton). Credit Default Swaps (CDS) A Credit Default Swaps is a credit derivative and a form of insurance policy on a bond or a loan. The protection buyer buys protection and makes regular payments just like an insurance premium, while the protection seller sells protection and takes the premium but agree to pay off the protection buyer in the event of a default . i. e. the CDS purchaser pays a fee in order to transfer the risk of a default to the CDS seller.

A CDS contract can last for a number of years and obliges that the seller of the protection offer collateral to make sure that the buyer will be paid if the seller where to default. CDS offers numerous advantages to individual participants that use them to hedge risk during the financial crisis and following economic downturn. Credit default swaps play a significant role in the financial crisis by contributing to the CDO market and its difficulties. CDS permit CDO mangers to make hybrid and synthetic CDOs at a huge pace.

CDS allows hedge funds to perform complex hedging and linkage that enable the purchase of junior and equity tranche. The CDS market lets investors and institutions to transfer risk, from the CDO market and elsewhere, to CDS issuers that were not in a position to assume the risk. One of the role CDS played in the financial crisis was that it was able to transfer credit risk through CDS which make it hard to estimate the riskiness of a specific intermediaries. One of the issues also was that bank were able to buys and sells CDS that was not show in their balance sheet.

This lack of disclosure makes it much more problematic for a bank counterparties to tell how risky it is. The lack of transparency in the CDS market made the financial system exposed to a shock that threatens trust in counterparties. CDS sellers became more exposed to a collapse by several sellers; this is due to the fact that a great number of CDS were trade over the counter (OTC), instead of in an exchange. And in an OTC market it is impossible for a seller to know what several buyers are doing with others.

An example is AIG was a victim of the CDS market because the firm misinterpret the risks of the CDS market and sold an excessive amount of credit protection through CDSs deprived not having an enough capital in a loss reserve. (Class Note by Joe Naughton) Mortgage Backed Security (MBS) Mortgage Backed Security is an asset backed security or a debt obligation by a mortgage or collection of mortgages loans.

They are bundle together into pools and sold as a single security. This is known as securitization. .i. e. banks lend money to an individual to buy a house in return the bank will collects monthly payment on the loan. The loan is then sold to a bigger bank that packages the loan together into a mortgage backed security. The bank then issues shares of this security, called tranches to investors who buy then and ultimately collect the dividends in the form of a monthly mortgage payment. These tranches can be further repackaged as other securities, called collateralized debt obligations (CDO) and then sold.

Mortgage backed security played a major role in the financial crisis of 2008, due to the increasing demand for MBS from investors eventually played a part in the financial market meltdown. The demand for MBS increased on mortgages of all risk, including subprime, which lead lenders to move towards the “Originate to distribute” business model, with the explicit intention of securitizing and selling the mortgages after completing them. The MBS tranches rating by the rating agencies led to believe that risks were understood and the investment were safe.

If the MBS had not been given investment grade ratings then the degree of the financial crisis would have been significantly less. The criterion on the MBS was relax making it easy to participate, therefore the market began endorsing different types of mortgages with a more risky kind that amplified the risk of a default to MBS investors. The MBS market was not regulated which also allowed financial institutions other bank to participate in the mortgage business. Mortgage backed security have weakness that was not accurately controlled in the run up to the crisis.

Originate to distribute model spark off a behavioural changes in the market, from consumers to investment banks, that were not expected but that could have been monitored and managed by the industry and its regulators. Financial innovation can not be held solely accountable for the financial crisis but it did contribute a great deal to the crisis and to the extent of the damage.

The risk associated with financial innovation was not properly calculated, inturn in more credit default to occur. Financial innovation has benefits to the economy but due to the current financial crisis financial innovation has receive a lot of negative view as a result of the misused and badly managed of the products and also due to the fact that they were insufficiently thought out and the misapplication of the innovations that might have a positive impact on the economy. But collateralized debt obligations and credit default swaps have done a lot of damage than good.

Bibliography

1. Bruno G, 2012. Rethinking Financial Innovation (online). Available from: http://www3.weforum. org/docs/WEF_FS_RethinkingFinancialInnovation_Report_2012. pdf .
2. (20 November 2012). (Online) Available from: http://www. mhhe. com/economics/cecchetti/Cecchetti2_Ch09_CDS. pdf.
3. (20 November 2012). (Online) Available from: http://www. scribd. com/doc/47101947/Financial-Crisis-of-2007-2010
4. (12 November 2012) (Online) Available from: http://provimet. weebly. com/uploads/2/4/3/4/2434228/global_financial_crisis. pdf (12 November 2012).

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