Friday, December 4, 2009

Causes of the credit crisis

Author: David Schwartz David Schwartz

The Bank of England has called the Credit Crisis an "extraordinary period" which will have "deep and long-lasting consequences" for the global capital markets. The United States Federal Reserve has said the "the sources of the crisis were extraordinarily complex and numerous," but at the root was the Fed’s belief that banks' "risk management systems were inadequate and their capital and equity buffers insufficient."

Financial innovation, according to the Bank of France, “fuelled a search for yield through increased risk taking.” In agreement, the Deutsche Bundesbank, said, "The most prominent shortcomings revealed by the financial crisis fall within the scope of credit risk transfer and the expansion of the 'originate to distribute' business model [which led to] insufficient capital backing for securitizations, as well as inadequate risk management within financial institutions and lack of transparency in the whole transfer process."

"Two weaknesses of the supervisory and regulatory approach" prior to the Crisis, according to the European Central Bank, were "too much [focus] on individual risks and too little on interconnections across intermediaries and markets." The tendency of financial institutions to react in similar ways to the Crisis magnified the market system's instability by transmitting volatility through the balance sheet connections among those institutions, according to the ECB. Once the Crisis hit with force, the contagion spread quickly because "large parts of the system relied on the same sources of funding or because they had similar exposures."