Lessons from the Financial Crisis

Posted 30.01.2009

Recent markets developments and the answers public authorities and regulators have so far given to the challenges they pause certainly create cause for concerns and reflexion on the sources of the crisis, the financial system, the pertinence of the behaviour of public authorities, and the impact on the financial system as a whole. It also should drive changes in the way institutions are regulated, but more importantly, on how risks are apprehended and measured.

Reasons for the markets instability witnessed over the past 18 months have been debated and discussed a number of times. It seems therefore reasonable to assume that they are well known and relatively well understood. However, the market – and more worryingly its regulators- seem taken of guard every time a new casualty appears, generating some suspicion as to how much awareness and understanding there is globally. Let us therefore attempt to draw a framework that will put some structure around the chaos currently unfolding.

How did it all got started?

All started with the subprime crisis. A segment of the mortgage market became out of favour, on the premises that delinquency rated were on the way up due to an expected slowdown in the world’s growth rate. This became quite suddenly an evidence to finance industry although the theme had been herald by a number of market participants for a number of months; some had even built significant positions ahead of the events, generating at the time at best incredulous reactions.  Overnight, every institution faced the difficult task of evaluating the exposure they had to this segment, and the likely resulting loss. They started to look into their balance sheet to find out. What they found out took them by surprise and this was that they could not really say. The Structured Bonds they held would not allow them to understand exactly what kind of risk they were exposed to; or at least not in sufficient detail. The loss of granularity was such that they could neither determine the scale of their exposure, nor the pain they should expect to take. They could not really estimate the value or the risk of significant part of their balance sheet.  They then turned to the market to find the answer; many of them; at the same time. The resulting unbalance triggered the events and the rest of the story is known. Before exploring the contamination mechanism, let us spend a moment on what happened then and why, more importantly. A Brief History of Recent Times

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