Financial Markets

A1. The Financial System and the Global Financial Crisis

The Financial System
Structure of the Financial System
The Financial System: Flow of Funds
Indirect Finance is Bigger than Direct Finance
Flow of Resources to Commercial Sector in India
INR billion 2017-18 2018-19 2019-20 2020-21 2021-22
Domestic 18,017 19,657 9,936 12,367 15,761
Banks/NBFCs/FIs 15,169 15,806 8,534 8,724 12,661
Capital Markets* 2,848 3,851 1,403 3,643 3,100
Foreign 3,385 3,867 5,435 3,772 6,244
FDI 2,540 3,019 3,970 4,068 4,188
ECB/FCCB/Short-term credit 845 848 1,466 (295) 2,056
Total 21,402 23,524 15,372 16,139 22,005
*Includes Public issues/rights issues/private placements by non-financial entities, non-SLR investments by banks and
subscription of CPs by non-banks
Source: Estimated based on figures from Handbook of Statistics on Indian Economy, 2021-22, RBI
Functions of the Financial Markets
Facilitate allocation of economic resources to best uses

Enable savers to earn returns, users to access funds

Facilitate discovery of prices

Provide liquidity to financial assets

Enable transactions at low cost

Help mitigate risks

Functions of Financial Intermediaries
Obtain funds from savers & make loans/investments in borrowers

Help reduce transaction costs

Facilitate trades

Pool resources

Mitigate risks

Reduce information asymmetry & related problems

Information Asymmetry
One party has more information than the other
• Used car sellers
• Borrowers from banks
• Issuers of securities
• Insurance customers

Consequences
• Adverse selection
• Moral hazard
Adverse Selection and Moral Hazard
Adverse selection
• Parties with more information will participate selectively in trades
• Consequences: lesser participation, lower trade volumes, reduced competition

Examples
• Financial markets: retail investors are likely to receive higher subscription of
lower quality companies in IPOs
• Banking: less creditworthy borrowers are more likely to seek loans
• Insurance: potential customers may want known problems covered, not
disclose them

How financial institutions deal with adverse selection

• Profiling, due-diligence, screening, assessment
Adverse Selection and Moral Hazard
Moral hazard
• A party has incentive to undertake risky actions because somebody else bears
part or full costs of the risk.

Examples
• Insurance: customers are likely to engage in risky activities after they are
insured
• Banking: borrowers have incentives to make riskier investments if they have
limited liability

How financial institutions deal with moral hazard

• Terms and conditions for lending/investing/insurance
• Monitoring of borrowers/issuers financial health and use of funds
Agency Problems and Conflicts of Interest
Principal-agent relationships
• Shareholders-management
• Investors/lenders-issuers
• Issuers-investment bankers
• Investors-fund managers
• Investors-credit rating agencies

Agency problems
• Information asymmetry: Agents know more than the principals
• Conflicts of interest: Agents’ interest may not be aligned with principals’
Financial Crisis (2007-08)
Causes, Developments and Consequences
Financial Crisis of 2007-08
Originated in the US housing market

Caused by reckless mortgage lending to low-income home buyers

Role played by investment banks, rating agencies, & other institutions;

failure of regulations

Resulted in the near-collapse of the US financial system

Had far-reaching impact on financial institutions, markets & economies

worldwide
The Housing Bubble in US
What caused the 2007-2008 Financial Crisis
Financial innovation enabled subprime mortgages
• Quantitative evaluation of credit risk enabled large scale lending
• Securitisation of mortgages into mortgage-backed securities
• Use of complex instruments – CDOs and CDSs

Big, overleveraged banks – too big to fail

• Repeal of Glass Stegall Act, 1932 of US in 1999 – combination of commercial
banking and investment banking
Causes of the 2007-2008 Financial Crisis
Adverse selection and moral hazard
• Lax lending standards
• Poor risk assessment of complex instruments
• High loan-to-value ratios

Agency problems
• Originate-to-distribute model of mortgage brokers
• Conflicts of interest of rating agencies
Causes of the 2007-2008 Financial Crisis

Behavioural reasons
• People over-extrapolated recent trends resulting in housing bubble
• Self-delusion that the subprime securities were not subject to high risk
• Initial losses led to panic selling resulting in crash in financial markets
Developments of 2007-2008 Financial Crisis
Trigger
• Housing bubble burst in US after peaking in 2006

Bankruptcies
• Lehman Brothers in Sep 2008

Bail-out by US Government & Acquisitions

• Bear Sterns, Fannie Mae & Freddie Mac, Merrill Lynch, AIG

Financial contagion
• Great recession (2007-09) across the world

Sovereign Debt Crisis in Europe (2009-2010)

Impact on Credit Spreads
The Impact on US Stock Prices
Long Term Consequences of the Financial Crisis
Quantitative Easing
• Low interest rate regime
• Rise in asset prices – the everything bubble
• Ultimately, rise in inflation followed by monetary policy tightening
Tightening Regulations
• Basel III for banks – increasing capital requirements
• Stricter norms for securitization and credit derivatives
• Dodd Frank Act
Weakening of trust in financial system
• Rise of fintech
Financial Crisis & The Rise of Fintech
Problems with the traditional financial system
• Overleveraged
• Oligopolistic
• Inefficient, high cost of intermediation
• Restricted access, unaffordable to masses

Effect of global financial crisis

• Questions raised about existing financial structure, forcing regulators to act

The fintech ecosystem is competitive and efficient

• But incumbents are acquiring fintech
• Regulators tend to be cautious
• Will tech giants create new oligopolies?

Reducing regulatory barriers, not just technology, is key to change