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Global Financial Crisis

Essay by   •  August 13, 2013  •  Research Paper  •  1,243 Words (5 Pages)  •  1,668 Views

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"To support decisions taken by both the providers of funds and the users of funds, the financial system is ... a provider of financial and economic information to market participants" (Viney, 2012, p. 8

Provide an example of the consequences of incomplete information for the financial system from recent history. How have market participants and market regulators responded to the issue of incomplete information?

Abstract

It has been seen that imperfect information can cause a lot of problems, it results in an over allocation of resources and due to the buyer and investor not having enough information compared to the seller, things usually take a bad direction. Imperfect information has been the cause behind the global financial crisis and has also led to the collapse of big companies like Goldman Sachs and Bear Sterns. This Paper will discuss the consequences of incomplete information and its relation to the global financial crisis and will also shed some light on what the market regulators and participants have done to cope with this issue.

Introduction

2007-2008 the world faced the greatest shock called the global financial crisis. It has been thought to be the hardest hit since the great depression of the 30s. It is hard to just blame it on one firm because multiple firms and institutions were involved.

Incomplete information has been one of the main causes behind this crisis. In the case of the GFC, some parties were more informed than others which caused the problem.

Using car dealership as an example, we can explain the GFC in simple terms. Let's assume you want to buy a car and you are willing to pay 20000 for it, you make your way to a car dealer, the car dealer takes you around the lot and shows you a lot of cars, however you seem to like the 2006 lexus more than the other cars, you and the dealer come to a price of $20000, and you happily drive off the lot in your 2006 lexus. What you didn't know is that dealer paid the mechanic and forced him to give the car a good rating. The dealer already knew that the car is going to break down after being driven a few kilometres but he chose to hide that information from you, he used the mechanic for his own benefit by paying him more and forcing him to give your lexus 2006 a good rating and making you pay $20000 for a car that you only would have paid $7000 for, provided you had the complete information.

The case of GFC is similar but the money involved and the consequences are much bigger to the scenario above. The incomplete information and the unethical behavior of the investment banks has led the world trade and the economies of several countries including US to depths of darkness.

What Happened?

In the case of GFC, a lot of sub prime borrowers with low credit rating were allowed to take out loans to own houses. The low income earners were encouraged by the government to take out mortgages in order to own homes. Due to weakened regulatory framework and unreliable assesments on the part of the lenders, a lot of the low income earners were able to take out loans. As the house prices started to fall in the US, these house owners started to have problems. Many house owners realized they were paying too much interest on an asset (houses) which were falling in price and this led to many borrowers defaulting and caused a lot of foreclosures.

What caused it?

Several microeconomic factors contributed to the GFC, these factors include, weakened regulatory framework, incorrect credit evaluation in individual companies in the financial sector and shadow banking. All these factors played a significant role in causing the GFC by ignoring long term risk and encouraging short term risk. Due the risks not being considered, a lot of low income earners were encouraged to become house owners by borrowing money from banks.

Along with the microeconomic factors described above, the consequences of incomplete information can also be seen with the

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