Banking and international banking system Essay Example | Topics and Well Written Essays - 2000 words

Banking and international banking system - Essay Example Major financial institutions collapsed or near collapsed and credit markets were frozen. Bear Stearns and Sachsen LB (German bank), banks fell in 2007. It was followed by IndyMac Bank in receivership and demise of Lehman Brother in the quarter of 2008 (Drea 2009). After September 2008, panic in the financial global sector escalated and spread to other sectors of the economies. Investors were shocked by losses that they incurred on assets they thought were safe. There was strong evidence that contagion was linked with global financial crisis. This happened through liquidity and risk-premium channels in the financial markets. There was clear evidence informed by research that contagion during subprime crisis was clearly shown by significance of t-statistic for lagged ABX index returns in 2006 (Longstaff, 2010). Cross-market linkages were stronger and significant during subprime crisis indicating that that 2007 subprime crisis resulted in large shifts in trading activity, liquidity and funding in the financial markets across the world. A number of reasons have been advanced concerning the recent global financial crisis. ... The foreign money was savings piling up and owners wanted to invest their monies away from home where they were assured of some returns. The net inflow of foreign savings into the United States in 2006 was about 6 percent of the United States’ output. Instead of investing foreign moneys appropriately, financial institutions in the United States that received the surplus funds from Asia converted the monies to loans that were aggressively given to borrowers, especially homeowners. Mortgage market was attractive to investors because over 80 percent of mortgage market in the United States was securitized and they that their monies would be invest well (Financial Crisis Inquiry Commission, 2010). Securitization created the much needed diversification to investors and liquidity for business entities and individuals. Securitization refers to pooling mortgages together as securities. Once pooled as securities, they are sold to investors. However, investors and players in the industry lacked the business acumen to realize that securitization lacked clarity and transparency. Financial institutions also underestimated the risk associated with securitization and sold mortgage backed securities to investors across the world. The investors, which included banks, money markets, pension hedge and mutual funds, purchased the mortgage backed securities thinking they were safe. However, securitization was not able to provide protection against systematic risks. Even, credit rating agencies failed to take into account systematic risks and awarded the mortgage backed securities with AAA rating because it was considered low risk securities. Therefore, credit rating agencies could not price systematic risks into subprime mortgage pools. In