Question

Define “financial frictions” in your own terms and explain why an increase in financial frictions is a key element in financial crises. How does a deterioration in balance sheets of financial institutions and the simultaneous failures of these institutions cause a decline in economic activity? How does a general increase in uncertainty as a result of the failure of a major financial institution lead to an increase in adverse selection and moral hazard problems? Describe the process of “securitization” in your own words. Was this process solely responsible for the Great Recession financial crisis of 2007–2009? What technological innovations led to the development of the subprime mortgage market?

Answer 1

Financial frictions are a set of conditions that prevent financial market to effectively assign funds to the best investment opportunities.

Financial frictions are key element in financial crisis because as the channeling funds through financial markets is interrupted or limited, the economy slows down.

Fewer resources to lend and lending will decline. The contraction in lending then leads to a decline in investment spending which slows economic activity.

Uncertainity with the failure of financial institution may lead to an increase in adverse selection and moral hazard. This can occur because of failure of a prominent financial or non-financial instruction, a recession or a stock market cash. Anyof these make it hard for lenders to screen good from bad credit risk.

Securtization is the process of turning assets into securtities.

Securitization was key driver of great recession financial crisis. Securtites of mortgage debt in bond like investment was a big cause of global crisis.

The innovations of computer techniques and new techniques of statistics called data mining caused the formation of subprime mortgage market.