Question

The Crash Course video linked below discusses the events of mid-2000s that led to the financial crisis of 2007-8 and the Great Recession of 2007-9. How much did banking and financial industry deregulation, unregulated assets, and the risky behavior on the part of financial institutions contribute to the crisis? What was the role of TARP and why was it important to prevent further implosion of banks and other institutions? Do you think regulations (e.g., the Dodd Frank Act) put in place after the crisis are helping to prevent a repeat of the Great Recession? https://www.youtube.com/watch?v=GPOv72Awo68

Answer 1

The deregulation of the banking industry led them to make investments into the risky assets having bubbled valuation, the greed to earn more make them creation and investment in instruments such as collateralized debt obligations (CDOs), credit default swaps and OTC derivatives increase the risk exposure and aggressive lending to the people with poor credit background known as subprime lending led to the huge impact upon the financial market and resulted into the financial crisis of 2007-08. The loss of jobs and bursting of the housing bubble in the USA, led to the creation of bad debt, nonpayment of the loans and big companies started failing in the wake of creation of financial crisis. In this crisis, credit rating agencies also played an important role as they always gave a higher rating to such risky assets for the investment, causing investors to go for the high return but risky investments. Later on the result of perverse incentive showed its negative effect and the industry suffered.

TARP was the relief program intended to help the financial institution to come out of the trouble and restructure their books so that they survive and reorganize their operations and the investor’s confidence remained intact up to a certain level. It was launched by the government by dedication the $700 billion and it achieved its object to resurrect the banking and financial industry and later on it was expected to the other industries also. But, it took long time to show the real impact to bring back the consumer confidence in the economy. It was required to do so due to the following reasons:

1. not using TARP, will lead to the further meltdown of the banks.

2. Loss of jobs will create anarchy in the economy and society

3. Investor’s confidence will be completely lost.

4. Economy can face the bigger crisis that that of the crisis of 1930s.

So, it was important to come up with the TARP program.

The acts and regulations like Dodd-Frank Act helped to the economy to make stringent regulatory environment that could prevent the scope of such crisis in the future. It happened due to the strong vigilance of the banking behavior, regulation of new financial instruments as well as special attention to the protection of the interest of the investors and consumers. these benefits reduce the scope of such crisis, but it still requires banks and financial institutions to come up with self-regulation, prevent of agency conflict and prevention of moral hazard in the decision making process. It will help to bring a real change in the industry to prevent the crisis.