In this part of the essay I will be detailing how the break down of market discipline played a role in triggering the financial crisis.
The cause of the 2008 financial crisis was since banks were giving out loans and easy to obtain mortgages that individuals could no longer pay back and from this the banks collapsed and caused a ripple affect around the whole world and in this essay, I will detail how market discipline played a part. Firstly, market discipline is the obligation made by banks, investors and financial institutions to control stake holders risks daily. Market discipline is important because it ensures that the markets are fair and equal with all parties having equal information. I will begin with why market discipline failed. Bank investors did not thoroughly gage the risks that could happen in addition to this even the markets did not identify the weaknesses and did not take note of the possible risks that are present to them which contributed to the financial crisis.
There are four pre-requisites for effective market discipline to ensure that there is financial stability. Participants in the market need to have the right level of information to produce well thought of conclusions. Secondly, they would need to possess the ability to process such information efficiently and correctly. Third, they would be required to have the right incentives to want said information. And lastly, they would need to possess the right mechanism to carry out work under discipline. Only when those four pre-requisites are met is when the market is disciplined and follows the correct order of operations.
However, market discipline comes with its fair share of limits such as markets can react late, abruptly, contagiously or excessively). Market discipline needs to be partnered with policies with strong disciplines and with strong regulatory standards. It also comes with its fair share of advantages, one being that it keeps information fair among of parties involved such as bank managers and investors also another advantage would be that it’s in the best interest of the involved parties to have a disciplined market because it maximises profit for all involved resulting in a win-win situation. Furthermore, the four pre-requisites themselves have their own limitations firstly beginning with information. Referring to the economic sectors information is often under-supplied for necessary financial discipline and the requirements to produce such information is monitored and concentrated and the benefits that come from this are spread and not properly managed by the creators which can create conflicts of interests between the suppliers of the funds and the users. These conflicts of interest may have originally resulted from the lack of identifying the relevant information however other factors may have contributed to the conflicts as well.
The second mentioned pre-requisite is the ability or process the gathered information effectively, if this is not done correctly individuals or organisation would be receiving false incorrect information, it’s essential to understand the information that comes and equally as important to know what the information means. The third mentioned pre-requisite is having the correct incentives to do what you do. When processing information its vital to have the right incentives to do it, making sure what your doing is for the correct reasons and in the benefit of all parties involved. And lastly mechanisms will not always necessarily operate sufficiently. The cost to stop financial instabilities can sometimes be delayed or not arrive on time to prevent problems from arising and sometimes when It does there’s the added problem that it won’t be effective enough to stop the problem.The beforementioned limitation alone can be enough to conclude in a financial instability and not having well developed back up plans to prevent major collapsed. When backup plans are not put in place a variety or problems can arise and cause issues which can be seen in the financial crisis in 2008 and seeing how they did not implement an effective safety net.
The breakdown of market discipline would have played several different parts into why the financial crisis happened. Banks rely on information on the risks they are taking for them to assess those risk and adjust accordingly to minimise those risks and even if it fails they are protected enough that it doesn’t affect them severely. This protocol became very lenient during 2008 the year of the financial crisis. Investors found themselves without sufficient information to give a calculated risk assessment but went on with the deals themselves, this led to an increase of funding increasing the crisis.
Asymmetric information Is one of the major causes for a market failing, so when a bank has more information about how much financial burden they can take compared to investors they get to decide what risks to take on and which one not to. When market discipline is effectively applied we see how debt investors make sure that banks do not take on too much risk at risk of collapse so when a bank is properly disciplined meaning when the bank managers have access to information they are not necessarily supposed to have it would begin to increase the equity prices so therefore it’s in their interest that both parties have equal and viable information, and no one Is above one another. In conclusion I believe the break down in market discipline played a big part in the cause of the financial crisis of 2008, there are several instances where the two can be linked and the trail it left causing the crisis for example having viable information was one of the pre-requisites and this can be linked to the financial crisis because the investors and financiers because they failed to receive accurate information on how they individuals who were granted loans and mortgages were going to pay them back or even when they failed to see when the house prices fell. There are also clearly many other factors that took place that also led to the financial crisis, but I believe these are the main reasons as to why the crisis originally happened