Behavior finance and market efficiency Essay Example | Topics and Well Written Essays - 2750 words

Behavior finance and market efficiency - Essay Example In this report, the main causes and underlying drivers of the recent global, financial crisis are explained. Also, comparison and contrast of behavioural and non-behavioural explanations commonly provided by finance academics have been made. The main causes behind the recent global, financial crisis include deregulation by financial institutions, accompanied by rapid financial innovation, which stimulated powerful financial booms. As the financial institutions became flawed, leading to the financial crises, governments responded to such crises with bailouts that allowed new expansions to begin (Crotty, 2009, p, 563). First, the integration of modern day financial markets with the era’s light government regulations, which is also referred to as the New Financial Architecture (NFA) led to the global, financial crisis (Crotty, 2009, p, 563). It should be noted that the New Financial Architecture is based on light regulation of commercial banks, lighter regulation on investment ba nks and little regulation on the shadow banking system. The shadow banking system represents hedge and private equity funds and special investments that are created by banks (Crotty, 2009, p, 563). Minimal regulation of financial institutions led excessive risk taking by numerous financial institutions because of the existing incentives in the market, without fear of restriction or limitation. The assumption that rational investors can make optimal decisions, and that only those who could handle risk, could take it is based on poor theoretical foundations, with no convincing empirical support (Crotty, 2009, p, 563). On the contrary, many investors and financial institution took excessive risk, which they could not manage. Consequently, the global, financial crisis had to arise when the potential losses associated with high risk occurred. Separately, it should be noted that perverse incentives affect key personnel of vital financial institutions such as commercial banks, insurance co mpanies, investment banks, hedge and private equity funds, as well as, mutual and pension funds to take excessive risk when financial markets are buoyant (Crotty, 2009, p, 563). For instance, the provision for no return of fees for securities for mortgage loans, if the securities suffered large losses made most market participants to take loans, as much as the loans may have not been viable or sound (Crotty, 2009, p, 563). Problems arose when the loan takers failed to service or repay the loans because their investments could not profit due to the prevailing market conditions. Financial innovation contributed to emergence of recent global, financial crisis because it led to the creation of financial products that are so complex that they are not transparent (Crotty, 2009, p, 563). This means that such financial products cannot be priced correctly. They are also illiquid and are not sold on markets. In the current financial market, there is a higher value of securities that are not s old on the markets than the existing securities (Crotty, 2009, p, 563). The fact, that sale of securities derivatives is mostly carried out by an investment bank negotiating with customers over the counter, led to