How Can Financial Innovations Lead To Financial Crisis

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Nevertheless, lack of supervision and regulations account for the negative side of integration of financial markets. Owing to the global financial markets deregulations, financial managers used creativity in spreading risks with ignorance that the same virtue will have adverse effects on the world economy (Llewellyn 2009 p.55)Financial globalization attributed to growth in the size of financing markets leading to cross-nation misbalance which caused the financial crisis. The developing countries are disadvantaged on the global financial systems. The collapse of the U.S mortgage market revealed the bottlenecks of the global financial markets with complex financial products lowering trust on the whole system.Currently, the global financial crisis is done through innovative investment instruments for instance securitization, derivatives and auction rate securities which were designed through quantitative techniques by mathematicians in an effort to eliminate risk. Securitization is the structured financial process where risks of banks are distributed by pooling loans into sellable assets. This was one of the greatest financial innovation in the 20th century where loans were being converted into securities with the buyer receiving regular payments and the banker disseminating the risk. Banks borrowed more money for lending to create more securitization for loans as they engaged in buying, selling and trading risks believing they have effectively spread the risks only to end in a financial crisis (Keys, Mukherjee, et al, 2007 p.67)The mortgage defaults were caused by the tightening of the monetary policy triggering disturbances in the financial institutions worldwide. The escalating subprime mortgage defaults led to a significant fall in house prices causing a severe liquidity crisis. The risks associated with subprime mortgage crisis involve the credit risk, which is borne by the lending financial institution representing the potential that the issuers of debt security might fail meeting the obligation of making remitting periodic payments and interest to investors.