What could we learn from the financial crisis?

Some media is discussing what we can learn from the financial crisis at this time of 10 year financial crisis anniversary. I am going to talk about the financial crisis as well, as it is always good for us to learn from the history, especially when the financial market is in boom at the moment.

In 2007-08, many experts believed that the decision of the US Fed to increase the rates caused the collapse in the US housing market. However, I think this conclusion is too simple to describe the crisis. I think that the most serious issue in the crisis is that many financial institutions did not understand the risk of the assets they held. However, this is only the surface issue not the core problem. Some may argue it is because of asymmetric information in the financial market; I think this is only partially correct, the core issue is conflicts of interests within the financial industry.

In all sectors, conflicts of interests exist as it is almost definitely that employers and their employees have different interests and goals; however, only in the financial market, the situation is slightly different from other sectors as the employees are more likely to behave in a more different way from the way their employers want them to behave. This is because in the financial markets, either employers or employees design their strategies in the financial markets based on their individual risk preferences. However, employees are more often taking strategies at a higher risk level than thee desirable risk level that their employers are willing to take. This is because as any fund is provided by the employees’ employers or clients, and the employees do not face the direct risk by themselves, to compare the risk and the potential risk, compared with their clients, their relative potential returns are higher than their clients and the risks they are taking are defintely lower than their clients or employers’ as they do not make direct financial activities by their own wealth. Therefore, even when employers and their employees have the same risk tolerance, the accumulated risk conducted by the employees will be higher than the risk tolerance of their employers, and due to the existence of asymmetric information, the employers are unaware of this situation.

Therefore, the nature of the financial industry determines that the employees are more willing to take higher risks than their employers do, this can create that institutions are not fully informed about the risk that they are currently taking. This is the major problem that is likely to lead to a financial crisis.