Term paper on Financial markets

Interdependence of factors of systemic risk shows that even the presence of small financial shocks can be sufficient for large imbalances in the economy. This indicates that the macroprudential supervision should cover a systemically important financial intermediaries, markets, infrastructure and tools. (Praet 2010)

Systemic liquidity risk has been at the epicenter of the past crisis, so central banks had to intervene using untested methods. It is therefore important to stress the need for a macroprudential system designed to reduce system-wide or systemic liquidity risk.

Regulation of the financial system can be realized through:
– prudential regulation (micro-prudential regulation at the level of individual institutions and macroprudential – at the level of the financial system);
– tools to maintain financial stability;
– oversight of payment and settlement systems;
– regulation of certain activities in the financial market (business management).

Ensuring the stability of the financial system lies in deterrence of instability factors, preventing their influence on the economic system, that is, transition to the stage of systemic risk.


The idea of separation of the commercial and investment banking emerged in the mid 30s of the XX century and became a logical consequence of the financial crisis, known as the Great Depression. The separation was legally fixed in the Glass-Steagall Act. It pointed the main principle of risk sharing of investment banks and commercial banks, which worked with the public, and therefore their stability was very much a cornerstone of the stability of the financial system and economy as a whole. So the Glass-Steagall Act was passed in 1933 to divide the activities of investment and commercial banks. The act was a response to the speculative operations of commercial banks in the securities market, which served as a factor in default on U.S. exchanges in 1929. Consequence of the law is the emergence of specialized banks. In turn, the law has caused great dissatisfaction in a professional environment, and even banks stood for the abolition of the law, arguing that diversification reduces risk.

For many years the main source of income of investment banks was the brokerage: up to May 1975 there was a fixed fee, charged by banks to their customers. This fixed fee has allowed investment banks to successfully overcome the crisis in 1973 caused by the oil shock.

Cancellation of the fixed brokerage commissions led to a decrease in the profitability of the brokerage activities of investment banks.

In turn, it required compensation from the new sources of income, often more risky. Investment banks began to administer their own and borrowed capital.

For example, investment bank Salomon Brothers created the first department of trade in securities for own account (proprietary trading).

In pursuit for super profits bank took greater risks. Certainly, among the various departments of investment banks soon appeared the so-called “Chinese walls” intended to ensure that confidential information about the status of companies, trades and upcoming releases would not be subject to those departments that are engaged in commerce and analytics.

Only in 1999 the Glass-Steagall Act was finally cancelled and replaced by the law Grammy-Leach-Bliley, which allowed the consolidation of commercial and investment banks, and preserved a number of restrictions aimed at preventing conflicts of interest. One of the first advantage of this law took Citibank, which merged with Travelers Group insurance company and formed a banking group that provides a full range of financial services including corporate and underwriting services under brands of Smith-Barney, Shearson, Primerica and Travelers Insurance Corporation.

However, over the last decade the investment banks began to experience serious difficulties. Increased competition in the sphere of investment activity resulted in a significant reduction in the relative profitability. Thus, the combination of the world’s largest banks, investment and commercial banks is becoming the leading trend in the global banking practice. In turn, this can be considered as part of a wider process of the formation of diversified financial and banking group with an expanded set of functions.

Financial innovations have made banks highly dependent on the development of stock markets. The policy of low interest, rates pursued by the Fed after the 2001 crisis, led to inflate the bubble of liquidity in capital markets and laid the foundation of the American mortgage crisis, which marked the beginning of the world financial crisis.

September 2008 was, probably, the most dramatic month in the history of modern finance. The banks that survived the crises of the nineteenth and twentieth centuries collapsed overnight. Thus, only in September 2008 became bankrupts such banks as Silver State Bank, Lehman Brothers, Merrill Lynch, AIG, Ameribank, HBOS, Washington Mutual, Bradford & Bingley. (Williams, 2010)

All of the above can be summarized according to the director of the International Monetary Fund Dominique Strauss-Kahn, who said: “The American model of independent investment bank collapsed. Henceforth, the investment component will exist in the universal banks. U.S. investment banks, including the most famous, were actively involved in speculative operations with dubious assets, and as a result have suffered enormous losses”. (Williams, 2010)

The crisis affected companies both in the financial and real sectors, but investment banking business suffered more, since many investment banks were unable to survive under new conditions, or were forced to seek for strategic partners. Among the investment banks managed to survive only those which had their own financial capital and the ability to use it.

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