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On the Causes of the Financial Crisis

Introduction

Over the past few years, there has been advanced growth in investment worldwide. Most investors considered investing their money in various economic sectors. One of the major sectors that were considered to b a secure investment vehicle is the financial sector. This has resulted in the emergence of numerous financial investment options such as mutual funds, bonds securities, and commercial papers. The increase in investment in these sectors is due to their lucrative nature in terms of returns. However, the occurrence of the recent financial crisis has resulted in a reduction in investor confidence in this sector.

About investment, financial reporting is an important element to the various stakeholders. Financial reporting refers to the process of presenting financial information detailing the financial position and its performance about cash flow during a given period. Various rules and regulations relating to financial reporting have been stipulated by the Financial Accounting and Standards Board (FASB). Financial reporting was partly the reason behind the current financial crisis. This is in contrast with the sentiments of the chairman of the FASB who asserts that the current financial crisis was not a result of accounting (Hertz 2009, 2). The discussion of this paper illustrates the relationship between the current financial crisis and financial reporting.

The financial reporting standards that are applied during reporting depict some weaknesses which have resulted in the financial crisis (Financial crisis advisory groups’ recommendations to improve financial reporting 2009, 1). The following are some of the weaknesses in financial reporting.

Inappropriate application of fair value

According to financial accounting standard 157 (FAS 157), fair value refers to the price that is received from selling an asset or paid in the process of transferring a liability in a market between the participants. Fair value is an important element in the process of financial reporting. This is because the financial reporting discloses the fair or the current value of the asset. The prices of various financial assets that are reported by various institutions, do not depict the actual fair value of the assets. For instance, most financial institutions inflated the value of their assets in their books. When reporting to the general public through the balance sheet, there was a perception that these financial institutions have a good financial base and hence their financial instruments were good investment vehicles (Jennifer 2009, 1).

Development of subprime mortgages and ineffective reporting

Most of the financial institutions in the US had developed subprime mortgages. These are mortgages that are specifically designed for individuals with low credit ratings (Jim 2008,1). The financial institutions did not report the actual cost of these financial instruments. Initially, the interest rate that was being offered in the issue of the mortgage loan was relatively low and did not reflect the actual cost of the financial instrument. The effect is that most individuals were attracted to these financial instruments. This is because they perceived an opportunity to own their own homes at a relatively low cost. As a result, the financial institutions increased the number of loans advanced about a subprime mortgage.

With time, the financial institutions revalued these assets to depict the actual price of the mortgage which increased the interest rate. With the revalued cost of the subprime mortgage, most individuals could not be able to pay their mortgages. This culminated in an increase in the number of mortgage defaults which presented a financial strain to the financial institutions and hence the financial crisis (Martin & Neily 2009, 2).

Increased use of off-balance sheet method of financing

The accounting standards were also not effective in regulating financial institutions. For instance, the financial standards permitted financial institutions to incorporate the concept of financing their operations off the balance sheet.

This is a method of obtaining finances by failing to report all the firms’ capital expenditure on their balance sheet (Mark 2009, 4). In using this strategy, the financial institutions kept their gearing ratio (equity debt) and other leverage ratios off their balance sheet. This is because the inclusion of huge capital expenditure in the firm’s balance sheet would result in the breaking of the debt agreement with the financing institution. In addition, the financial institutions developed the Special Investment Vehicles (SIVs) (Mark 2009, 4). This encouraged the firms to engage in risky and speculative investments.

Through the SIVs, the financial institutions increased the number of loans issued to both individuals and institutional customers. These assets increased contingent liabilities. The effect is that the onset of the financial crises resulted in a decline in the financial institution’s creditworthiness.

By allowing financial institutions to finance their activities off the balance sheet, the accounting reporting standards enabled these firms to have a relatively low capital base compared to the potential losses. Through the adoption of this ineffective financial reporting standard concerning financing, the investors could not understand the true financial position of the financial institution (Mark 2009, 4).

Increase in over the counter derivatives

Currently, there are no clear financial reporting standards about Over The Counter (OTC) derivatives (Financial crisis advisory groups’ recommendations to improve financial reporting 2009, 1). OTC is a financial derivative in which the transaction is negotiated directly between the two parties without the involvement of an exchange (Stephanie 2008, 3). The effect is that the various market participants had limited information regarding the degree of risk associated with these instruments.

Poor financial reporting by the rating agencies

The financial crisis also resulted from ineffective financial reporting by the rating agencies such as Dow Jones, and Standard and Poors. Most of the rating agencies rated the financial securities that were backed by subprime mortgages as AAA (Mark 2009, 5). This resulted in the creation of low-risk perception to the investors. In addition, the legal environment increased the level of confidence in the rating agencies about investment. This is because there was increased over-dependence on the rating agencies as a source of investment information. The effect is that there was an increase in the number of investors who invested in these securities due to increased confidence. Due to poor reporting by the rating agencies, these financial instruments turned out to be of junk status which means that their degree of risk was very high.

Increased deregulation amongst the financial institutions

Apart from financial reporting, other factors resulted in financial crisis, for instance, increased deregulation (Anthony, Ellen & Jill 2008, 3).

Over the past few decades, there has been steady economic stability in the US. This resulted in increased confidence about the concept of self-regulation amongst the financial institutions. For instance, the formulation of the Gramm-Leach- Bliley Act enabled financial institutions to engage in risky transactions (Mark 2009, 4).

Conclusion

Financial reporting is an important element in illustrating the financial performance of a firm. Through financial reporting, the potential investors can identify potential investment vehicles. The current financial crisis was partly a result of poor financial reporting. Various firms did not adhere to the concept of fair value in reporting their financial information to the public. This resulted in the creation of false confidence about their financial instruments. The relaxation of financial reporting standards allowed financial institutions to incorporate the concept of financing their activities off the balance sheet. There was also increased development of subprime mortgages by the financial institutions, which resulted in an increased default rate. The rating agencies were also ineffective in their reporting about credit rating.

This resulted in the creation of false confidence amongst the investors. There was also ineffective reporting about the OTC. These investment vehicles had a high degree of risk which the investors did not understand due to lack of information. The financial stability over the past decade in the US resulted in increased confidence in self-regulation amongst the financial institutions. This resulted in financial institutions involving themselves in risky activities. It is paramount that comprehensive amendments be made to financial reporting standards to prevent the re-occurrence of another financial crisis (Emily 2009, 3).

Reference list

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