The Financial Crisis And The Investment Banks Challenges

We all know that Subprime Mortgage Crisis, that burst out in August 2007; has developed into the largest financial shock since the Great Depression inflicting heavy loss to the financial markets and institutions. Dean Baker, an analyst, analyzed that from 1895 to 1995 real prices of houses in the US had not changed. While after 1995 the price increases in houses were well over inflation. He foresaw that it would result in a major crisis. So it happened.
But the question is how did it happen?

In 1990, stock bubble was growing which increased the wealth of people. Then the bubble burst. So people lost faith in stock market and began investing in houses. Also 9/11 event led Federal Reserve Bank to cut interest rates. So this was a huge incentive to buy a house. Up until 2006, the housing market in US was flourishing so individuals were taking on Subprime Mortgages with the hope of rising of home prices.

At this time 1 in 5 mortgages were subprime. However, the housing bubble burst and people began to sell their homes to pay their mortgages. If a person couldn’t sell his home, he was left with one option – Default. So, billions of dollars were lost in mortgage backed securities causing great loss to investors. It not only impacted US but all Central Banks around the world. It shattered all the major economies of the world. It had become a Global Financial Crisis.

Due to this, major banks suffered huge losses. Lehman Brothers, the fourth biggest US Securities Firm collapsed on September 15th. Goldman Sachs faced significant challenges. Morgan Stanley started focusing on lower-risk businesses. Countryside Financial Corporation, the biggest US mortgage lender, was taken over by Bank of America. Fannie Mae and Freddie Mac collapsed and subsequently rescued by the government.

Some reports found that financial crisis was avoidable. It was caused due to excessive borrowing & risk taking by Investment Banks. Its main reasons were failure in financial regulation, breach of corporate governance and malfunctioning of Wall Street.

The Federal Reserve in partnership with Central Banks around the world has taken many major steps to control the crisis. It worked towards improving the market liquidity. It affected functioning of major Investment Banks by tightening the regulations. Federal Reserve made certain guidelines for Proprietary Trading also. On the whole, it strained the operating environment of Investment Banks.

So Investment Banks should prepare for the future challenges while keeping eyes on the present as well. They should carefully assess future opportunities and the probability & capability of their success in capitalizing on them. They should pinpoint the core challenges lying ahead of them. They should strategically respond to regulations, while continuing to satisfy shareholders’ expectations & embedding effective risk management.

They should shift their focus from complex product innovations towards better understanding the client needs and maximizing their profit potential. It will make them to stand out from their competitors. They should narrow down their focus towards using innovative technologies rather than wasting time & money on unsubstantial things. They should not spread their wings in all emerging markets; rather they should rake a calculated approach for picking the right market and completely understanding their culture and way of working.

Now, the International Debt Crisis is also looming on the World Economy. Hence it will further check the core strengths of Investment Banks. The future challenges are going to be more grueling so Investment Banks should start preparing to overcome these challenges in a “real world” context, otherwise anybody can become “The Next Lehman Brothers”.

Sumit Goyal