Financial Innovations A Catalyst Of Financial Crises

(A Study of Great Depression, Recession 2008 &

Pakistan's Economy)

Faiza Nawaz
M.Phil
Hailey College of Commerce
University of Punjab

1
Part I

Financial Innovations
&
Great Depression 1930

2
Financial Securities: A Major Source of Capital

 Till World War I : Less Financial Innovation

 1922 Organizations Shifted From Banks To Capital

Market
 Securities Issuance Became A Major Source Of

Capital

“Historical Perspective on the Financial Crises : Ivar Kreuger, the Credit-Rating Agencies, and Two Theories about the Function, and
Dysfunction, of Markets” by Frank Partony
 Attitude of Investors

 More Optimistic
 Investment in Stock Markets--- a Fashion
 Every one wanted to buy--- High demand
 Greediness to earn a lot
 Buying on Margin
 Banks have also invested deposits in Stock market
without depositors consent
 Presumed that Stock Market Prices will always keep
on rising
 Demand for productive & capital formation relating
products shrinked
4
Advent Of New Complex Financial Instruments

• Participating Debentures
• Structured Notes
• Offshore Subsidiaries & Off Balance Sheet
Transactions
• SPV
• Non Voting Stock
• Participating Preference Shares With
Dividend
• Debentures With Varying Conversion Rights
& Obligations

5
 Complexity Facilitating Poor Risk
Evaluation

 Complex Financial Methods

 Accountants & Auditors Perform Superficial Examination

 No Legal Obligation Binding Accountants & Auditors To

Additional Responsibility
 Most Of The Companies Don’t Issue Financial Statements;

Others Include Only Cursory Information

 Financial Statements : Not A True Picture Of Financial Position
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 Worst Night Mare for Over Traded
Investors
A Financially Sound Company , Including The Money
Of A Number Of Investors & Creditors ; Suddenly
Declared Bankrupt
 Sudden Fall in Stock Prices
 Stock Market Crash
 Investors lost money
 Have to payback to brokers the borrowed money
 Banks lost the depositors money
 A number of Institutions lost their existence
 Unemployment replicated
 Great Depression………
7
 PART II

Financial Innovations & Recession 2008

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 Causes of Recession 2008 :
Piling Up of Five Major Bubbles

New Economy ICT Bubble

Real Estate Bubble
Innovations In Financial Engineering With
Derivatives
Commodity Bubble
Stock Market Bubble

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Financial Bubbles, Real Estate Bubbles, Derivative Bubbles, and the Financial and Economic Crisis
D. Sornette, R. Woodard
 Financial Engineering with Derivatives

 Derivative is contract whose value is based on

or derived from a traditional security or an
asset.
Future
Forward
Swap
Options
• Call Option
• Put Option
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 Types of Derivatives

Derivatives

Foreign Exchange
Credit Derivatives Interest Rate Derivative Equity Derivatives
Derivatives

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Development of Credit Derivative Markets: Implications on Monetary Policy and Financial Stability of Developing Economies
like India
Anil Kumar
 Financial Instruments That Triggered
Recession 2008

Asset Backed Securities (ABS)

Mortgage Backed securities (MBS)

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Development of Credit Derivative Markets: Implications on Monetary Policy and Financial Stability of Developing
Economies like India by Anil Kumar
Collateralized Mortgage Obligation (CMO)

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Collateralized Debt Obligation (CDO)

Asset Sold Principal & Interest

to SPV
Senior
Originating Middle
SPV
Bank Risky Notes
Cash Funding

14
15
 Credit Default Swaps (CDS)

16

Development of Credit Derivative Markets: Implications on Monetary Policy and Financial Stability of Developing Economies
like India by Anil Kumar
 Outcomes of Using Complex Financial
Instruments
 Violation of Basic Principle of Risk & Return Sharing
 Fed Increased interest rates in 2005-2006
 Adjustable rates on mortgages moved up
 Monthly payments on loans increased
 Borrowers were unable to pay back: defaulted
 Demand for homes decrease
 House prices Fall
 Banks defaulted due to CDOs
 Insurance companies defaulted due to CDS
 Perpetual Money Machine; stopped working
 Recession 2008….

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PART III

Derivatives & Pakistan’s Economy

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 Advent of Derivatives in Pakistan

Equity Derivative products were

launched in KSE in 2001.
Still after ten years it is considered as
under developed as compared to India

Pakistan Equity Derivatives Market by Faiza Naz 19

 Users of Derivatives in Pakistan

(Authorized Derivative Dealers)

Banks
DFIs
Mutual Funds
Non Banking Financial Institutions

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 Types of Derivatives Traded in
Pakistan

Foreign Currency Options

Forward Rate Agreement
Interest Rate Swaps
Future Contracts--- Traded on National
Commodity Exchange Limited (NCEL)

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 Reasons of Slow development of
Derivative Market
Some institutions like Banks & Mutual
Funds are only allowed to use derivatives
to hedge their existing position in spot
market
Internal policies prohibitation
Lack of knowledge & expertise
Cash margin requirement & unique
identification number based margin 22

collection from brokers

 Recommendations For Promoting
Derivatives In Pakistan

Require initiatives by the regulator and the

exchange to create investor awareness
Inform and educate brokers, dealers, traders,
and market personnel
Devote more resources to develop the business
processes and technology necessary for
derivatives trading.
Institutions should try to build competent staff
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at all levels.
 Recommendations For Promoting
Derivatives In Pakistan

Market development reforms ;state owned

institutions like Employee Old Age Benefit Fund
and National Investment Trust should be
encouraged to participate in the derivatives
market. This will help increase liquidity.
SECP in association with the Karachi Stock
Exchange Board and Members should design
some mandatory study guidelines for traders,
fund managers, settlement officers and other
related parties. 24
 Conclusion

“More the transparency, lesser the

complexity & uncertainty, higher the
preference given to productive rather than
speculative activities and better justified
the risk & return sharing ratio: higher &
prolonged would be the market stability.”

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Thank You

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