Out of the two causes, poor financial regulation significantly led to the 2008 financial crisis. The financial market deregulations create a situation in which the banks engaged in a hedge fund where they traded with derivatives. Deregulation within the financial system permitted the banks to use deposits to invest in derivatives ( Orhangazi, 2015 ). The investment in derivatives was so profitable, which then attracted the banks to lend even to borrowers who could not afford to pay. One fundamental law was the Financial Services Modernization Act of 1999, which increased investment in risky areas, thus threatening the customers' securities ( Funk& Hirschman , 2014). This law excluded the derivatives from regulations, allowing large banks with adequate resources to manage such complex derivatives. Because the loans were affordable even to the subprime borrowers, many people took mortgaged loans. By 2007, the price of houses was falling as supply became more than demand. Many house owners could not sell their houses but were also unable to pay for the loan. The situation created a crumble in the derivatives, making banks stop lending, thus creating a financial crisis. The deregulations in the derivatives were aimed at increasing competition for foreign firms, but the banks failed to limit their investment to low-risk areas.
The other cause, which is inflated asset prices, is a consequence of the financial market's poor regulations. The deregulations of the financial system gave the banks more autonomy to invest in areas that seemed more profitable. With a little caution, however, the banks failed to avoid investing in risky areas. Providing loans to subprime borrowers was a risk to the mortgage market as the supply for housing exceeded the demand. The outcome was the inability of homeowners to either sell their homes or make payments.
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References
Funk, R. J., & Hirschman, D. (2014). Derivatives and deregulation: Financial innovation and the demise of Glass–Steagall. Administrative science quarterly , 59 (4), 669-704.
Orhangazi, Ö. (2015). Financial deregulation and the 2007–08 US financial crisis. In The Demise of Finance-dominated Capitalism . Edward Elgar Publishing.
