Corporate Risk Management

CHAPTER 17Structured Finance and the Financial Crisis of 2007–2009¹

Structured finance includes all advanced financial arrangements intended to refinance and effectively manage and cover credit risk of all economic activities. It has changed the role of banks and the functioning of financial and monetary markets. In many countries, structured finance has become a very important economic activity that has radically transformed the links among borrowers, lenders, and investors. Yet structured finance is also often cited as a major cause of the most recent financial crisis.

The objective of this chapter is to show that structured finance (and its complex products) did not cause the financial crisis. Rather, the problem stems from poor risk management in the years leading up to the crisis. We will look at the following examples: Agency problems in the securitization market, poor rating and pricing of structured financial products, lack of incentives for rating agencies to make objective evaluations, lack of market transparency, quest for high short-term returns by top management not motivated by the long-term financial stability of their companies, and the failure of regulators and central banks to understand the implications of a constantly evolving financial environment.

As a result of the crisis, several major banks declared bankruptcy, and governments and central banks had to rescue many other financial institutions. These bailouts protected financial markets in the short term, ...