July 17, 2015    5 minute read

The Threats of Investment Banks on Financial Markets

   July 17, 2015    5 minute read

The Threats of Investment Banks on Financial Markets

Since the financial crisis of 2008, there have been great disputes regarding the activities of investment banks. Reputation of various banks and the investment banking industry has declined severely in recent years. As a response to investment banks taking on too much risk and harming financial instability worldwide, there has been a substantial need for stricter regulation. This article uncovers why investment banks are needed, but also how they can be dangerous to a financial system and the manner by which they have the potential to harm economies around the globe.

The importance of investment banks

Despite investment banks often being portrayed in a negative light, they are significantly necessary for large and emerging economies. Aside from various investment banks offering private, commercial and wealth management services, they provide financial services to governments and large financial institutions. For instance, corporate finance facilities are provided that involves accumulating finance for governments through issuing bonds. Investment banks also assist leading financial and non-financial companies by offering specific advisory services and mitigating any form of financial exposure they may incur through currency and commodity hedging and derivatives.

Overall, investment banks are essential in providing credit, capital and insurance for households and consumers, namely through indirect methods. Without investment banks, financial markets around the globe would struggle. As a result, global investment banks are vital for the day-to-day economic activities for all large nations. However, as the crisis exposed the various risks of these banks and the need for structural reforms within the industry, the dangers have become more apparent.

Why investment banks can be harmful

When investment banks suffer, not only will the bank itself experience losses, but there would also be a chain of events that would harm other financial corporations, non-financial institutions and the economy as a whole. The recent economic crisis demonstrated this, as economies around the globe were suffering in terms of declining economic activity, output and growth levels.

Current forms of trading securities that are becoming increasingly popular are known as dark pools of liquidity. Dark pools are unique because there is a lack of transparency, i.e. individuals trade anonymously. This form of trading benefits participants by lowering transaction costs. Whilst this can seem to benefit those involved, it does indeed cause risks and issues to financial stability, especially as often the risks are difficult to identify, due to the limited amount of transparency. Firstly, if the usage of dark pools of liquidity continues to gain pace, this decreases liquidity within the market, potentially hampering efficiency. For example, dark pools effectively divide up markets and so negatively impacting market prices for trading. Secondly, trading in dark pools may lead to the prices of stocks on the exchange market not reflecting the true market price. As the main feature of dark pools prevents regulators from performing extensive actions, the most that can be done is to watch the evolution of anonymous trading and see if any further potential issues arise.

Investment banks often hold assets that are difficult to price, which can often lead to mispricing. An example of this would be collateralised debt obligations (CDOs), which have been seen in the past. In terms of the investment banking activity, banks that operated with securitisation of loans had miscalculated the risk of the loans included in the pool. Following this, after the US housing market prices began to fall, which was not expected nor taken into consideration by banks, the estimated values of CDOs dropped significantly. After the CDO bubble had ruptured, financial institutions had suffered great losses, which led to bailouts, driving the financial crisis. The events that followed showed that CDOs were one of the worst financial instruments to date.

The term, ‘too big to fail‘ can be attached to global investment banks. If an investment bank becomes insolvent, the negative impacts caused would ripple throughout the industry due to their interdependent nature and consequently pose great dangers to financial markets. So investment banks play such a vital role in financial markets that if one fails it would cause chaos to financial stability. For instance, central counterparty clearing houses would also take a hit if a bank became insolvent. The losses that a bank made would also impose losses on to such clearing houses, which would then be passed onto financial institutes that are a part of the clearing house. Due to one bank failing, the losses would continue to be imposed and passed on to other corporations involved, which in turn damages the financial market as a whole. If the losses are so severe that various banks begin to fail then this would impact the solvency of central clearing houses and so the effect would spread throughout the entire financial system.

Investment banks make a financial system much stronger, but in its strength lies an inherent vulnerability. Financial markets rely on the operations of investment banks. For instance, these institutes have become so important and necessary that if one begins to fail, the economy and other nations begin to suffer. Due to threats and riskiness imposed by the banks, there has been a greater purpose for regulatory bodies. It is increasingly important to spot and solve potential risks that activities from global banks pose on financial markets and use certain matters to prevent or minimise the threats. However, it is important to note that there are other key factors that can harm financial markets to a greater extent.

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