Although a number of developments helped trigger the 2007 financial crash, the most prominent one was the the prospect of significant losses on residential mortgage loans to subprime borrowers that became apparent shortly after house prices began to decline. Along with the structural weaknesses in the financial system, regulation as well as supervision, these triggers help propagate and amplify the initial shocks of the 2007 financial crisis. Following the inadequate regulation of financial innovation, a shadow banking system of structured vehicles was invented. As the shadow banking system constituted of institutions that did not take deposits, they were not thought to be susceptible to a run and were not regulated as tightly as banks. This resulted in the creation of overly complex credit products like the structured investment vehicle, a legal entity created by the banks to sell loans repackaged as bonds with high credit ratings whose assets were often securitised loans that turned out to be much riskier and less valuable than expected.

In the final report by the Financial Crisis Inquiry Commission, the panel determined that the crisis could have been avoided as there had been numerous warning signs that were ignored, among them: an explosion in risky subprime mortgage lending, an unsustainable rise in housing prices, widespread reports of unscrupulous lending practices, steep increases in homeowners’ mortgage debt and a spike in Wall Street firms’ trading activities, especially in high risk financial products. The report also called out the Bush and Clinton administrations, the current and previous Federal Reserve chairmen, and Treasury Secretary Timothy Geithner for allowing the crisis to happen and criticised bankers who got rich by creating trillions of dollars in risky investments (Financial Crisis Inquiry Commission, 2011). However, the conclusion was only supported by the 6 Democrats and was dissented by 4 Republicans on the panel, suggesting that the findings may have been affected by partisan politics and hence, may not be representative of the full situation.

Policy Options to Prevent Financial Crises

According to modern economic theory, information asymmetries and financial market failures are central in explaining macroeconomic fluctuations and financial crises (Estrada, 2011). As lenders know less than borrowers about the use of their funds and cannot compel borrowers to act in the lenders’ best interests, lenders ca