Enhanced Funds Seeking Higher Returns

In this report we discuss the factors driving the growth of the global financial sector that are considered by many authors (e.g. Toporowski,1999 and Orhangazi, 2008) to have precipitated the financial crisis of 2007-2008. Our analysis focuses on the behavior of the different types of financial as well as non-financial companies that financed the global expansion of financial assets. First, we find that investors of hedge funds and private equity funds lacked clear guidance on the expected performance due to the lack of transparency of operation and because conventional risk-return measures have proven to be inapplicable. Furthermore, it is also likely that hedge funds drastically decreased liquidity in certain markets during the crisis as they rushed to cash in on their assets. On the other hand, most of their investors were institutional investors, which prepared for potential losses and the collapse of hedge funds during the crisis did not shake the financial system. We also demonstrate the important role of NFCs in the process of financialisation of the economy. We point out that, as a result of a change in NFCs’ relationship with financial markets following 1980, financial assets held by non- financial corporations increased relative to the value of their real assets. This micro- based process of financialisation was triggered by a shift in corporate governance norms towards maximizing shareholder value as well as NFCs’ drive to compensate for falling rates of return in the real sector. The increased interconnectedness of the financial and the corporate sector also seems to explain why the crisis of thefinancial sector inevitably led to a full-fledged economic crisis. Finally, we show that the active proprietary trading of the leading US investment banks was also an important element in the buildup of risks in the financial system preceding the crisis.