Introduction Financial crisis is a bubble created by excessive investor inclination towards a particular market. It shadows the valuations and when the bubble bursts, the investors want to exit and therefore rapidly start selling their stake.Too much of capital led to lower interest rates and this in return forced the investors to look for creative investment platforms where the yield was high. This requirement led to an unprecedented growth in the securitization market as the inclination towards such derivative instruments was high. Investors were willing to take higher risks as compared to the returns they would receive for their investments. Greed for higher returns, excessive leverage and low volatility led to the financial crisis of 2008. This low volatility which was a result of shadowed valuations led the borrowers to borrow over and above what their asset base allowed notwithstanding the criteria of credibility.However, prior to the crisis there was a strong merger wave that took over the world financial markets. In the wake of the strong and sustained economic growth, high corporate profits and competition; the M&A activity thrived. But soon this wave came to an end due to the skepticism of the corporate managers about the instruments of structured finance. This wave was classified by a cash sub set and excessive cash reserves of the bidder destroyed the value for the target. During this period the valuation diversity between the target and the bidder was less. In the backdrop of relaxed regulatory regime the decisions that were taken were more rational.[1]The desire to seek higher returns while diversifying risks had led to the crisis which further led to consolidation in the banking sector as a means to combat the effects of negative synergies that the crisis had entailed. Merger seemed a viable option[2] as the government players and the robust banks with better credit and equity positions directed their efforts towards smaller deals with acquisitive advantages. This included targets with weak credit and equity standing. Though effect of the crisis that originated in the US housing market did not reach the banking sector till 2009.Despite high leverage in the market, there was fear looming over the Europe which held back the buyout activity. There was freezing of credit and banking panic that slammed leverage loans. The wall of refinancing was knocked down as there was a dearth of new buyers for these collateralized loans. [3]There is a vicious cycle that engulfs the global financial markets. It constitutes deleveraging of the assets, price decline and investor redemption that makes the financial markets uncertain and volatile. Crisis of 2008 saw a decline in the commodity, oil and equity price. Simultaneously, a collapse of the housing mortgage market made things worse. The residential mortgages were bundled and sold off as securities in the form of bonds and collateralized debt obligations. A lot of foreign banks bought these securities.So when the payers in the US housing mortgage market defaulted, these buyers were affected in their respective home markets. US banks lost money and this gave rise to a liquidity crunch; the receivables from the mortgage loans were stopped as a result of which the return on securities and CDOs were affected. [4]In response to the prevailing conditions there were regulatory reforms that the financial markets were resorting to. US introduced Dodd-Frank Wall Street Act and Consumer Protection Act. A G20 summit called for Basel III reforms which were however, introduced in 2010 but member states were given time to incorporate these in their domestic system. In UK about 80 new legislations were made in order to incorporate preventive measures into the existing regulatory framework as well as to remove the inadequacies of the same. [5]In this essay, we shall be evaluating the regulatory reforms that were introduced post crisis and its contribution towards the recovery of the financial markets. We shall also analyze the following thesis question: “Are the risks inherent in the financial markets or is it possible to regulate these risks and provide for safer financial markets?”. The first section of this essay shall enumerate the reasons behind the financial crisis and its impact on the global financial markets. In the second section we shall study EU’s regulatory and supervisory response to the crisis and its internationally cooperative contribution in the G20 meetings. Also in this section we shall focus on the banking & financial sector in UK. We shall highlight similar changes that were made to the US regulatory framework. However, section 3 of this essay shall talk about consolidation of the banking sector as a measure to reduce the effect of crisis and the role of the government in this post crisis merger wave. Section 4 shall be attributed to the findings and analysis. Reasons behind the Financial Crisis of 2008 1.Low Volatility and High Leverage:Low volatility means that the risk is low as the value of the security does not fluctuate dramatically but, changes at a steady pace. And thereby there is more capital available at a lower asset base. This leverage fueled the rising housing market in the US. A lot of savings turned into investments as lower risks were reflected at the existing volatility rates.  Thus, the lower interest rates remained low for a considerably longer duration due to the inability of the Federal reserve to raise the interest rate amidst such financial conditions. [6]Tracing the beginning of the problem, let us study the role of Fannie Mae and Freddie Mac in the US Housing sector.“Fannie Mae’s and Freddie Mac’s public purpose is to facilitate the steady flow of low-cost mortgage funds[7]. Their primary focus is on residential mortgage market and they won’t abandon it or change lines. Their charter states that the mortgages that they purchase and guarantee must be below an amount specified by the Office of Federal Housing Enterprise Oversight (OFHEO). Also, they are barred from entering the business of other housing finance companies e.g. mortgage origination. They must meet annual goals established by the Department of Housing and Urban Development (HUD). These goals center around low and moderate income housing and housing for minorities. They are subject to risk-based and minimum capital requirements and annual examinations by OFHEO. Fannie Mae and Freddie Mac are driven by profits, as their shareholders demand. While fulfilling their public mission, they make their profit in two primary ways: guarantee fee income and retained portfolios.”[8]“Fannie Mae and Freddie Mac are regulated by the OFHEO (Office of Federal Housing Enterprise Oversight) and the HUD (Department of Housing and Urban Development (HUD). OFHEO regulates the financial safety and soundness of Fannie Mae and Freddie Mac, including implementing, enforcing and monitoring their capital standards and limiting the size of their retained portfolios. OFHEO also sets the annual confirming loan limits. HUD has responsibility for the housing mission of Fannie Mae and Freddie Mac.”[9]“There is no doubt that Fannie Mae and Freddie Mac played a critical role in US housing finance system. However, there was a danger in having so much risk concentrated in only two companies. They managed an immense amount of credit and interest rate risk. Many critics feel that, due to their size and the complexity of managing mortgage risk, they posed too large of a systematic risk to the US economy. Put simply, there was a danger that the two companies have been allowed to take on too much risk at the potential expense of the American tax payer. To put things in perspective, according to Treasury Secretary Steel, at the end of 2006, Fannie Mae and Freddie Mac had about $4.3 trillion of mortgage credit exposure, which was about 40% of total outstanding mortgage debt in the U.S. In the summer of 2007, the market for all mortgages except those guaranteed by Fannie Mae and Freddie Mac came to a complete standstill, emphasizing the importance of the roles played by the two companies. In the fall of 2007, Freddie Mac shocked the market by announcing large credit-related loses, fueling the fire for the argument that the two companies pose a tremendous risk to the entire financial system the impact of which could be seen worldwide.”[10]2. Financial innovation during the period in question: This housing bubble of the mortgage market became a part of a more attractive system of securitization.[11] The mortgages tendered to the consumers purchasing houses were pooled together and sold off as tradeable assets. Due to low volatility the underlying risk was ignored. After reaching the peak, the market saw a decline and this affected the securities backed by these mortgages. Due to consumer default and excessive mortgage, the mortgage market faced a slump and house prices fell. This raised investor panic.Although, the conditions preceding the crisis which are characterized by high risk appetite, high leverage and low volatility significantly contributed towards the development of structured finance[12] within the capital markets, it was also one of the main reasons behind the crisis. The global interconnectedness and the wrongful risk assessment of these innovative financial structures led to the disruption in the financial markets.“The assignment of receivables has traditionally represented a means for trading companies and finance houses to raise funds readily and to predict the cash-flow with some degree of certainty and independently from debtors’ defaults.[13] This was conventionally achieved through factoring agreements whereby a factor would purchase receivables for a discounted sum or for a periodic commission, providing thereby necessary funds for the assignor to continue trading without having to rely on receivables to be serviced.[14] In its essence securitization developed as a more sophisticated form of factoring, one of the main developments being that assets are sold to a special purpose vehicle (SPV) that funds the operation by issuing bonds on the capital market, secured on the receivables.” This fairly linear process started to be more extensively employed in the US housing market in the 1970s, when two government-sponsored agencies—”Fannie Mae” and “Freddie Mac” began acquiring home mortgages from lending institutions and issuing securities backed by pools of those mortgages. Subsequently investment banks as well embraced this financing model, and set up trading departments to specifically handle these securities. When banks then entered the securitization market for their home loans new frontiers opened up, with wider classes of assets being involved in the transaction and a broader category of originators participating in the market.[15] Although the vehicle is sponsored by the originating company, it qualifies for the purpose of the transaction as an independent company and not as originator’s subsidiary.[16] The SPV is anyway likely to be an almost non-substantive shell entity, whose only function is to raise money through the bond issue; complementary functions, in particular the servicing one, are mostly still carried out by the originator that will maintain existing relationships with borrowers.[17] This risk mainly affects US courts, where assets and liabilities of an entity affiliated to the insolvent one can be merged to create a single common estate for the benefit of creditors.[18] “If the sale was to be legally characterized as a security the assets would remain on the originator’s balance sheet, as well as their underlying liabilities, hampering therefore the function of the transaction. [19] Securities issued by the SPV are then rated by credit rating agencies, and at this stage of the transaction bonds receive a higher rating than would otherwise be obtained by the originator directly through a bond issue, chiefly because of the insulation of the former from the originator’s assets and business.”[20]Over the last two decades securitization has blossomed, both among financial institutions that could obviate the maturity mismatch intrinsic to the lending business (especially in the context of mortgages) and also bypass capital adequacy requirements, and among corporations and government agencies wanting to get most of the profits of a certain cash-flow up front. To fully appreciate the advantages of securitization, however, an initial examination needs to look at the regulatory incentives provided by the first enactment of the Basel Accord of 1988.[21] The Accord and the ensuing harmonized capital regulation provided the major incentive for the development of the “originate-and-distribute” model.[22]The way in which loans and other assets weighted on balance sheets became critical in the way banks started to manage risk accumulation by separating this process from that of credit origination, and by intensifying balance sheet management. This new model allowed banks to lend to a wider pool of borrowers without necessarily having to hold those loans to term on their balance sheets. Loans became the subject of negotiations among banks and other financial institutions, such as investment funds, which were all keen to get involved in the debt finance market where they could originate loans, sell the relating risks to a wide range of investors and thus remain insulated from potential defaults. The legal mechanisms through which this twofold purpose could be achieved—namely the compliance with capital requirements and the risk-shifting off-balance sheet—can be identified with securitization technique.[23] While improving its financial ratio, originators can also improve the return on capital because they have removed assets and liabilities from their balance sheet while still retaining relating profits.[24] From a strategic perspective, securitization provides originators with a corporate finance tool that liberates them from the tight terms of general loan agreements employed by most banks. This is for the simple reason that the bargaining power of investors purchasing bonds is much less constraining than that of a dominant bank that is in a position to negotiate and enforce restrictive covenants. [25]The off-balance sheet structure can potentially lead to the more problematic issue of the originator’s disincentive to monitor the quality of the receivables it originates, since they become the property—as well as the burden—of some other entity further down the transaction chain. It is worth observing that during the years prior to the crisis this became particularly evident as demand for securitized products increased dramatically, leading originators and CRAs to conduct little due diligence on underlying assets, and overall the exuberance that permeated the economic environment led to a decline in the level of transparency of transactions, as well as in their supervision.[26]“Moving to collateralized securities, such as, for instance, residential mortgage-backed securities, which are subject of a securitization, so representing in essence a securitization of securitization. CDSs can be more closely associated with derivatives and can be defined as a type of protection against default, whereby the seller of a CDS agrees to pay the buyer if a credit event occurs, and the buyer agrees to pay a stream of payments equivalent to the payments that would be made by the borrower. Since the seller of the CDS receives payments that resemble a loan, the CDS can be regarded as a form of synthetic loan, and a mechanism to acquire credit risk of an unrelated party. Arguably, the over-exposure to these products in the broad context of the global crisis is what triggered the downfall of the insurance giant AIG.” [27]3. Role of Credit Rating Agencies (CRAs): Credit rating agencies rate not only institutions but also credit instruments and securities. It is mainly about the concept of investment grade[28] – a rating given by these agencies keeping in mind a certain threshold. The CRAs hold the view that these ratings are not for the purpose of triggering the decision whether or not to invest in a security but they give relative information about the credit worthiness of an institution. CRAs are exempt from civil liability for their core activity and their financial duty of care as such does not exist. [29]In US there was a system of nationally recognized CRAs called NRSRO[30] i.e. Nationally Recognized Statistical Rating Organizations. This status gave CRAs an unparalleled reputation and investor confidence. There was a privileged market position for CRAs with this status. Apart from rating institutions and securities CRAs were also caught in a web of ancillary services[31] where the anticipatory expectations of the enterprises affected the quality of information that reached these CRAs which inhibited the ratings. Official recognition has more cons than pros. For instance, the status of NRSRO given to CRAs in US led to over – reliance on their assessments as they were implicitly taken to be backed by government that would indemnify any losses generated from wrong credit ratings. It also inhibits new entries in the field and thereby hampers innovation of assessment methodologies and new technology from coming in .[32]CRAs were insufficiently equipped in both qualitative and quantitative terms. They had no rules of procedure to follow for assessment of RMBS and CDOs.[33] The activities of the CRAs were non- transparent and their credit ratings were heavily relied upon by the investors specially with regards to investments in securitized instruments and collateral debt obligations. Also, CRAs did not do significant research about the underlying assets in RMBS and CDOs. For instance, certain loans underlying RMBS had no documentation. [34]Considering the Enron scandal that raised concerns, let us understand what exactly happened. Enron was a company in the energy sector that generally received good ratings from CRAs. However, eventually it ended up filing for insolvency. Prior to this step the company was in talks with Dynegy Inc. regarding a merger. Enron wrote down assets worth US $ 2.2 billion and though there was a further write down of USD 500 million, the CRAs ignored this at the behest of Enron that talks of merger are in process and improvement in the financial condition of Enron was assured. As things unfolded it became clear that Enron could not survive without a merger and a balanced merger agreement seemed a far-fetched idea as Dynegy had backed off. Seeing this the CRAs were adamant at reducing the ratings of Enron from investment grade to a notch above junk. Post filing of insolvency by Enron these ratings went into negative. [35]This shows that credit rating agencies were lax in dealing with the information available to them. They had detailed information about the financial position of the companies but they just restricted its use. Like in the case of Enron off balance sheet inquiries were ignored and only cash flow was assessed.[36] Regulatory Reforms Post Crisis In EU the crisis was able to takeover mainly due to the inherent regulatory and supervisory flaws in its system. However, the crisis that originated in US had spread its terror in EU as well. The interconnection of global financial markets had played its role. It was evident from the need for nationalization of Northern bank.Northern bank had to be nationalized to stop the upsurge on the road. In the wee hours of the morning people lined up at various branches of the bank. The investors and depositors wanted to withdraw their money from the bank. The bank was based on the warehousing model and was heavily relying on securitization as a means of generating liquidity for its loan generation. It was under a compulsion to issue bonds every three months and in September 2007 when the crisis began to show its colors, an installment of bonds had to be issued by Northern bank. This was because most of its lending was financed by mortgages that it bundled into such securities. So, once the US housing mortgage market failed, the international buyers of these bonds grew skeptical and ran to withdraw support. They were not ready to finance the model on which Northern bank was generating capital for its loans. Northern bank had no alternate source of funding. Hence, government was left with no other option than plumbing liquid into the financial markets and guaranteeing the deposits of Northern bank. This provided short term relief but could not stop the collapse of the banking sector in UK.[37] The banks failed to assess the underlying risks associated with the inter-relationship of the markets and did not imagine the derivative instruments suffering at the hands of the skeptical investors.Need was felt for a coordinated action to the crisis and thus, certain short term and long term measures were taken by EU. One such measure was introduction of European Economic Recovery Plan (EERP). The objective of EERP is to limit the negative consequences of the crisis by injecting capital to stimulate demand and purchasing power in the short term while increasing the competitiveness in the long run. [38] This fiscal stimulus accounts for 5% of the EU GDP.[39] Long term measure included the establishment of European System of Financial Supervision (ESFS). This was mainly established in 2010 to bridge the gap in institutional framework. It comprises of European Systemic Risk Board (ESRB) and European Supervisory Authority ( ESA).[40] The former would focus on macro prudential supervision while the latter on the micro prudential supervision. The primary role of ESA is to codify the EU rule book and draft technical standards that can be adopted as EU law.[41] The decision of the ESA would be legally binding on the national supervisory authorities and firms.[42]Another important step that was taken was revision of the Capital requirement directive (CRD) to incorporate Basel II in EU law.[43] Basel II increased the capital adequacy requirements. Basel accords are a series of recommendations on banking laws and regulations issued by Basel Committee on Banking Supervision.[44] However, the financial crisis intervened and Basel III was adopted. “The G20 Leaders at the Seoul Summit endorsed the Basel III framework and the Financial Stability Board’s (FSB) policy framework for reducing the moral hazard of systemically important financial institutions (SIFIs), including the work processes and timelines set out in the report submitted to the Summit.”[45] “The framework includes an internationally harmonized leverage ratio to serve as a backstop to the risk-based capital measures. The new framework will be translated into the EU national laws and regulations, and will be implemented starting on January 1, 2013 and fully phased in by January 1, 2019.” “In response to this call, in 2012 the Committee initiated what has become known as the Regulatory Consistency Assessment Programme (RCAP). The RCAP process will be fundamental to ensuring confidence in regulatory ratios and promoting a level playing field for internationally-operating banks.”[46] Basel III requires a 4.5% common equity ratio to risk weighted assets. It has strengthened capital requirements for complex securitization transactions and requires banks to conduct rigorous credit analysis. Under Basel III the minimum capital adequacy ratio is 8%. [47]Also EU targeted other important flaws in the system with respect to Alternative Investment Funds (AIFs), in particular hedge funds[48]. A directive on AIF was made which regulated funds instead of managers. AIF managers who have European passport can only provide services[49]CRAs were also heavily regulated. Third country ratings were acceptable if governing regulation were similar. The idea of European Credit rating agency took birth.[50] “ In the European Union, apart from the annual monitoring by the Committee of European Securities Regulators (CESR) of compliance with the Code of Conduct Fundamentals for CRAs of the International Organization of Securities Commissions (IOSCO), there is no supervision yet on the ins and outs of CRAs.”[51] “CRAs are out of reach of Directive 2003/125 as regards the fair presentation of investment recommendations. However, the European Commission is of the view that CRAs are obliged to disclose conflicts of interest as a result of art.1(8) in conjunction with point 10 of Directive 2003/125.”[52] “There is a CRA regulation of 2009 in place in the European union to deal with the supervising of CRAs. It establishes a centre point for registration of CRAs which makes their administration and governance by the EU norms easy. This way it becomes easier for the supervisors at national level to deal with CRAs efficiently. This happens by way of single registering body that has information about all the CRAs in the zone. National supervisors operate on site and job of supervisors is not related to scrutinization of method by which ratings are assessed by the CRAs.”[53] It is further stated that no one CRA shall be associated with a client for more than four years. Also, CRAs shall not indulge in any other function than credit rating. “The idea of the Commission is to achieve increased transparency and integrity by, respectively: (1) keeping data and making them public; and (2) adopting procedures to prevent abuse of relevant non-public information, unpermitted conflicts of interest, forms of abuse of market position, and practices deviating from established methodologies within the CRA.”[54] “The Commission also proposes that the body or part of the board of a CRA that supervises the board must at least have three independent non-executive directors, in accordance with item 13 s.3 of Recommendation 2005/162.”[55]Post crisis banking sector in UK also saw some worthy reforms in its regulatory regime. A lot of changes were introduced in the banking sector. In Dec,2011 tougher restrictions were imposed on payment of bonuses. About 20-30% banks were advised to defer the payment of such bonuses for the next three to five years. Also, the banks were encouraged to claw back the compensation in case employee proves to be a non-satisfactory contributor. Further, banks were levied with a temporary annual tax on their balance sheets at the rate of 0.04% in January 2011 which was made permanent in 2012 at the rate of 0.088%. [56] The Financial Services Act replaced the Tripartite structure. [57]The Bank of England is responsible for looking after the money markets while FSA administers bank and consumer interest. The treasury provides funds for this. The financial policy committee ( FCP ) watches the Prudential Regulation Authority (PRA) and the Financial Conduct Authority ( FCA). The former  ensures sound financial health of the firms, whereas the latter ensures compliance with rules and consumer protection.[58]  Ring fencing is another thing; where the Investment banking arm is separated from the other functions that a bank has to perform. The banks in UK can write down the interest of certain loss facing credits and convert it into capital. Bonuses are paid partially in shares and not entirely in cash. The Senior Manager and Certification Regime clarifies the responsibility of the top management of banks and allows the regulator to hold senior personnel liable. Banks have to now disclose the material risks they take. Also under these guidelines new criminal sanction to punish failure of banks are established.[59] “Under the Financial Services Compensation Scheme up to £85,000 of each customer’s deposits are now 100% protected – up from £2,000 in 2007. This scheme, which is funded by the banks, covers 98% of customers.”[60]Internationally, EU has been very cooperative in G20 meetings and negotiations. It agreed with regards to principles of accountability, transparency, stringent regulatory framework, integrity of financial markets. EU states also agreed to act for economic growth post crisis. [61]Consolidation in the Banking Sector Mergers come in waves. The sound base for a wave is a more over-valued firm acquiring a less over-valued firm. [62] There are reasons for M&A activity to take place. The force behind it ranges from financial performance to technological innovation to market trends. Improvement in the financial performance is expected by lowering the costs within the same revenue stream. These costs are reduced by economies of scale, financial and operational synergies and better management. The ultimate goal is of course profit maximization. Then, there are tax benefits and expansion of market share. Further, risk diversification, flourishing regulatory shifts etc. also contribute to the rise in M&A activity.[63]Effects of M&A could be both positive or negative. There could be value creation or value destruction. There could be abnormal returns in the long run and the short run with of course varying affects. It could be that the initial over-valuation of the acquirer leads to the future underperformance of the target. However, success of a merger depends upon how well are the organizations integrated.[64]The financial crisis that began in the US and trickled down to the global banking sector brought the inherent weakness of the EU’s banking regulations out. Fortis and Dexia became first EU banks to be rescued.[65] The impact of the crisis was seen more in developed markets than in emerging markets. That is concentration was taking place more in developed countries than in emerging markets. Consolidation in the banking sector was highest in US and UK. This affected the competition in long run as due to high market share banks would charge arbitrary interest and fees or increase these charges. On the contrary there could be lack of competition due to monopolization.[66] “In the long run, evidence from extant literature suggests that the consolidation process and increase in bank concentration driven by a financial crisis will reduce after some time. Indeed, concentrated banking systems may reduce fragility by boosting bank profits, which might strengthen the banking system and create incentives for new banks to enter the market. Thus, we anticipate that bank concentration in markets that experienced crisis-driven consolidation will eventually decrease.”[67]During the period of crisis community banks were the main targets. Cross border consolidation not only increase the asset base of the distressed banks but also diversified its risks. [68]The mergers during this period can be termed as “Shotgun M&A”. [69] The banks with the weaker position could merge with the ones that were in a better financial position. The resources from these banks could help the banks in trouble to bail out from it. These deals need not necessarily be large deals.As the crisis of 2008 caused the Bear and Stearns and Lehman Brothers to surrender, the US government encouraged mergers amongst the investment and commercial banks. They set aside anti-trust regulations in practice. The government supported these “shotgun” mergers by either funding them or guaranteeing them.[70] This was done by bringing the FDIC[71] ( Federal Deposit Insurance Corporation) and TARP ( Troubled asset relief programme) guarantee.This stabilized the condition in the short run but posed problems in the long run. Three main US banks[72] held about 45% of the assets of all US banks. [73] These kinds of consolidation tend to pose regulatory problems as the regulators tend to be co-opted by the industries they are regulating.[74] These consolidated giant entities would want big investments and clients. They may force smaller borrowers to use non-bank funding which is restrictive in the terms of banking functions that they have to offer. They charge higher interest and pose a risk of lopsided market conditions flaring up. If there has to be consolidation in the banking sector, we cannot neglect the need for regulation on transparency. The tax payers are entitled to know how the government is using their money in the time of crisis to bail out distressed entities. This helps eliminate systemic risks and also render confidence to the investor which are essentials if a merger has to be successful. Deregulation contributed to the crisis by opening the gates of global financial m