This post is by Mark Thoma
from Economist's View
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This is a summary of the "causes and nature" of the financial crisis. I've
added a few comments along the way:
Lessons for the future:
Ideas and rules for the world in the aftermath of the storm, Part I, by Guido
Tabellini, Vox EU: Almost two years after the beginning of the financial
crisis that has overwhelmed the world economy, it may be time to draw some
conclusions and outline the main lessons for the future. Is it really a turning
point for market economies, a systemic crisis that will radically change the
division of tasks between state and market? Or will everything be back to normal
once a number of important technical problems concerning financial regulation
Let us start with the market failure. There is no
doubt that the crisis has revealed a serious failure in one of the most
sophisticated markets in the world – modern finance. One of the crucial tasks of
financial markets is allocating risk. They have failed stunningly. Risk has been
underestimated, and many intermediaries took excessive risks. The reasons for
this failure and the implications for economic policy, however, are less clear.
One possible explanation is that it was just due to
poor judgement. Financial innovation has been so fast that even sophisticated
operators were not always able to fully understand the degree of risk of the
financial instruments that were constructed. The systemic implications of those
instruments were even less clear. As a consequence, many investors overestimated
global financial markets’ capacities, overlooking the systemic risk and the
illiquidity risk that proved crucial in this crisis. This mistake can partly be
explained by the difficulty of correctly evaluating the probability of rare or
infrequent events. If this were all, there would be no need to worry. This
crisis will not be forgotten, and it will certainly leave a mark on risk
management practices and organisation models of financial intermediaries.
There is also a less benevolent explanation for the
failure of financial markets, however, that highlights a systematic distortion
of individual incentives rather than a mistake. First of all, the “originate and
distribute” model, which separates the concession of the loan from the financial
investment decision, entails obvious moral hazard problems. Secondly, rating
agencies, paid by those issuing the very assets being rated, experience an
obvious conflict of interest. Third, managers’ remuneration schemes encourage
myopic behaviour and excessive risk taking – if the bonus depends on short-term
performance indicators, each individual manager is induced to take risks that
are large but rare. If this is true, it means that we cannot trust the ability
of markets to learn. Distorted incentives must also be redressed, through new,
stricter regulation, even at the cost of significantly slowing down financial
innovation or giving up some of its beneficial effects.
It's worth pointing out that there are distinct market failures here because
the best policy to overcome the market failure depends upon the type of market
failure it addresses. I would have also highlighted the asymmetric information
problem in these markets since the desire for reliable information on risks is
what drives the need for the ratings agencies, and I would have also noted that
the mal incentives extended beyond just the "originate and distribute" model,
homeowners (with no recourse loans), real estate agents (who want to sell as
many houses as they can for as much as they can to increase commissions),
appraisers (who share some of the conflicts that ratings agencies have and also
exist to solve an information problem), and so on. So it wasn't just banks and
brokers responding to the bad incentives of the originate and distribute model,
just about every link in the chain had bad incentives that distorted outcomes in
ways that encouraged the build up of excessive risk.
Also, these two explanations are not mutually exclusive.
The market failures can lead to excessive risk accumulation, and the extent of
this risk could be misperceived. I think it was the interaction of the market
failures and the misperception, not predominantly one or the other. If the
market failures do not allow dangerous risk levels to accumulate, misperceiving
it is not nearly so dangerous.
Mistakes in risk management cannot be only
attributed to private operators. Supervisors have made major mistakes as well,
allowing banks to accumulate off-balance-sheet liabilities and tolerating an
excessive growth of leverage (i.e. the ratio of total assets to shareholders'
equity) and indebtedness. This could be due to capture of supervisors by banks,
arbitrage and international competition among supervising agencies, or
implementation deficiencies. But more importantly, there has been a fundamental
conceptual mistake –monitoring each financial institution solely on an
individual basis, considering as the value at risk of the individual
intermediary without taking systemic risk into any consideration. This is the
same mistake that the individual intermediaries made.
I agree with the conceptual mistake noted here, but there was another one
too. Everyone thought it was a good idea to get risk off of the traditional
banking systems balance sheet. Somehow the notion was present that this would –
through worldwide distribution of risks – reduce the chances of a meltdown to
nearly zero, i.e. to reduce systemic risk. This, of course, turned out to be
wrong since risk did, in fact, get concentrated in dangerous ways.
A crisis of these proportions cannot have stemmed
exclusively from mistakes in risk management. The reason is that high-risk
investments were relatively small compared to the overall dimension of global
financial markets (Calomiris
2007). Many observers expected that the American real estate bubble would
burst. But few imagined that that would overwhelm financial markets all over the
world. If this has happened, it must be that the shocks hit important amplifying
mechanisms. This amplification can largely be attributed to financial
regulation. In other words, even more than a market failure, the crisis was
triggered by a failure of regulation (see the
eleventh ICMB-Geneva Report, summarised by
Not so much that regulation was too lenient, or
that deregulation had gone too far – rather, the very founding principles of
regulation have amplified the effects of a shock that in reality was not that
large. Subprime mortgages, the financial products whose insolvency has
originated the current crisis, amount to about one trillion dollars. It is a
large number in absolute terms, but small with respect to the total of about 80
trillion dollars of financial assets of the world banking system. As a
comparison, consider that the losses originally estimated in 1990 during the
savings and loans crisis were about 600-800 millions of dollars, less than the
total of subprime mortgages, but the total amount of financial assets was much
smaller then. Yet, that crisis was quickly overcome without major upheavals. Why
has it been so different this time?
There are two aspects of regulation that have
amplified the effects of the initial shock: (i) the procyclicality of leverage,
induced by constraints on banks’ equity, and (ii) accounting principles that
require assets to be evaluated according to their market value. In case of a
loss on investments, which erodes the capital of financial intermediaries,
capital adequacy constraints under the Basel accord require reduced leverage and
thus force banks to sell assets to obtain liquidity. The problem is thus
exacerbated: forced sales reduce the market price of assets, worsening the
balance sheets of other investors and inducing further forced sales of assets,
in a vicious circle. Exactly the opposite happens during a boom: capital gains
on portfolio assets allow intermediaries to expand leverage, which means taking
on more debt in order to acquire new assets, in such a way that the price of
assets is pushed up and other intermediaries become indebted chasing
increasingly high prices. In sum, banking regulation has created a mechanism
that amplifies the effects of shocks and accentuates cyclic fluctuations in the
indebtedness of financial intermediaries.
I am coming around on the need to regulate leverage, and it does appear to
have important cyclical variations. As to the mark to model versus mark to
market debate, I still don't like the bad incentives and the possibility for
error that exists with the mark to model framework. But the general question of
how to best value the assets on a balance sheet during a time like this is an
area where I still have some uncertainty.
One of the main lessons to be drawn from this
crisis is that we need to deeply reconsider financial regulation and ask
ourselves what its ultimate objective is – correcting distorted incentives of
agents, creating buffers that reduce procyclicality of leverage, or reducing
risks, and, if so, which risks? A sound regulatory system should address two
- Correct distorted incentives of individual intermediaries or financial
- Reduce negative externalities and systemic risk, bearing in mind that
evaluating risk management practices within individual intermediaries is not
Finally, inevitably, this will have to translate
into rules that reduce the size of leverage in absolute terms and its
And just to amplify a point from above, since a variety of problems caused
the crisis, no single solution can fix them all. It will take a variety of fixes
to shore up the system going forward.
Mistakes in managing the crisis
It is widely held that the current situation is
mostly the result of economic policy mistakes (in regulation, in supervision
and, according to some, monetary policy) made before the outbreak of the crisis.
The corollary of this thesis is that it is sufficient to correct these mistakes
in order to avoid the next crisis. But the truth is that many serious mistakes
have been made during the management of the crisis and have significantly
contributed to worsening the situation.
The unclear causes of the crisis have resulted in
its management being improvised from step one without a clear path in mind. Bear
Stearns was saved, Lehman Brothers failed, AIG was saved. Each decision was
improvised, guided by neither pre-established criteria nor a sound and
consistent strategy. The result is that, rather than boosting confidence,
economic policy interventions have contributed to increasing confusion, panic,
I have made this point many times as well, and believe it created a lot of
additional uncertainty. The handling of Lehman was a costly misstep.
Loss of confidence is always at the heart of any
financial crisis. Expectations concerning the behaviour of authorities and other
operators play a fundamental role in determining whether there will be contagion
or whether the shock will be absorbed. But in order to influence expectations
and restore confidence, policymakers must act according to procedures and
criteria that are agreed upon and well understood, identifying the ultimate
objectives and the policy tools to reach them. There has never been such clarity
in this crisis, and that is an important lesson. To avoid repeating similar
mistakes, it will be necessary to elaborate new and detailed procedures for
managing complex phenomena such as the bankruptcy of large banks and more
general policies aimed at preventing the worsening of systemic crises.
I agree, but how do we make these plans credible? We cannot bind future
policymakers – they can do as they please – so how do credibly commit to these
plans? When the next crisis hits and we have bankruptcy plans for a too big to
fail institution, will we actually carry through or will we worry that it might
not work out so well after all and step in as we did this time? Still, I think
it's important that we try, and if the plans are good ones, we at least have a
Given that large banks with systemic implications
are typically multinational, these procedures will need to be coordinated at the
international level. This is not easy, since, after all, only the state, and
hence taxpayers, can cover systemic risk. Taxpayers must take on the burden of
failing institutions’ debts, at least temporarily. But which state, which
taxpayers, when the institution is a large multinational bank?
Although difficult, this problem is not new.
Financial crises in developing countries, which occurred almost yearly in the
1990s, have now become less frequent and less devastating thanks to the
procedures of crisis management elaborated within the International Monetary
Fund. It is now time to learn from those experiences, adapting them to the
specific problems of large multinational banks.
Yes, we need an institution that can serve as a global and modern version of
a lender of last resort.
In my next column, I will outline where we might go
One final comment. I think there are dangers when political power becomes concentrated in too interconnected to fail financial institutions, and this potential contributor to the crisis deserves more emphasis.
Brunnermeier, Markus K, Andrew Crockett, Charles A
Goodhart, Avinash Persaud, and Hyun Song Shin (2009).
The Fundamental Principles of Financial Regulation. Centre for Economic
Policy Research and International Center for Monetary and Banking Studies.
Calomiris, Charles (2007). “Not
(Yet) a ‘Minsky Moment’” VoxEU.org, 23 November.
Wyplosz, Charles (2009). “The
ICMB-CEPR Geneva Report: ‘The Future of Financial Regulation’” VoxEU.org, 27
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