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 are solved?
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 Wyplosz 2009).
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 concerns:
- Correct distorted incentives of individual intermediaries or financial operators;
- Reduce negative externalities and systemic risk, bearing in mind that evaluating risk management practices within individual intermediaries is not sufficient.
Finally, inevitably, this will have to translate into rules that reduce the size of leverage in absolute terms and its procyclicality.
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, and fear.
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 chance.
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 from here.
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 January.
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