Origins of the financial crisis and requirements for reform
Introduction
At the July 2008 Reserve Bank of Australia conference on the current financial turmoil the paper by Adrian Blundell-Wignall and Paul Atkinson explained the current financial crisis as being caused at two levels: by global macro liquidity policies and by a very poor framework for incentives of financial sector agents, conditioned by bad regulations, tax systems and governance standards. Far from acting as a second line of defense to excess liquidity, policies at this level actually contributed to the crisis in important ways.1 The liquidity policies were like a dam overfilled with flooding water. Global liquidity distortions, including interest rates at 1% in the United States and 0% in Japan, China's fixed exchange rate and recycling of its international reserves, and the Sovereign Wealth Funds (SWF) investments, all helped to fill the dam to overflowing. That is how the asset bubbles and excess leverage got under way.
However, the main focus of this paper is with the second set of issues. The faults in the wall of the dam—the regulatory, tax and governance incentives—started to direct the water more forcefully from about 2004 into some very specific areas: mortgage securitization, including synthetic (derivative-based) bonds, strong off-balance sheet activity and the use of tax havens. The pressure became so great that that the dam finally broke, and the damage has already been enormous.
Many papers analyzing the causes of the crisis focus on behavior within the financial sector, such as irrational behavior and non-profit maximizing incentives (Akerlof & Shiller, 2009) and lack of transparency of new and complex products and the ability of banks to manage and their exposures with their complex value at risk models (Jenkinson et al., 2008, Haldane, 2009). Others have focused on compensation schemes in the financial sector that encouraged excess risk taking (Blinder, 2009). One focused on poor underwriting standards and lack of regulation of mortgage brokers (Gramlich, 2007). Still others have focused on the greater interconnectedness of risk taking between institutions and markets, making it more exposed to systemic risk (Rajan, 2005). Some groups have focused on the role of credit rating agencies (CRAs) that play a key role in providing inputs to risk models, arguing that they improperly managed conflicts of interest (e.g. SEC, 2008a, SEC, 2008b).
However, many of these conditioning factors in the crisis have been around for a very long time—irrational behavior, greed, poor underwriting standards, poor risk models, globalization, and complex products—and do not explain the very sudden avalanche of activity in bank securitization and the use of credit default swaps (CDS) from 2004. Focus on symptoms of the crisis distracts attention from the pivotal role of policy making in causing the crisis—i.e. in creating distorted incentives and then permitting a massive expansion of leverage enabling the private sector to take full advantage of them. Regulators and supervisors collectively failed on a massive scale to achieve even mildly risk-averse outcomes. There is also a certain lack of accountability amongst policy makers that does not encourage optimism about the reforming the policy process itself.2
When economists talk about causality they usually have some notion of exogeneity in mind; that relatively independent factors changed and caused endogenous things to happen—in this case the biggest financial crisis since the Great Depression. Fig. 1 shows the veritable explosion in residential mortgage-backed securities (RMBS) after 2004. This class of assets was in the vortex of the crisis, and any theory of causality must explain why it happened then and not at some other time.
Many of the above-mentioned factors identified for reforms, were not causal in the above sense. This would require that these factors were subject to independent behavioral changes. CRA practices did not change in 2004. Nor did banks switch to inferior risk models in that year, or mandate weaker underwriting standards, and so forth. Reform in these areas is of course welcome—they are conditioning factors that are worth serious attention. But if the more fundamental (causal) factors are not addressed, then agents in the financial sector will find new ways to exploit them in the future.
This paper argues that four aspects of policy played the most important roles in causing the crisis: (i) capital rules and tax wedges set up clear arbitrage opportunities for financial firms over an extended period—these were policy parameters that could not be competed away as they were exploited. Instead they could be levered indefinitely until the whole system collapsed; (ii) regulatory change permitted leverage to accelerate explosively from 2004; (iii) systemically important firms were permitted to emerge and barriers to contagion risk within them were explicitly broken down as a new business model in banking with an equity culture emerged; and (iv) cumbersome regulatory structures with a poor allocation of responsibilities to oversee new activities in the financial sector were in place.
Section snippets
Arbitrage opportunities: capital rules and tax
Businesses, banks, investors and their agents are supposed to act according to the hidden hand of Adam Smith—the micro players act individually in their own self interest and desirable outcomes emerge that enhance the wealth of nations. But these micro players within the banking sector found themselves interacting with a set of distorted financial and tax regulations, shifts in the technology platform and product innovations, all of which combined to allow arbitrage opportunities to be
2004: regulation and the leverage explosion
In 2004 four time-specific factors came into play that combined to cause explosive growth in leverage (with a concentration in mortgage-related products and taking strong advantage of all of the above arbitrage opportunities: (1) the Bush Administration American Dream zero equity mortgage proposals were signed into law and became operative, helping low-income families to obtain mortgages; (2) the then regulator of Fannie Mae and Freddie Mac, the Office of Federal Housing Enterprise Oversight
Systemically important firms and contagion risk
The Basel rules and SEC supervision allowed a too-low cost of capital for IBs: their leverage ratio was high and they attracted only a 20% capital weight under Basel I for any bank lending to them. This meant that these high-risk businesses became much bigger than they would have been with a higher cost of capital and better regulation. That is, systemically important (‘too big to fail’) financial firms emerged, as a direct consequence of policy, with excess leverage and lots of concentrated
The policy making process
All of the above developments took place within an overall framework of complex rules and regulation by multiple agencies whose responsibilities have not always been clear or adapted to a changing world. Furthermore, at times these agencies have found themselves with responsibilities that they were poorly placed to carry out. Partial deregulation in such a context can easily lead to “second best” problems, causing worse outcomes by reinforcing existing distortions. This seems to be what has
Dealing with the crisis and reforming regulation
In essence the current crisis is a solvency crisis, which has been exacerbated by liquidity problems as uncertainty rose. This has led to massive deleveraging with rapid negative impacts on the economy.
Containing the current crisis has already required massive support for failing or failed financial institutions in many jurisdictions. So long as property prices continue to fall and recession damages the quality of bank assets, new cases requiring support will emerge. Too many banks whether
Conclusions
It seems very unlikely that the building blocks for financial reform will be in place any time soon — many governments do not even accept all of those outlined above as desirable features. Certainly the US proposals for regulatory reform of June 2009 are very far from the ideals presented above.33 In course of 16 months the US Treasury has come up with not less than three very different sets of proposals—the first was quite radical and very close to the
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