The economic theory of regulation pioneered by Stigler (1971) stipulates that reg- ulation often induces changes in behavior that go against the very effects that regulation intended in the first place. During periods of investor exuberance and comparative regulatory complacency, these adverse effects of regulation are very likely to be muted if not invisible altogether. Any new regulation, such as Basel II, will bring with it the so-called boundary problem of regulation, that is, the problem that institutions in the regulated sector and those in the unregulated sector face different incentives.10 Supervisors must thus attempt to learn how the regulated are seeking to avoid the constraints placed upon them. During the Great Mod- eration in the run-up to the crisis, the boundary problem profoundly misaligned incentives in the financial sector. This induced large-scale regulatory capital ar- bitrage, for example, in the form of securitization, which offset some or all of the intended regulatory effects. Regulation failed to take account of the risks that can emerge from the interaction between regulated and unregulated institutions, activities, and markets. In particular, bank regulation did not reflect risks from off- balance-sheet vehicles, monoline insurance companies, or loan originators with weak underwriting standards. Equipped with the analysis from ratings agencies, even sophisticated investors could not be relied on to assess risk accurately on more complex financial products.
In very broad terms—as the global economy no longer stares into the abyss of a financial market fallout and the first green shoots of a tentative recovery are
Exhibit41.2ListofEntitiesRelatedtotheBaselProcess AcronymFullNameScopeReportingEntityLocationa BCBSBaselCommitteeonBankingSupervisionBanksG10GovernorsBIS,Basel CBCDGCentralBankCounterfeitDeterrentGroupBanknotesG10GovernorsBIS,Basel CBGFCentralBankGovernanceForumOperationandgovernanceBISBIS,Basel CGFSCommitteeontheGlobalFinancialSystemFinancialmarketsG10GovernorsBIS,Basel CPSSCommitteeonPaymentandSettlementSystemsMarketsinfrastructureG10GovernorsBIS,Basel FSBbFinancialStabilityBoardGlobalfinancialstabilityG20MinistersandGovernorsBIS,Basel FSIFinancialStabilityInstituteSupervisorystandardsBISBIS,Basel IAASBInternationalAuditingandAssuranceStandardsBoardAuditstandardsPIOB,IFACNewYork IADIInternationalAssociationofDepositInsurersDepositinsuranceMemberagenciesBIS,Basel IAISInternationalAssociationofInsuranceSupervisorsInsurancesupervisionMemberagenciesBIS,Basel IASBInternationalAccountingStandardsBoardAccountingstandardsIASCFLondon IASCFIASCFoundationAccountingstandardsMemberinstitutionsLondon IFCIrvingFisherCommitteeonCentralBankStatisticsStatisticalissuesCentralbankmembersBIS,Basel IIFInternationalInstituteofFinanceFinancialinstitutionsMemberinstitutionsWashington,DC IOSCOInternationalOrganisationofSecuritiesCommissionsSecuritiesregulationMemberagenciesMadrid JFJointForumFinancialconglomeratescBCBS,IOSCO,IAIS— PIOBPublicInterestOversightBoardAuditstandardsIFACMadrid aThelocationeitherindicatestheseatofanorganization’sheadquarters(i.e.,whereitsmostimportantfunctionsareconcentrated)orthelocationofacommittee’s permanentsecretariat.TheBISQuarterlyReviewregularlyprovidesanoverviewofthemostrecentactivitiesoftheBasel-basedcommitteesandtheFSF.These activitiesarealsoreviewedintheBISAnnualReport,forexampleBIS2009,153–186. bInApril2009,themembershipoftheFinancialStabilityForum(FSF)wasenlargedtoincludethecurrentFSFmembers’jurisdictionsplustherestoftheG-20, Spain,andtheEuropeanCommission.Inaddition,theexpandedFSFwasre-establishedastheFinancialStabilityBoard(FSB)withabroadenedmandatetopromote financialstability. cThistermisusedbytheJointForumtodenote“anygroupofcompaniesundercommoncontrolwhoseexclusiveorpredominantactivitiesconsistofproviding significantservicesinatleasttwodifferentfinancialsectors(banking,securities,insurance).” Source:ReproducedwithpermissionfromBieri(2009).
333
visible—the principal regulatory lesson is twofold. First, at a microprudential level, the regulatory perimeter needs to be strengthened and extended. Indeed, it was excessive risk taking by global financial actors outside this very perimeter that lies at the origin of the current crisis. Going forward, this implies both expanding the scope of regulation of institutions (improved disclosure, limits on leverage, liquid- ity requirements, governance standards) and a tighter regulation for markets and individual financial products (Carvajal et al. 2009). At the same time, macropru- dential regulation ought to incorporate the idea that systemic risk is an endogenous component of the global financial system; the seamless monitoring of the growing interconnectedness of its various institutional building blocks forms a central part of this new regulatory paradigm. The new financial supervisory framework for the European Union (EU) that was endorsed in June 2009, consisting of a macro- and a microprudential pillar, represents a first comprehensive supranational attempt in this direction (Masciandaro et al. 2009).
Yet better regulation will not be enough; complementary adjustments to macroeconomic policy frameworks are equally essential. These adjustments would call for a more symmetric response to the build-up and unwinding of financial im- balances. The BIS (2009) sees a need to explore how to incorporate credit and asset price booms and the associated risk taking more meaningfully in monetary policy frameworks. Likewise, additional consideration to the possible role of fiscal policy, including that of the tax system and fiscal balances, seem inevitable.
NOTES
1. Unprecedented global bank writedowns in excess of $1.2 trillion (or 12 percent of U.S.
GDP) and the massive policy interventions are just some of the superlatives of the current crisis. Policy rates in the United States and Europe are at historic lows. With nominal rates at or close to zero, central banks are employing alternative policy tools on a large scale to combat the crisis. For example, in the six months between October 2008 and April 2009, the Federal Reserve expanded its balance sheet from around $850 billion to just over $2 trillion. In addition, the Fed committed a further $1.75 trillion to the purchase of large quantities of longer-term Treasury debt to help bring down corporate bond and other rates that are linked to Treasury yields by the end of 2009.
2. One of the earliest definitions of financial stability is given by Bagehot (1873): “[It is. . .] not a situation when the Bank of England is the only institution in which people have confidence.” More recently, at the 1997 Jackson Hole conference dedicated to
“Maintaining Financial Stability in a Global Economy,” Crockett (1997) introduces the distinction between two types of financial instability: that of institutions and that of markets.
3. Mishkin (1992) offers a systems-based definition, describing a stable financial system as one that ensures “. . .without major disruptions an efficient allocation of savings to investment decisions.”
4. If financial stability is indeed defined as interest rate smoothness, a trade-off with price stability immediately follows from the result of Poole (1970) whereby in the face of an aggregate demand shock, monetary authorities need to choose the degree to which they want to stabilize interest rates or output and inflation.
5. See Schwartz (1995, 2002) for one of the most prominent proponents of this school of thought.
REGULATION ANDFINANCIALSTABILITY IN THEAGE OFTURBULENCE 335
6. Borio et al. (2003) provide an overview of how the new environment hypothesis relates to the continuity view.
7. In a more radical interpretation of the issue, Laidler (2004) argues that the authorities should stick to the basic task of targeting inflation, while holding the lender of last resort powers in reserve. Consequently, policy makers should not be tempted by any form of trade-off simply for the sake of achieving financial stability.
8. Nier (2009) discusses four types of regulation and the two main examples of regulatory structures, which comprise two agencies (in addition to the treasury and a deposit insurance fund): the single integrated regulator model and the twin peaks model.
9. As a complement to this section, I recommend to the interested reader a very com- prehensive guide by Davies and Green (2008) that covers the inner workings of the international regulatory system in a level of detail that is well beyond the scope of what is possible here. With regard to the Basel Process, Bieri (2009) contains a detailed overview of its place in the global financial system and its role for financial stability.
10. Brunnermeier et al. (2009) offer a more detailed discussion on the boundary problem of financial regulation.
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Borio, C. E., and M. Drehmann. 2009.Towards an operational framework for financial stabil- ity: Fuzzy measurement and its consequences. Basel, Switzerland: Bank for International Settlements, working paper 265.
Borio, C. E., W. English, and A. Filardo. 2003.A tale of two perspectives: Old and new challenges for monetary policy. Basel, Switzerland: Bank for International Settlements, working paper 127.
Brunnermeier, M., A. D. Crockett, C. A. E. Goodhart, A. D. Persaud, and H. S. Shin. 2009.The fundamental principles of financial regulation. Geneva, Switzerland: International Center for Monetary and Banking Studies, Geneva reports on the world economy 11.
Carvajal, A., R. Dodd, M. Moore, E. Nier, I. Tower, and L. Zanforlin. 2009.The perimeter of financial regulation. Washington, DC: International Monetary Fund, staff position note SPN/09/03.
Crockett, A. D. 1997. Why is financial stability a goal of public policy. InMaintaining financial stability in a global economy, 7–36. Federal Reserve Bank of Kansas City: Proceedings from the Jackson Hole symposium.
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ABOUT THE AUTHOR
David S. Bieriis at the School of Public & International Affairs at Virginia Tech in Blacksburg. He holds degrees in economics from the London School of Eco- nomics (LSE) and international finance from Durham University (U.K.). Bieri’s current research focuses on equilibrium models of locational sorting and nonmar- ket interactions. He also pursues research on regulatory aspects of international finance, monetary economics, and applied econometrics. From 1999 until 2006, Bieri held various senior positions at the Bank for International Settlements (BIS), most recently as the adviser to the general manager and CEO. As head of business development in the BIS banking department, he was responsible for financial ser- vices and reserve management advisory for central banks before joining the BIS Monetary and Economics department, where he worked as an economist. Prior to the BIS, Bieri worked as a high-yield analyst at Banker’s Trust in London and in fixed-income syndication at UBS in Zurich.
CHAPTER 42
The Financial Crisis of 2007–2009
Missing Financial Regulation or Absentee Regulators?
GEORGE G. KAUFMAN
John Smith Professor of Banking, Loyola University, Chicago, and consultant to the Federal Reserve Bank of Chicago
A. G. MALLIARIS
Professor of Economics and Finance, and Walter F. Mullady Sr. Chair in Business Administration, School of Business Administration, Loyola University, Chicago
The financial crisis that began in August 2007 is now in its third calendar year and has evolved into the most severe recession since the Great Depression of the 1930s. This brief discussion examines some of the causes of the crisis and in particular the role of financial regulation, financial regulators, and the problem of both defining and containing systemic risk. The discussion concludes that many of the difficulties that arose during the financial meltdown may be attributed to the reluctance of bank regulators to enforce the regulations that were in place. Such enforcement could have reduced, if not prevented, systemic risk from occurring.
Most economists agree that the trigger of the current crisis may be found in the reversal of the rapid increase of housing prices in both the United States and in many other industrial countries. John Taylor (2007, 2009), Hayford and Malliaris (2009), and others have argued that the housing bubble was driven by an easy mon- etary policy that kept interest rates too low for too long, while Alan Greenspan and Ben Bernanke, the former and current chairmen of the Federal Reserve, claim that the global character of the housing bubble should be attributed largely to a global savings glut, primarily from Asia. Financial innovation in packaging together large numbers of individual mortgages, rating such financial instruments, and distribut- ing them among a large class of investors helped to finance the boom in housing price increases. At the same time, the price of risk was underestimated because the historical data used in testing the banks’ risk models was too short to contain national housing price crashes. Housing prices began to escalate rapidly during the period from 2000 to 2006. By 2005, the proportion of risky subprime mortgages
337 Lessons from the Financial Crisis: Causes, Consequences, and Our Economic Future
by Robert W. Kolb Copyright © 2010 John Wiley & Sons, Inc.
had increased sharply relative to the total pool of mortgages and increased overall financial leverage. When defaults on these mortgages jumped sharply in 2007, the crisis began. In ending the crisis and repairing the financial system, it is important that we do not throw out the baby with the bathwater.