FINANCIAL CRISIS OF 2008-09

The Financial Crisis Of 2008-09

The Financial Crisis Of 2008-09

Introduction

Loan brokers and mortgage originators had few incentives to more realistically assess risk which, in any case, they sold on to others—this was part of the “financial innovations” so warmly welcomed by market participants. Investors relied too unthinkingly, in assessing asset quality, on unrealistic or overly optimistic analyses done by credit rating agencies, which, again, proved a time-tested ability to be lagging indicators of crises (remember the 1997 Asian financial crisis?). Regulation and supervision were too concentrated on firms and not sufficiently focused on issues of systemic risk. None of these weaknesses is being addressed in a credible way yet. This paper discusses that to what extent the financial crisis of 2008-09 demonstrates the underlying weaknesses of particular national financial and banking systems.

Discussion

The shadow banking system—investment banks, mortgage brokers, hedge funds, among others—were lightly regulated by a multitude of agencies. The assumption was that only deposit-taking institutions needed to be regulated and supervised, thereby encouraging financial innovation in the rest of the system which, the thinking went, would act under a regime of self-imposed market discipline, spurred by the self-correcting nature of financial markets. Obviously the system had a huge amount of moral hazard built in which, regrettably, the financial crisis has not eliminated. Excellent results in some financial institutions in recent quarters—and levels of compensation that in many cases are no worse than those last seen in 2007—are partly the result of risk profiles fuelled by public funds.

We need to move to a system where, as noted by the IMF in its latest World Economic Outlook, “all activities that pose economy-wide risks are covered and known to a systemic stability regulator with wide powers.” This would include banks, institutions issuing CDOs attached to mortgages or insurance companies selling credit default swaps. Disclosure obligations within this “extended perimeter” should then allow the supervisory authorities to determine relative contributions to systemic risk and to calibrate the scope of the prudential oversight needed. For instance, one would discourage the emergence of mega-banks. The financial system has become too concentrated. Over the past 20 years, the share of US financial assets held by the 10 largest US financial institutions has risen from 10 percent to 50 percent. This is not desirable and, not surprisingly, has led to calls for change—Chancellor Angela Merkel recently stated that “no bank should be allowed to become so big that it can blackmail governments”—a thoroughly sensible proposition. One way to achieve this is to simply force very large financial conglomerates to spin off assets, although there is also merit in proposals to do this via capital ratios that rise with the contribution to systemic risk. Indeed, many of the recommendations put forth by the IMF in the aftermath of the crisis are quite sensible, but we are not moving anywhere near fast enough to implement them. In particular, there seems to be a reluctance to address the issue of institutions that “are too big to ...