Repairing a Failed System: An Introduction

Viral V. Acharya and Matthew Richardson

There are many cracks in the financial system, some of which we now know, others no doubt we will discover down the road. The eighteen white papers and executive summaries of each chapter of our book, "Restoring Financial Stability: How to Repair a Failed System", forthcoming this March by John Wiley & Sons, describe a relevant issue at hand and corresponding regulatory proposals. A common theme of our proposals notes that fixing all the cracks will shore up the financial house but at great cost. Instead, by fixing a few major ones, the foundation can be stabilized, the financial structure rebuilt, and innovation and markets can once again flourish.

This short note is meant to encapsulate the key themes from the book, focused on the causes of the financial crisis of 2007-2009 and regulatory principles that we recommend drive the longer-term reforms.


Yes, there was a housing bubble and a crash...

There is almost universal agreement that the fundamental cause of the crisis was the combination of a credit boom and a housing bubble. There are many statistics to back this up. For example, in the five year period from 2002-2007, the ratio of debt to national income went up 100% from 3.75 to 4.75 to one. It had taken the prior full decade to accomplish this feat, and fifteen years prior to that. During this same period, house prices grew at an unprecedented rate of 11% per year.

When the "bubble" burst, it necessitated a severe economic crisis to come. The median family, whose house represented 35% of all their wealth and who was highly levered, would not be able to continue as is. The economy was going to feel the brunt of it.

It is much less clear, however, why this combination of events led to such a severe financial crisis, that is, why we had widespread failures of financial institutions and the freezing up of capital markets. The systemic crisis that ensued reduced the supply of capital to creditworthy institutions and individuals, amplifying the effects to the real economy.

There is no shortage of proximate causes. Mortgages granted to people with little ability to pay them back and designed to systemically default or refinance in just a few years, depending on the path of house prices. The securitization process that allowed credit markets to grow so rapidly but at the cost of lenders having little "skin-in-the" game. Opaque structured products that were rubber stamped AAA by the rating agencies more interested in fees than risk assessment.

But wasn't the risk transferred through credit derivatives?

Somewhat surprisingly, this is not the ultimate reason the financial system collapsed. If this were it, then capital markets would have absorbed the losses, and the financial system would have moved forward. Instead, blame needs to be squarely placed at the large, complex financial institutions (LCFIs) — the universal banks, investment banks, insurance companies, and (in rare cases) even hedge funds — that dominate the financial industry.

The biggest fault lies in the fact that the LCFIs ignored their own business model of securitization and chose not to transfer the credit risk to other investors.

The whole purpose of securitization is to lay risks off the economic balance-sheet of financial institutions. But the way securitization was achieved, especially during 2003-2Q 2007, was more for arbitraging regulation than for sharing risks with markets. The reason why banks face capital requirements is that they have incentives to take on excessive risks given their high leverage. Capital requirement ensures that first, banks find it costly to take on risks, and second, when they get hit by a shock, there is enough of a buffer zone to protect them.

But that's not what happened. Banks set up a shadow banking sector of SIV's and conduits funded by asset-backed commercial paper that was guaranteed — often fully — by banks through liquidity and credit enhancements. Designing things this way allowed banks to transform on-balance sheet loans and assets into off-balance sheet contingent liabilities, and thereby exploit loopholes in regulators "Basel" capital requirements. Measures of risk barely moved even as their balance sheets exploded with liquidity "puts" (sold to the shadow banking sector) and AAA-asset backed tranches. These risky assets were systemic in nature as they were in effect equivalent to writing out-of-the-money put options on aggregate crises.

This lack of risk transfer — the leverage "game" that banks played — is the ultimate reason for collapse of the financial system, in our opinion.

Bankers and regulators are both to blame...

It is important to acknowledge that in the period leading up to the crisis, bankers and insurers increasingly paid themselves through short-term cash bonuses based on volume and marked-to-market profits, rather than on long-term profitability of positions created. There was neither any discounting for liquidity risk of asset-backed securities, nor any proper assessment of true skills of large "profit"-centers. All this just served to make regulatory arbitrage the primary business of the financial sector.

Thus, the current regulatory architecture cannot escape blame either. In fact, its cracks made the system vulnerable to bankers' errors and short-term incentives in the first place. In a world without regulation, creditors of financial institutions (depositors, uninsured bondholders, etc.) would put a stop to excesses of risk and leverage by charging higher costs of funding, but lack of proper pricing of deposit insurance and too-big-to-fail guarantees has distorted incentives in the financial system. And, for years, regulation — capital requirement in particular — has targeted individual bank risk, when the justification for its existence resides primarily in managing systemic risk. It is to be expected that financial institutions would maximize returns from the explicit and implicit guarantees by taking excessive aggregate risks, unless these are priced properly by regulators.

Regulatory principles

Where should the regulators start to fix the system? The integration of global financial markets has certainly delivered large welfare gains through improvements in static and dynamic efficiency — the allocation of real resources and the rate of economic growth. These achievements have however come at the cost of increased systemic fragility, evidenced by the ongoing crisis. The challenge of redesigning the regulatory overlay to make the global financial system more robust must be met without crippling its ability to innovate and spur economic growth.

Four changes seem paramount, each addressing either regulatory arbitrage or the externality imposed by actions of individual institutions on systemic stability. We argue in the book that future regulation should:

  • Change the incentives of traders and large profit centers at large financial institutions with "bonus-malus" reserve accounts, which penalize employees whose actions trade current profit for future losses. This would essentially bring "clawbacks" into the compensation system. UBS's bonus scheme, granting bonuses in the form of claims on a portfolio of toxic assets, is a good example.
  • Prevent obvious regulatory arbitrage (privatizing, for example, the financial investments of government-sponsored enterprises) and charge for guarantees — deposit insurance, too big to fail, loan guarantees and the bailout — using marking-to-market that reflects leverage and risk in a continual manner. It will be good to know whether the financial system can even pay for the subsidies it receives.
  • Recognize the negative externality of LCFIs. Then quantify the systemic risk of LCFIs and "tax" (through capital requirements or deposit insurance fees) their contributions to systemic risk rather than individual risk. This is hard to do, but present regulations do not even claim to address the problem. The need for such systemic risk regulation, possibly by augmenting Central Bank agendas, is only underscored by the growing size of the few remaining players in the financial arena.
  • Enforce greater transparency of over-the-counter derivatives positions and off-balance-sheet transactions, employing centralized clearing for standardized products and, at a minimum, centralized registries for customized ones so that counterparty risk can be assessed.

Some say that these changes inhibit financial innovation. We think this gets the issue wrong. The goal is not to have the most advanced financial system, but a financial system that is reasonably advanced but robust. That's no different from what we seek in other areas of human activity. We don't use the most advanced aircraft to move millions of people around the world. We use reasonably advanced aircrafts whose designs have proved to be reliable. The same is the case with ethical drugs. Although we are now in a golden age of biomedical research, our goal is to sell only products that have been tested extensively.

Return to the NYU Stern White Papers Project

© 2008 New York University Stern School of Business.

All Rights Reserved.