How To Prevent the Next Financial Crisis

Last Updated Nov 16, 2009 9:55 AM EST

What caused the financial and economic crisis? Understanding what went wrong is important because it provides a guide to the best types of legislative and regulatory responses to use to minimize the chances of this happening again.

I think we understand the broad outline of what happened, and I agree with Federal Reserve Bank of New York president William Dudley's recent characterization of the problem (the shadow banking system he mentions consists of institutions such as Bear Stearns and Lehman Brothers that perform many of the same functions as traditional banks, but are not subject to the same regulations):

In assessing the causes of this crisis, one clear culprit was the failure of regulators and market participants alike to fully appreciate the strength of the amplifying mechanisms that were built into our financial system. These mechanics exacerbated the boom on the way up and the bust on the way down. Only by better understanding the sources of these damaging dynamics can we construct solutions that will strengthen our financial system and make it more robust...

At its most fundamental level, this crisis was caused by the rapid growth of the so-called shadow banking system over the past few decades and its remarkable collapse over the past two years...

Though the shadow banking system was often credited with better distributing risk and improving the overall efficiency of the financial system, this system ultimately proved to be much more fragile than we had anticipated. Like the traditional banking system, the shadow banking system engaged in the maturity transformation process in which structured investment vehicles (SIVs), conduits, dealers, and hedge funds financed long-term assets with short-term funding. However, much of the maturity transformation in the shadow system occurred without the types of stabilizing backstops that are in place in the traditional banking sector.

My explanation of the crisis begins with the excess liquidity that came from low interest rate policies adopted by central banks in the wake of the dotcom bubble, and the additional liquidity that came from the excess of savings relative to the profitable investment opportunities in China and other developing countries. This excess liquidity found a home in mortgage markets due to the false promise of relatively low risk returns, a false promise that came from ratings agency failures, failures of risk assessment models, and the belief that we had entered a new era where housing prices would continue to increase for a substantial period of time.

When this excess liquidity was combined with an array of incentive and other problems in mortgage markets such as no recourse loans for borrowers, banks being able to remove loans from their balance sheets through securitization, the lack of transparency for some of the complex financial assets that were created, appraisers too cozy with real estate agents, CEO pay favoring short-run returns even at high risk, ratings agencies being paid by the firms issuing the assets they are rating, and so on and so on, there was, in retrospect, a clear path to disaster.

This disaster could have been prevented by a strong regulatory response, but the belief that markets would self-regulate, i.e. that firms would maintain adequate capital reserves and take other steps to ensure they weren't exposed to excessive risk, led to a regulatory hands-off approach to the growing shadow bank industry, an industry that provided the means to inflate the housing bubble to dangerous levels. The hands-off regulatory approach was a mistake.

So what should we do try to prevent this from happening again? Fixing these incentive problems is certainly a start, as is bringing the shadow banking system under the same regulatory umbrella as the traditional system. And there are additional things we can do to reduce the extent to which shocks are magnified to a disastrous size within the system, i.e. to reduce the "amplifying mechanisms that were built into our financial system." Along these lines, I would be in favor of limiting leverage ratios (through higher capital requirements), a key factor in how much damage a particular shock can do. The ratios we saw prior to the crisis of 30-1 or more leave the system far too vulnerable.

We also need to make sure that financial firms are not too big or too interconnected to fail. And if it turns out that somehow a troubled financial institution is more interconnected than we thought and hence systemically dangerous, despite our efforts to make sure that doesn't happen, we need to have the plans and the legal authority in place to deal with insolvent financial institutions, something that was very much needed but missing in the present crisis.

When it comes to more specific legislative or regulatory change, those that target particular assets or particular types of financial firms (e.g. hedge funds), I think we need to be more careful. Not all financial products, even very complex financial products, are bad and sweeping with too broad a brush can do unnecessary damage. But there are some types of financial products, e.g. naked CDS's that amount to an insurance contract between parties with no stake whatsoever in the outcome of the bet they are making, that need close scrutiny before allowing their continued use. And as a general principle, we need much more transparency in these markets and in the assets that are traded. All financial transactions should either pass through organized exchanges, or be subject to some sort of strict reporting requirements to regulators.

Anything that limits the ability of the financial industry to do the things they have done in the past, or to do whatever new things they dream up, will face substantial resistance. The financial industry will do all that it can to delay reform while it mounts a defense against it. The biggest danger of all, in my opinion, is that the delay tactics will be successful and the passage of time along with the eventual recovery of the economy will cause us to lose our will to battle the special interests that will have to be overcome to impose any sort of meaningful change on the financial industry. If the industry's tactics are successful, then the reforms will be too watered down and too limited to do much good. The sooner we begin the difficult process of reforming the financial sector, the more likely it is that we'll be able to impose the type of change that is needed.