Feb 10, 2009
What Really Caused the Crisis?
Check out this short article by Viral Acharya and Matthew Richardson, two economists at New York University. They summarize the conclusions from a forthcoming book they edited, Restoring Financial Stability: How to Repair a Failed System, based on papers from a series of conferences held at NYU on the current financial crisis.
The authors essentially argue that the reason the crisis spread beyond housing is because of all the explicit and implicit government guarantees for large financial institutions. Thus, they emphasize that the problem was most definitely not the spreading of risk through securitization and fancy credit derivatives. Rather, the problem was the financial system’s failure to spread risk. The large institutions used these innovations to engage in regulatory arbitrage in order to take on and concentrate excessive risk.
Let me quote a central paragraph: “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 maximise returns from the explicit and implicit guarantees by taking excessive aggregate risks, unless these are priced properly by regulators. ”
I’ve been claiming for some time that deposit insurance was central to the crisis. It is striking to have that analysis confirmed by mainstream economists who in no way share my opposition to government guarantees and indeed explore ways (ultimately futile, in my opinion) to “fix” them. This should make their book, when it comes out, one of the more important on this enormous government failure.
Hat Tip: Tyler Cowen.
The authors essentially argue that the reason the crisis spread beyond housing is because of all the explicit and implicit government guarantees for large financial institutions. Thus, they emphasize that the problem was most definitely not the spreading of risk through securitization and fancy credit derivatives. Rather, the problem was the financial system’s failure to spread risk. The large institutions used these innovations to engage in regulatory arbitrage in order to take on and concentrate excessive risk.
Let me quote a central paragraph: “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 maximise returns from the explicit and implicit guarantees by taking excessive aggregate risks, unless these are priced properly by regulators. ”
I’ve been claiming for some time that deposit insurance was central to the crisis. It is striking to have that analysis confirmed by mainstream economists who in no way share my opposition to government guarantees and indeed explore ways (ultimately futile, in my opinion) to “fix” them. This should make their book, when it comes out, one of the more important on this enormous government failure.
Hat Tip: Tyler Cowen.