Influential policymakers emphasise that the US financial crisis was precipitated by a series of unforeseeable events. Ben Bernanke (2009), Alan Greenspan (2010), Henry Paulson, Christina Romer (2009), and Robert Rubin (2010) stress that large capital inflows to the US lowered interest rates, fuelled a boom in mortgage lending, a reduction in loan standards, and toxic financial innovations.
This view characterises the collapse of the financial system as a series of “accidents”, such as the bursting of the housing bubble, and “suicide”, such the herding behaviour of financiers rushing to create increasingly complex financial products. Greenspan (2010), for example, depicts the financial crisis as a once in a “hundred years flood” and a “classic euphoric bubble”. From this perspective, policymakers responded to a crisis that happened to them.
Policymakers' “negligent homicide”
This view goes against the evidence. In a recent autopsy of the US financial system (Levine 2010), I examine key policies during the ten years from 1996 through to 2006. This is a period of relative calm, during which the regulatory authorities could assess the evolving impact of their policies and make adjustments.
Senior policymakers repeatedly designed, implemented, and maintained policies that destabilised the global financial system. The policies incentivised financial institutions to engage in activities that generated enormous short-run profits but dramatically increased long-run fragility.
The regulatory agencies were aware of the consequences of their policies and yet chose not to modify them. The policies reflected neither a lack of information nor an absence of regulatory power. They represented the selection – and most importantly the maintenance – of policies that increased financial fragility.
By failing to act prudently, regulators and policymakers recklessly endangered the global financial system. My verdict is that the US financial system is a case of “negligent homicide”. The crisis did not just happen to policymakers – they helped cause it.
For example, the Federal Reserve made a momentous decision on credit default swaps (CDSs) in 1996 that allowed banks to reduce their regulatory capital and increase risk-taking. In principle, banks can use CDSs to reduce their exposure to credit risk. For example, if a bank purchases a CDS on a loan, then if the loan defaults, the counterparty to that CDS will compensate the bank for the loss. The Fed decreed that a bank that buys a CDS for an outstanding loan is allowed to put aside less capital to cover potential future loses on the loan. With this decree, a bank with a typical portfolio of, say, $10 billion of commercial loans could reduce its capital reserves against these assets from $800 million to under $200 million by purchasing CDSs for a small fee. Hence the new regulatory framework allowed banks to reallocate capital to higher-expected-return, higher-risk assets.
There were, however, serious practical problems associated with allowing banks to reduce their capital by using default swaps. Given the active trading of CDSs, it was sometimes difficult to identify the actual counterparty legally responsible for compensating a bank if an “insured” security failed. Furthermore, some bank counterparties, such as AIG, developed massive exposures to CDS risk. These problems should have – and did – raise concerns about the ability of CDS counterparties to pay off banks in bad times.
The Fed was aware of the growing dangers associated with CDSs many years before the crisis and the Fed had full discretionary power to change its policies. It did not.
As a second example, the Securities and Exchange Commission changed its policies toward the five major investment banks (Bear Stearns, Goldman Sachs, Lehman Brothers, Merrill Lynch, and Morgan Stanley) in 2004. The Securities and Exchange Commission:
- Eliminated the net capital rule, which allowed the banks to issue more debt to purchase more risky securities without putting commensurately more of their own capital at risk;
- Took responsibility for supervising the holding company and affiliates of the major investment banks; and
- Dismantled its risk management office and weakened its enforcement division.
In other words, the Securities and Exchange Commission wilfully neutered its ability to assess and limit risk-taking.
In fact, the Securities and Exchange Commission had only seven people to examine the parent companies of the investment banks, which controlled over $4 trillion in assets. It failed to complete a single inspection of a major investment bank in the year and a half before the collapse of Bear Stearns. The Securities and Exchange Commission’s fingerprints are indelibly imprinted on this debacle.
There are many other examples in which policymakers made – and maintained – destabilising policies.
The epic failure of the two housing-finance giants, Fannie Mae and Freddie Mac, which could cost US tax payers a half trillion dollars, did not occur because of a lack of information. Report after report over the last fifteen years highlighted the deteriorating state of these government-sponsored entities and the role of national policies in pushing them toward the precipice.
Similarly the opaque nature of the multi-trillion dollar over-the-counter derivatives market is a conscious regulatory choice, not an accident. The leaders of the US Treasury, Federal Reserve, and Securities and Exchange Commission successfully lobbied Congress to prohibit regulatory actions that would have brought greater transparency to the over-the-counter derivatives market.
What about securitisation? It was known by the early 2000s that the explosive growth of securitisation would dramatically intensify the incentives of credit rating agencies to inflate their ratings. Securitisation involves the packaging and rating of trillions of dollars worth of new financial instruments. Before securitisation, rating agencies might have been unwilling to damage their reputations by inflating ratings for a few extra million dollars. With the emergence of securitisation, however, the agencies were looking at many billions of dollars in additional income if they greased the wheels of securitisation with optimistic ratings. The profits rolled in.
Recognising that the crisis was partially – if not primarily – caused by the systemic and enduring failures of the financial regulatory apparatus is necessary for designing comprehensive, effective reforms (Barth et al. 2010). Although the US government is overhauling financial regulation, the focus of these reforms is on empowering official regulatory agencies and limiting proprietary trading by banks. But an absence of regulatory power and proprietary trading played relatively minor roles in actually triggering the collapse. To create a healthy financial system, the authorities need to address the institutional underpinnings of why the financial regulatory system failed so miserably in the decade before the crisis.
Barth, James R, Gerard Caprio, Jr., and Ross Levine (2010), Guardians of Finance: How to Make them Work for Us. Forthcoming.
Bernanke, Ben S (2009), “Four Questions about the Financial Crisis”, speech at Morehouse College, Atlanta, Georgia, 14 April.
Geithner, Timothy (2009), Written Testimony, House Financial Services and Agriculture Committees Joint Hearing on Regulation of OTC Derivatives, 10 July.
Greenspan, Alan (2010), “The Crisis”, Brookings Institution, Forthcoming.
Levine, Ross (2010), “An Autopsy of the US Financial System”, NBER Working Paper 15956, April.
Romer, Christina D (2009), “Back from the Brink”, Paper presented at Federal Reserve Bank of Chicago Conference, “The International Financial Crisis: Have the Rules of Finance Changed?”, 24-25 September.
Rubin, Robert (2010), Testimony Before the Financial Crisis Inquiry Commission, 8 April.