By exploring causes of the 2007–08 global financial crisis from a banking perspective, the author finds that banks expanded through riskier liquidity and term asset/liability mismatches. He suggests that regulatory capital policies and liquidity requirements incentivized regulatory arbitrage and financial leverage, unintentionally creating conditions for increased system-wide exposure. He concludes by evaluating regulatory policy in response to the crisis.
What’s Inside?
The author addresses two questions about the global financial crisis. First, as Queen Elizabeth II famously asked, why did nobody notice it? And second, what caused it? He also reviews regulatory policies in response to the financial crisis—in particular, the Dodd–Frank Act in the United States and the Basel III Accord. He examines these issues through the lens of the banking industry, predominantly in the United States and Europe. Investment professionals with an interest in banking, financial intermediation, and the effects of regulatory changes may find the article especially relevant.
How Is This Research Useful to Practitioners?
The global financial crisis, according to the author, had two direct causes:
- growth in banking assets and increasingly risky asset/liability mismatches, resulting in sizable increases in financial leverage, and
- increased liquidity mismatches between assets and liabilities, with long-term assets financed with short-term liabilities.
The author argues that policies, including Basel I, have encouraged regulatory arbitrage. Reduced capital ratio minimums incentivized banks to increase leverage. These changes, along with a significant reduction in reserve requirements in the 1990s, precipitated lower liquidity and higher leverage, creating the conditions for a systemic crisis.
He outlines two paradoxes to explain why the crisis was not noticed earlier. In the 2002–06 run-up to the crisis, profits were high but several large banks required bailouts. Additionally, the low intermediation margins that were evident during this period seem incongruous with high profits. Banks increased profits through both balance sheet and off-balance-sheet growth and by taking on riskier asset/liability mismatches. These actions countered shrinking intermediation margins.
Next, the author reviews regulation since the crisis. He concludes that Dodd–Frank regulations will strengthen the U.S. financial system. After reviewing Basel III capital and liquidity requirements, including the Tier I capital leverage ratio, liquidity coverage ratio, and the net stable funding ratio, he concludes that Basel III will work better than Basel I but will introduce nonmarket distortions into the financial intermediation process. He suggests an alternative approach to reduce distortions.
Although emerging markets are implementing similar regulations, the author focuses on developed markets.
How Did the Author Conduct This Research?
Departing from the usual definition of financial intermediation, the author includes activities that take on default, liquidity, and maturity risk, such as proprietary trading, market making, and securitization. He formulates a banking model in which single period profit is the sum of five components: fee and commission revenue, noninterest costs, bank losses, total default spread, and total term spread. The first two are both a function of total assets and liabilities. Bank losses are functions of total assets and factors external to the bank. The default spread, which includes the liquidity spread, varies across banks, but the total term spread is not bank specific. The second and third components are the only two that reduce profits. The author uses his banking model to explain profit-maximization behavior.
He also analyzes the regulatory context before the crisis and studies research on the recent global financial crisis. The reliance of banks on wholesale funding and leverage are examined as contributing factors to the propagation of the crisis. He evaluates the regulatory framework after the crisis, particularly in Europe and the United States.
Abstractor’s Viewpoint
By looking at the financial crisis in the context of banking, the author contributes to our understanding of the events. He considers in particular the constraints and incentives created by regulatory policies, focusing on institutional incentives. An interesting extension would be to study agency costs and incentives.
Prediction often relies on the assumption that the past is indicative of the future. As financial market regulations continue to be developed and implemented, empirical results will help us better understand prediction and thus the effectiveness and effects of regulation.