Restoring Financial Stability: How to Repair a Failed System is a collection of white papers about the global financial crisis, written by 33 faculty members of New York University’s Stern School of Business. Topics include bank leverage, hedge funds, government-sponsored enterprises, fair-value accounting, derivatives, short-selling restrictions, and the moral hazard of financial rescues. The book is meant to be practical rather than merely academic, in that each chapter offers a number of specific policy recommendations.
The intent of Restoring Financial Stability is most welcome. Policymakers are frequently the first to acknowledge that circumstances during the crisis sometimes forced them to make critical decisions in an ad hoc fashion without the luxury of extended debate. A rigorous examination by academic scholars can help policymakers step back, evaluate the longer-term consequences of those decisions, and see what can be learned and improved before the next crisis. Unfortunately, however, the book falls short of achieving that objective. It does too much poking around the edges and fails to explore some of the more fundamental issues.
The main thesis of Restoring Financial Stability is that the current crisis resulted from a combination of a credit boom and a housing bubble, even if it is not yet clear why the collapse of either had such a wide, systemic impact. The book’s contributors propose that the ultimate cause of the global financial crisis was the violation of time-honored diversification principles by large, complex financial institutions (LCFIs) that did not lay off enough of the credit risk associated with subprime mortgage loans. Securitization, a tool for diversifying credit risk, was instead used for regulatory arbitrage —that is, for exploiting a loophole in banking regulations. This was done by constructing off-balance-sheet vehicles for which capital requirements were comparatively light. Add to this the time inconsistency of a compensation system based on near-term transaction volumes rather than long-term profitability, inadequate pricing of government deposit insurance, and a lack of pricing altogether of government insurance inherent in the too-big-to-fail status of LCFIs, and one can see the contours of a perfect storm beginning to take shape.
The trick now, the authors argue, is to redesign regulation without stifling the innovation and economic growth made possible by the existing regime. In an overview chapter, they offer four main proposals for regulatory reform. First, LCFIs should redesign their financial compensation systems to include not only a bonus plan but also “bonus-malus” reserve accounts that feature long-term claw-back provisions. Second, regulatory arbitrage should be prevented. For example, government-sponsored enterprises should be strictly taxpayer financed and institutions should be charged adequately for such government guarantees as deposit insurance and too-big-to-fail status. Third, transparency of over-the-counter derivatives and off-balance-sheet transactions should be increased by using a central clearinghouse for standardized derivative instruments. Fourth, to reflect the negative systemic externality that LCFIs can create, a tax in the form of increased capital requirements or deposit insurance fees should be imposed on them. A systemic-risk regulator, perhaps the Federal Reserve Board, should supervise LCFIs, albeit within the context of a global regulatory framework.
Restoring Financial Stability is a missed opportunity in that it leaves unexplored too many critical issues. For example, why did so many LCFIs concentrate credit risk to the point of self-destruction? Why did their risk management systems fail? Why were no high-profile hedge funds among the subprime casualties? Did the government do the right thing in arranging rescues for Bear Stearns and AIG but not for Lehman Brothers? When the next LCFI comes calling for a lifeline, what principles should policymakers apply in deciding whether to arrange a rescue? How should policymakers determine whether an institution is too big or too interconnected to fail?
Another unanswered question is whether the government should shore up the financial system by purchasing bad assets or injecting capital into LCFIs. If the former is the case, what price should the government pay for bad assets? If the latter is true, should the capital be in the form of debt or equity?
What should the terms of a rescue be? The authors propose basing rescues on market prices. During a market disturbance, however, just when those prices are needed the most, they may be subject to a temporary lack of clarity.
Should injections of capital be voluntary or involuntary? The authors argue for voluntary injections of capital, but they do not mention the consequences of the stigma for institutions that need to accept the injections, let alone show why the benefits of voluntary acceptance outweigh the costs of the stigma.
How active an operating role should the government play once it has injected capital into an LCFI? How can policymakers evaluate the trade-off between the presumed immediate need for a rescue and the long-term moral hazard posed by a rescue? Unfortunately, Restoring Financial Stability fails to resolve these essential issues.
Readers who share the authors’ view that increased regulation is needed to prevent the recurrence of systemic meltdown are likely to find the book’s proposals a sensible first step in that direction. If the core problem is one of arbitraging regulatory requirements, however, the notion that increased regulation will prevent the next crisis is not intuitive. Indeed, as the authors point out, most of the losses so far have been incurred by the heavily regulated banks and investment banks. The more lightly regulated hedge funds have come away relatively unscathed or at least have not posed anything close to the systemic risk created by the banks.
Although Restoring Financial Stability argues that regulatory requirements were the crux of the problem, it is silent on the appropriate regulatory scope. The authors point out that “in a world with deposit guarantees and other implicit subsidies, market discipline imposed by bank runs is effectively outsourced to regulatory supervision and intelligence.” But if that is true and regulatory requirements lie at the heart of the financial crisis, could it be that what is needed to prevent the next crisis is not an expansion of regulation but a rollback? For example, a rollback would increase the burden on market participants to conduct more in-depth due diligence themselves before making credit and investment decisions. That may be a radical thought, but after what has happened over the past two years, everything we thought we knew should be on the table for reevaluation. Unfortunately, Restoring Financial Stability does not reach quite that deeply.
—J.H.T.