WILL IT HAPPEN AGAIN?
Over an expansion, new financial instruments and new ways of financing
activity develop. Typically, defects of the new ways and the new
institutions are revealed when the crunch comes.
Underlying the bubble and its collapse was a dynamic that had been predicted several decades ago by a little-known economist, Hyman Minsky. He observed that financial boom-and-bust cycles, such as he studied from the Great Depression, were a natural consequence of the financial markets. Understanding these cycles helps to place governance and risk management into context. In the aftermath of a crisis, lenders and borrowers both become cautious. At that point, governance and risk management, whatever their quality, are unlikely to lead to overlending and systemic risk. Problems arise largely as memories fade, the economy enters a period of apparent prosperity, leverage increases, and lending standards become more lax. That is when good governance and strong risk management count most. Badly managed firms can fail in strong economic times, but the chances of systemic risk are smaller then. The key is to manage firms well during good times so that they can survive when circumstances change.
For Minsky, there are three types of lending: (1) loans based on the ability of the borrower to repay them, (2) loans based on anticipated cashflows from assets, sufficient to make timely interest payments but not the original principal, and (3) loans based on future increases in the value of collateral. As prosperity flourishes, banks and other lenders take on greater leverage as a way to increase their returns to shareholders, and to the managers who are rewarded with stock options.
Because asset values such as the value of homes securing mortgage loans increase, lenders begin to relax their standards. They move away from loans based on the borrower’s ability to repay, or even on ability to repay interest, to