Engineering the Financial Crisis: Systemic Risk and the Failure of Regulation

Engineering the Financial Crisis: Systemic Risk and the Failure of Regulation

Engineering the Financial Crisis: Systemic Risk and the Failure of Regulation

Engineering the Financial Crisis: Systemic Risk and the Failure of Regulation

Synopsis

The financial crisis has been blamed on reckless bankers, irrational exuberance, government support of mortgages for the poor, financial deregulation, and expansionary monetary policy. Specialists in banking, however, tell a story with less emotional resonance but a better correspondence to the evidence: the crisis was sparked by the international regulatory accords on bank capital levels, the Basel Accords.

In one of the first studies critically to examine the Basel Accords, "Engineering the Financial Crisis" reveals the crucial role that bank capital requirements and other government regulations played in the recent financial crisis. Jeffrey Friedman and Wladimir Kraus argue that by encouraging banks to invest in highly rated mortgage-backed bonds, the Basel Accords created an overconcentration of risk in the banking industry. In addition, accounting regulations required banks to reduce lending if the temporary market value of these bonds declined, as they did in 2007 and 2008 during the panic over subprime mortgage defaults.

The book begins by assessing leading theories about the crisis--deregulation, bank compensation practices, excessive leverage, "too big to fail," and Fannie Mae and Freddie Mac--and, through careful evidentiary scrutiny, debunks much of the conventional wisdom about what went wrong. It then discusses the Basel Accords and how they contributed to systemic risk. Finally, it presents an analysis of social-science expertise and the fallibility of economists and regulators. Engagingly written, theoretically inventive, yet empirically grounded, "Engineering the Financial Crisis" is a timely examination of the unintended--and sometimes disastrous--effects of regulation on complex economies.

Excerpt

A bank’s “capital” is the security blanket it needs because of the fragile nature of banking. Any corporation’s capital boils down to its net worth, or “the residual after subtracting liabilities from assets” (Gilliam 2005, 293, emphasis added). “The greater a bank’s capital, the more it can absorb net losses before liabilities exceed assets”: capital serves as a buffer against bankruptcy, which occurs when a corporation’s assets dip below its liabilities. Capital is thus rightly seen as a “cushion” for any corporation, but it is especially important for banks. This is because of the unique nature of a (commercial) bank’s assets, from which its liabilities are subtracted to determine its net worth.

A manufacturing corporation’s assets, for example, will probably consist largely of cash and items that could be sold in case of bankruptcy to meet its liabilities, such as its factories and equipment, inventory of unsold goods, real estate, and so on. in the case of a bank, however, most of its assets are not plant or equipment; they are loans—mortgages, business loans, and credit-card accounts, for instance. a sufficient “capital” buffer, in the accounting sense of the term with which we are concerned here, is important to banks because of the general unpredictability of these assets.

A factory may unexpectedly burn down, but such possibilities are actually “risks” in Keynes’s sense, and therefore they can be insured against.

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