The Agenda

Chris Papagianis and Arpit Gupta on Fragile Financing Mechanisms and the 2008 Financial Crisis

My Economics 21 colleagues Chris Papagianis and Arpit Gupta have a column arguing that the post-crisis success of AAA/Aaa subprime mortgage-backed securities suggests that the source of the crisis wasn’t so much the poor performance of these loans as the broader fragility of the shadow banking system:

The lesson is that it wasn’t just the product that was the issue – fragile financing mechanisms were really the key driver in the financial crisis. If financial intermediaries had held their asset positions with less leverage or with longer-duration borrowings, they would have been able to ride out market gyrations. Instead, reliance on debt and short-term holdings forced banks into costly sales and drove widespread insolvency.

The mix of leverage and the shared interdependence on extremely short-term wholesale funding markets (comprising both repos and commercial paper) turned what were initially relatively small losses into tens of trillions in lost output globally.

They end by calling for a new approach to financial reform:

Another option would be to recognize the systemic fragility and work to combat the underlying sources. The first of these is the widespread reliance on “safe assets,” which itself is partially a regulator-driven phenomenon. As we’ve seen, regulators’ preferences for seemingly safe assets incentivizes market participants to create and transform risky assets into new products that can be passed off as safe. Additionally, no asset is truly safe from losses to begin with, and doubling down on that fiction simply raises the stakes when default finally happens.

The second core reform should be to restructure the liability system of systemically important financial institutions. Maturity mismatch, to the extent it happens, should take place in traditionally regulated commercial banking institutions. Firms should be free to pursue real financial innovation, so long as their actions do not result in demands for bailouts or contagious financial losses for others.

One hopes that opponents of Dodd-Frank, a law described in vivid detail by The Economist back in February, will reach a consensus around a more stability-enhancing replacement. 

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