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Chapter1
Introduction
The financial system promotes our economic welfare by
helpingborrowersobtainfundingfromsaversandbytransshy
ferringrisksDuringtheWorldFinancialCrisiswhichstarted
in2007andseemstohaveebbedaswewritein2010the
financialsystemstruggled toperformthesecritical tasks
Theresultingturmoilcontributedtoasharpdeclineinecoshy
nomicoutputandemploymentaroundtheglobe
The extraordinary policy interventions during the Crishy
sishelpedstabilizethefinancialsystemsothatbanksand
otherfinancial institutionscouldagainsupporteconomic
growthThoughtheCrisisledtoaseveredownturnareshy
peatoftheGreatDepressionhassofarbeenavertedThe
interventionsbygovernmentsaroundtheworldhaveleft
ushoweverwithenormoussovereigndebtsthatthreaten
decadesofslowgrowthhighertaxesandthedangersof
sovereigndefaultorinflation
HowdowepreventareplayoftheWorldFinancialCrishy
sis This is one of the most important policy questions
confrontingtheworld todayand it remainsunanswered
Inthisbookweofferrecommendationstostrengthenthe
financialsystemandtherebyreducethelikelihoodofsuch
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2 bull CHapTer 1
damagingepisodesThoughinformedbythelessonsofthe
Crisisourproposalsareguidedbylongshystandingeconomic
principles
Whendevelopingourrecommendationswethinkcareshy
fully about the incentives of those who will be affected
andaboutunintendedconsequencesWetrytoidentifythe
specificproblemtobesolvedandthedivergencebetween
privateandsocialbenefitsbehindthatproblemwecareshy
fullyexaminethepossibleunintendedeffectsofourproshy
posedsolutionandweconsiderwaysinwhichindividuals
orinstitutionscancircumventtheregulationorcapturethe
regulators
Two central principles support our recommendations
Firstpolicymakersmustconsiderhowregulationswillafshy
fectnotonlyindividualfinancialfirmsbutalsothefinancial
systemasawholeWhensettingcapitalrequirementsfor
exampleregulators shouldconsidernotonly the riskof
individualbanksbutalsotheriskof thewholefinancial
systemSecondregulationsshouldforcefirmstobearthe
costsoffailuretheyhavebeenimposingonsocietyreducshy
ing the conflict between financial firms and society will
causethefirmstoactmoreprudently
Intheremainderofthisbookwepresentaseriesofpolshy
icyproposalseachofwhichcanbereadonitsownorin
combinationwith theothersTheconclusionsummarizes
theseproposalsandshowshow theymighthavehelped
duringtheWorldFinancialCrisis
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InTroDuCT Ion bull
What happened In the World FInancIal crIsIs
The Prelude
ThefirstsymptomsoftheWorldFinancialCrisisappeared
inthesummerof2007asaresultoflossesonmortgage
backed securities For example in august Bnp paribas
suspended the redemption of shares in three funds that
hadinvestedinthesesecuritiesandamericanHomeMortshy
gageInvestmentCorpdeclaredbankruptcyMortgagereshy
latedlossescontinuedthroughoutthefallandindicators
ofstressinthefinancialsystemincludingtheinterestrates
thatbankschargeeachotherwereunusuallyhighDespite
hugeinjectionsofliquiditybytheuSFederalreserveand
theeuropeanCentralBankfinancialinstitutionsbeganto
hoardcashandinterbanklendingdeclinednorthernrock
wasunabletorefinanceitsmaturingdebtandthefirmcolshy
lapsedinSeptember2007becomingthefirstbankfailure
intheunitedKingdominover100years
Thenextbigproblemwasinthemarketforauctionrate
securitiesalthough auction rate securities are longshyterm
bonds shortshyterm investors found them attractive before
theCrisisbecausesponsoringbanksheldauctionsatregushy
larintervalsmdashtypicallyevery728or5daysmdashtoallowthe
securityholderstoselltheirbondsThousandsoftheaucshy
tionsfailedinFebruary2008whenthenumberofowners
whowanted tosell theirbondsexceeded thenumberof
bidderswhowantedtobuythematthemaximumratealshy
lowedby thebondandunlike inpreviousauctionsthe
sponsoringbanksdidnotabsorbthesurplusaftermuch
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bull CHapTer 1
litigationthemajorsponsoringbanksagreedtopaymany
oftheirclientsrsquolossesThemarketforauctionratesecurishy
tieshasnotrevived
BearStearnsrsquofailureinMarch2008provedinretrospect
acriticalturningpointThefirmhadfundedmuchofitsopshy
erationswithovernightdebtandwhenitlostalotofmoney
onmortgagebacked securities its lenders refused to reshy
new thatdebtat the same timecustomers ran from its
primebrokeragebusinessaprocesswedescribeindetail
belowovertheweekendofMarch15theuSgovernment
brokeredarescuebyJpMorganthatincludedagenerous
commitmentbytheFederalreserveManyobserversand
officialsthoughtthattheCrisiswascontainedatthispoint
andthatmarketswouldpolicecreditrisksaggressively That
hopeprovedunfounded
The Remarkable Month of September 2008
The World Financial Crisis moved into an acute phase
in September 20081 Fannie Mae and Freddie Mac large
governmentshysponsored enterprises that create sell and
speculateonmortgagebackedsecuritiesfailedduringthe
firstweekofSeptemberandwereplacedundertheconsershy
vatorshipoftheFederalHousingFinanceagency
ThepeakoftheCrisisstartedonMondaySeptember15
2008LehmanBrothersabrokerageandinvestmentbank
headquarteredinnewYorkfailedwitharunbyitsshortshy
term creditors and prime brokerage customers that was
similartotherunexperiencedbyBearStearnsLehmanrsquos
bankruptcy was a surprise since the government had
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InTroDuCT Ion bull 5
steppedintopreventthebankruptcyofBearStearnsonly
monthsbefore
WithindaystheuSgovernmentrescuedamericanInshy
ternationalGroupaIGhadwrittenhundredsofbillionsof
dollarsofcreditdefaultswapswhichareessentiallyinsurshy
ancecontractsthatpayoffwhenaspecificborrowersuch
as a corporation or a specific security such as a bond
defaultsaseconomicconditionsworsenedanditbecame
increasingly likely thataIGwouldhave topayoffonat
leastsomeofitscommitmentstheswapcontractsrequired
thefirmtopostcollateralwithitscounterpartiesaIGwas
unable to make the required payments Goldman Sachs
wasaIGrsquosmostprominentcounterpartyandGoldmanrsquosdeshy
mands forcollateralwerean importantpartofaIGrsquosdeshy
miseThecost to taxpayersofgovernmentassistance for
FannieMaeFreddieMacandaIGisnowprojectedathunshy
dredsofbillionsofdollars
ThatsameweekTreasurySecretaryHankpaulsonanshy
nounced thefirstTroubledassetrelief program (Tarp)
askingCongressfor$700billiontobuymortgagebacked
securities Federal reserve Chairman Ben Bernanke and
presidentGeorgeWBush also gave important speeches
warningofgravedangertothefinancialsystemTheSecushy
ritiesandexchangeCommissionbannedtheshortshyselling
of several hundred financial stocks causing pandemoshy
niumintheoptionsmarketwhichreliesonshortshyselling
tohedgepositionsandamonghedgefundsthatemployed
longshyshortstrategies2
Theturmoilof theweekdidnotstopthereInterbank
lending declined sharply the commercial paper market
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bull CHapTer 1
slowed to a crawl and there was a run on the reserve
primaryFundamoneymarketmutualfundunlikeother
mutual funds money market funds maintain a constant
sharepricetypically$1byusingprofitsinthefundtopay
interestratherthantoincreasesharevaluesBecausethe
sharepriceisfixedat$1lossesthatpushafundrsquosnetasshy
setvaluebelow$1persharecantriggerarunasinvestors
rushtoclaimtheirfulldollarpaymentsandforcethelosses
ontootherinvestorsThereserveprimaryFundwhichhad
morethan1percentofitsassetsincommercialpaperisshy
suedbyLehmansufferedjustsucharunonSeptember1
2008afterLehmandeclaredbankruptcythefundrsquosnetasshy
setvaluedroppedto$097pershareandinvestorswithshy
drewmorethantwoshythirdsofthereserveFundrsquos$bilshy
lioninassetsbeforethefundsuspendedredemptionson
September17Concernspreadtoinvestorsinothermoney
marketfundsandtheywithdrewalmost10percentofthe
$5trillioninvestedinuSmoneymarketfundsoverthe
nexttendaysTostabilizethemarketthegovernmenttook
theunprecedented stepof offering a guarantee to every
uSmoneymarketfund
In normal timesany one of these eventswould have
beenthefinancialstoryoftheyearyettheyallhappened
inthesameweekinSeptember2008althoughmuchcomshy
mentaryandpopularpresscoverageblamestheWorldFishy
nancialCrisisentirelyonthegovernmentrsquosdecisiontolet
Lehmanfailsuchananalysisignorestheevidentcontribushy
tionsofthemanyothermomentouseventsthatoccurred
duringthatweek
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InTroDuCT Ion bull 7
October 2008 The Bank Bailout and Credit Crunch
Byearlyoctober2008theuSgovernmentrealizedthat
theTarpplantobuymortgagebackedsecuritiesonthe
openmarketwasnotfeasibleInsteadtheTreasuryDepartshy
mentusedtheappropriatedmoneytopurchasepreferred
stockinlargebanksandtoprovidecreditguaranteesand
othersupportThoughnowrememberedastheldquobankbailshy
outrdquotheTarppurchaseswerenotsimplyatransfertofailshy
inginstitutionsHealthybankswerealsoforcedtoaccept
capital inanattempt tomask thegovernmentrsquosopinions
aboutwhichbankswereinmoretroublethanothersMany
policymakersseemedtothinkthatbankswerenotlending
becausetheyhadlosttoomuchcapitalandwerenotable
orwillingtoraisemoreThusthegoalseemedtobenotto
savethebanksbuttorecapitalizethemsotheywouldlend
againIn theendthe former resultwasachievedmdashnone
of the large banks that receivedTarp funds failedmdashbut
thelatterarguablywasnotWeanalyzetheseissuesindeshy
tailbelowandrecommendsomealternativestructuresand
policiesthatwebelievewouldhaveworkedbetter
DuringmuchoftheWorldFinancialCrisistheFederal
reserveexperimentedwithawiderangeofnewfacilities
beyonditstraditionaltoolsofinterestratepolicyandopen
market operations The Fed lent broadly to commercial
banksinvestmentbanksandbrokershydealersandendedup
buyingcommercialpapermortgagesassetbackedsecurishy
tiesandlongshytermgovernmentdebtinanefforttolower
interestratesinthesemarketsByDecember2008excess
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8 bull CHapTer 1
reservesinthebankingsystemhadgrownfrom$billion
before the Crisis to over $800 billionThese actions are
notafocusofouranalysisbuttheysurelyhelpedprevent
theCrisisfromturningintoanotherGreatDepressionat
aminimumtheyeliminatedmostbanksrsquoconcernsabout
sourcesofcash
Bankfailuresineuropeinthefallof2008ledtomore
directbailoutsThenetherlandsBelgiumandLuxembourg
spent$1billiontopropupFortisamajoreuropeanbank
with about $1 trillion in assets The netherlands spent
$1billiontobailoutInGabankingandinsurancegiant
Germanyprovideda$50billionrescuepackageforHypo
realestateHoldingsSwitzerlandrescueduBSoneofthe
tenlargestbanksintheworldwitha$5billionpackage
Iceland took over its three largest banks and its subseshy
quent difficulties highlight what happens when the cost
ofbailingoutacountryrsquosbanksexceedsthegovernmentrsquos
resources
Throughoutthefallof2008therewasaldquoflighttoqualityrdquo
inmarketsaroundtheworldWheninvestorsareworried
aboutdefaulttheydemandhigherinterestratesYieldson
securitieswithanyhintofdefaultriskrosesharplyespeshy
ciallyinthefinancialsector
Theflighttoqualityisapparentintheinterestrateson
commercialpaperinFigure1Commercialpaperisshortshy
termunsecureddebtissuedbybanksandotherlargecorshy
porationsandisanimportantpartoftheirfinancingThe
commercialpaperratesforfinancialinstitutionsandlowershy
creditqualityborrowers jumped inSeptemberandoctoshy
berbutafterasmallincreasetherateforlargecreditworshy
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InTroDuCT Ion bull 9
7
6
5
4
3
2
1
0
A2P2 Nonfinancial
AA Financial
AA Nonfinancial
Jul 2008 Aug 2008 Sep 2008 Oct 2008 Nov 2008 Dec 2008
Figure1annualizedpercentYieldson0shyDayHighshyQuality(aa)FinancialandnonfinancialCommercialpaperandMediumshyQuality(a2p2)nonfinancialCommercialpaperinpercentaugusttoDecember2008SourceFederalreserve
thynonfinancialcompaniesactuallydeclinedTherateon
uSTreasurybillswhichareviewedas themost secure
investmentalsofellthethreeshymonthTreasurybillrateacshy
tuallydroppedtozeroforbriefperiodsinnovemberand
December2008
the run on the shadoW BankIng system
Thepanicthatstruckfinancialmarketsinthefallof2008
hasbeencharacterizedasarunontheshadowbankingsysshy
temandwithgoodreasonBeforetheCrisismanybonds
mortgagebackedsecuritiesandother credit instruments
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10 bull CHapTer 1
wereheldbyleveragednonshybankintermediariesincluding
hedgefunds investmentbanksbrokeragefirmsandspecialshy
purposevehiclesManyoftheseintermediarieswereforced
toldquodeleverrdquoduringoctoberandnovembersellingassetsto
repaytheircreditors
Hedgefundsandotherleveragedintermediariesusethe
securitiesintheirportfoliosascollateralwhentheyborrow
moneyDuringtheWorldFinancialCrisismanywarylendshy
ersdecidedthecollateralborrowershadpostedbeforethe
Crisis was no longer sufficient to guarantee repayment
Whenthelendersdemandedeithermoreorbettercollatshy
eralmanyborrowerswereforcedtoselltheirleveredposishy
tionsandrepaytheirloansTheresultwasareductionin
thequantityofassetstheyheldandintheirleverageInadshy
ditionhedgefundsandotherintermediariessufferedlarge
withdrawalsbypanickycustomersagainforcingthemto
sellsecuritiesonthemarketTheassetsbeingsoldweregenshy
erallyacquiredbyindividualinvestorsthefederalgovernshy
mentorcommercialbankswhichasagroupfinancedmost
oftheirpurchasesbyborrowingfromthegovernment
The financing difficulties faced by arbitrageurs and lishy
quidity providers are apparent in a series of fascinating
market pathologies In financialmarkets there are often
manydifferentwaystoobtainthesameoutcomeaninvesshy
torcanusemanydifferentcombinationsofsecuritiesfor
exampletorisklesslyconvertdollarstodayintodollarsin
sixmonthsThe actionsof arbitrageursusuallykeep the
costsof thedifferent approaches closely alignedDuring
thefallof2008thecostsoftendivergedwiththeapproach
thatrequiredmorecapitaltypicallycostingless
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InTroDuCT Ion bull 11
Theprincipleofcoveredinterestparityforexamplesays
thataftereliminatingexchangerateriskriskshyfreeinvesting
shouldhavethesamereturnineverycurrencyaninvestor
whowantstoinvestdollarstodayandreceivedollarsinthe
futureusuallybuysauSbondHecouldaccomplishthe
samethingbyconvertinghisdollarsintoeurosinvesting
inarisklesseurobondandlockingintheconversionof
theeuropayoffbackintodollarswithaforwardcontract
Sincebothstrategiesconvertdollarstodayintodollarsin
thefuturetheyshouldhavethesamereturn5 Supposeinshy
steadthereturnontheuSbondislowerThenanarbitrashy
geurcouldborrowmoneyintheunitedStatesatthelower
rateinvestitintheeurotransactionatthehigherrateand
makeaprofit
During the Crisis covered interest parity violations as
largeas20basispoints(020percent)emergedThismay
seemtrivialbutinnormaltimestheseviolationsrarelyexshy
ceed 2 basis pointsMoreover traders can usuallyldquolever
uprdquotransactionslikethisandmakealargeprofitButthatrsquos
thecatchmdashhedgefundsbrokeragesandinvestmentbanks
werebeingforcedtodeleverduringtheCrisisand20basis
points is not enough to enticemany longshyonly investors
to replace theuSbond theyarecurrentlyholdingwith
aforeignbondandsomeseeminglycomplicatedcurrency
transactions
other recent research finds similar disruptions of the
normalpricing relations linking (1)Treasurybondscorshy
poratebondsandcreditshydefault swaps (aTreasurybond
shouldbethesameasacorporatebondplusacreditdefault
swapmdashexceptforliquidityfinancingandCDScounterparty
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12 bull CHapTer 1
risk)(2)fixedandfloatingrate investments (asequence
ofshortshyterminvestmentsplusacontractswappingafloatshy
ing interest rate forafixed interest rateshouldhave the
same payoff as a fixed rate investment) () convertible
bondsdebtandequity()newlyissuedldquoonshytheshyrunrdquoand
recently issuedldquooffshytheshyrunrdquoTreasury bondswhich have
essentially the same payoff but differ in liquidity and
(5)stockandoptionpriceswhicharelinkedbywhatfishy
nancialeconomistscalltheputshycallparityrelation7
Thebreakdownofthesenormalpricingrelationsdoes
littledirectharm to the restof theeconomya20shybasisshy
pointviolationofcoveredinterestparityhaslittleeffecton
auSexporterusingcurrencycontractstolockintherate
atwhichitcanconvertfutureJapaneserevenuebackinto
dollarsTheseviolationsshowhoweverthatmarketswere
notfunctioningnormallyInparticulartheysuggestthere
wasnotmuchcapitalavailabletoprovideliquiditytobuyshy
ersandsellersanyoneneedingtosellsecuritiesquicklyin
suchamarketmdashsuchasafinancialinstitutiontryingtoreshy
duceitsriskmdashwasnotlikelytogetagoodprice
lendIng BankIng and the recessIon
Duringthefallof2008outputandfinancingactivityconshy
tracted sharply Commercial paper corporate bond and
equityissuanceallfelldramaticallyasdidmortgageorigishy
nations
originations of most types of asset backed securities
alsoslowedtoatrickleManybanksintheunitedStates
Jan 20
04Ju
l 200
4Ja
n 2005
Jul 2
005
Jan 20
06Ju
l 200
6Ja
n 2007
Jul 2
007
Jan 20
08Ju
l 200
8Ja
n 2009
Jul 2
009
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InTroDuCT Ion bull 1
0
50
100
150
200
250
Figure2assetBackedSecuritiesIssuedintheunitedStatesJanushyary200toDecember2009BillionsofDollarsperMonthSourceFederalreserve
and other countries no longer hold much of the credit
theyissueTheyhavemovedinsteadtoanldquooriginateand
sellrdquomodel inwhich theybundle together similar loans
suchasjumbomortgagescommercialloansstudentloans
or credit card debt and sell them to investors as asset
backedsecuritiesnewissuesofthesesecuritiesessentially
stopped inoctoberandnovember2008Figure2shows
that the amount of asset backed securities issued in the
united States rose from$288 billion in January 2000 to
$85billioninJune2007andthenplungedto$102bilshy
lioninSeptember2007IssuanceintheunitedStatesconshy
tinued to decline over the next year eventually falling
to only $87 billion in october 2008 and $ billion in
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1 bull CHapTer 1
novembermdashjust2percentofthevolume18monthsearlier
onlymortgagespooledbyFannieMaeandFreddieMac
withanexplicitgovernmentguaranteeandsubjecttohuge
Federalreservepurchasescontinuedtoflowtothemarket
There isplentyof anecdotal and surveyevidence that
banklendingalsodriedupduringtheCrisisForexample
loanofficerssurveyedbytheFederalreservereportedthat
credit conditionsprogressively tightenedduring2008In
asurveyabouttheirperceptionsofcreditconditionsand
corporatedecisionsasoflatenovember2008morethan
halfofthechieffinancialofficersoflargeamericanfirms
whorespondedsaidthattheirfirmswereeitherldquosomewhat
orveryaffectedbythecostoravailabilityofcreditrdquo8
There is a lively and fundamentally important debate
about why the quantity of lending fell Some financial
economists argue that banks wanted to lend more but
wereunable todosobecausetheyfacedbindingcapital
constraintsInthisviewinformationcostsandotherfricshy
tionsintheloanoriginationprocesskeptcustomersfrom
movingtolessconstrainedbanks
othersarguethattheprimaryreasonbankswereunwillshy
ingtolendisthattheircustomershadbecomelesscreditshy
worthyTheseeconomistspointoutthatthehighlevelof
uncertainty about future economic conditionsduring the
Crisisratchetedupthedefaultriskofeventhemostrelishy
ableclientsThisinterpretationofthedeclineinbanklendshy
ingimpliesthatnoamountofcapitalwouldhaveinduced
banksasagrouptolendmorebecauseallthegoodloans
werebeingmade
Figure shows data on the quantity of bank lending
Jan 20
08
Mar
2008
M
ay 20
08Ju
l 200
8Se
p 2008
Nov 20
08Ja
n 2009
Jan 20
09
May
2009
Jul 2
009
Sep 20
09Nov
2009
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InTroDuCT Ion bull 15
1050
1100
1150
1200
1250
1300
FigureCommercialandIndustrialLoansbyuSCommercialBanks2008ndash9inBillionsofDollarsSourceFederalreserve
intheunitedStatesin2008and2009Startinginoctober
2008therewasaspikeinlendingfollowedbyaprotracted
declineVVChariLawrenceChristianoandpatrickKehoe
takethespikeatfacevalueinaggregatebankslentmore
ataminimumthebankingsystemasawholemdashasopposed
to individual banksmdashwas not deleveraging to overcome
loss of capital9 Victoria Ivashina and David Scharfstein
notethatmuchoftheincreaseinbanklendingwasinvolshy
untaryonthepartofthebankstheresultofdrawdowns
byborrowersonexistinglinesofcredit10 Theyalsoshow
thatbanks thatweremorevulnerable todrawdownsbeshy
causetheywereinmoresyndicateswithLehmanreduced
subsequent lending more and conclude that there was
indeed a genuine contraction in the effective supply of
bankcredit
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1 bull CHapTer 1
economistswillargueabouttheeventsoftheWorldFishy
nancialCrisisforyearstocomeInfactwestillargueabout
theGreatDepressionnoneoftheanalysisbehindourrecshy
ommendationshoweverdepends onhow these debates
aresettledForexamplenomatterhowcapitalshyconstrained
thebankingsystemreallywasinthefallof2008ourproshy
posalsforchangesthatmakesuchconstraintslessbinding
andgivepolicymakersbettertoolswhentheyfearcapital
constraintsremainvalid
What Was Wrong WIth the FInancIal system durIng the crIsIs
The Crisis revealed a number of serious problems with
ourfinancialsystemSomehadbeeninthebackgroundall
alongothersdidnotappearuntiltheCrisisInthisbook
weemphasizefourcategoriesofproblemsconflictsofinshy
terestknowntoeconomistsasagencyproblemsthediffishy
cultyofapplyingstandardbankruptcyprocedurestofinanshy
cialinstitutionstheemergenceofamodernformofbank
runsandtheinadequacyoftheregulatorystructurewhich
hadnotkeptupwithrecentfinancialinnovation(Infact
muchinnovationservedtoescaperegulations)
Conflicts of Interest Agency Problems
Conflictsofinterestthatcannotberesolvedeasilybyconshy
tractsormarketsoccurthroughouttheeconomybutthey
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InTroDuCT Ion bull 17
canbeparticularlyharmfulinthefinancialsystemThere
areseveralreasonsFirstmanyfinancialtransactionsand
contractsinvolveaprincipalsuchasaninvestororshareshy
holderaskingatradermanagerorotheragenttoacton
hisorherbehalfSecondmostfinancial transactions inshy
volvehighlyuncertainfuturepayoffsandinmanytransacshy
tionsonepartyisbetterinformedaboutthepayoffsthan
the otherThird the high volatility of the future payoffs
oftenmakesithardtoassesswhethertheoutcomeofafishy
nancialtransactionisduetotheagentrsquoseffortsorluckand
fourththesumsinvolvedcanbehuge
Someproprietarytradersforexampleearnalotwhen
their tradesdowellbuttheirpersonal lossesare limited
whentheirtradesdopoorlyBecauseoftheasymmetricnashy
tureoftheircompensationthesetraderscanincreasetheir
expectedincomebytakingriskierpositionsThisproblem
isdramaticallyillustratedbyperiodiccasesinwhichldquorogue
tradersrdquoincurlossesthatarebigenoughtodamageoreven
destroy large financial institutions In 1995 nick Leeson
broughtdownBaringsBankwitha$1billionlossandin
2008itwasrevealedthatJeacuterocircmeKervielhadseverelydamshy
agedSocieacuteteacuteGeacuteneacuteralewithalossofover$7billion
Conflictsofinterestorldquoagencyproblemsrdquoalsoexistat
manyotherlevelswithinthefinancialsystemShareholders
offinancialinstitutionshaveaconflictofinterestwiththe
bankrsquosseniorexecutivesespeciallywhenthoseexecutives
arerewardedforgoodperformancebutdonothavealarge
fractionoftheirwealthtiedupinthesharesofthebank
Manyfinancialinstitutionshavelargequantitiesofdebt
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18 bull CHapTer 1
which creates a conflict of interest between the bankrsquos
creditorsanditsshareholdersShareholdershaveanincenshy
tivetoauthorizeexcessivelyriskyinvestmentsforexample
especiallyafterabankhasincurredlossesthaterodethe
valueoftheshareholdersrsquoclaimThegainsontheserisky
investmentswillaccruelargelytoshareholderswhilethe
losseswillmostlybebornebycreditorsTheconflictwith
creditorsalsoreducestheincentivesfortheshareholders
of troubled institutions to raisenewcapitalbecause that
wouldstrengthen thepositionofcreditorswhilediluting
theshareholdersrsquopositionThisldquodebtoverhangrdquoproblem
waswidelycitedduringtheWorldFinancialCrisiswhen
many banks that were insolvent or close to insolvency
seemedreluctanteithertoraisenewcapitalortoreduce
theirrisksbysellingdistressedsecurities11
atthehighestlevelthereisaconflictofinterestbetween
societyasawholeandtheprivateownersoffinancialinshy
stitutions Because robust financial institutions promote
economicgrowthandemploymentduringfinancialcrises
governmentsoftenrescuetroubledfirmstheyperceiveto
be systemically importantThe result is privatized gains
andsocializedlossesIfthingsgowellthefirmsrsquoowners
andmanagersclaimtheprofitsbutifthingsgopoorlysoshy
cietysubsidizesthelosses
The candidates for government bailouts are popularly
describedasldquotoobigtofailrdquoMorepreciselytheargument
for government supportmdashwhich many economists chalshy
lengemdashisaboutfirmsthataretoosystemicallyimportantto
failInits200annualreporttheeuropeanCentralBank
describedsystemicriskasldquoTheriskthattheinabilityofone
Copyrighted Material
InTroDuCT Ion bull 19
institutiontomeetitsobligationswhenduewillcauseother
institutions to be unable tomeet their obligationswhen
dueSuchafailuremaycausesignificantliquidityorcredit
problemsandas a resultcould threaten the stabilityof
or confidence in marketsrdquo Systemically important firms
arethosewhosefailurecouldposealargethreattothestashy
bilityoforconfidenceinmarketsThesefirmsarelikelyto
belargebuttheyalsotendtohavecomplexinterconnecshy
tionswithotherfinancialinstitutions
Tooshybigshytoshyfailpoliciesoffersystemicallyimportantfirms
theexplicitorimplicitpromiseofabailoutwhenthingsgo
wrongThesepoliciesaredestructiveforseveralreasons
Firstbecause the possibility of a bailoutmeans a firmrsquos
stakeholders claim all the profits but only some of the
lossesfinancialfirmsthatmightreceivegovernmentsupshy
porthaveanincentivetotakeextrariskThefirmrsquosshareshy
holderscreditorsemployeesandmanagement all share
thetemptationTheresultisanincreaseintherisksborne
bysocietyasawhole
Secondthesepoliciesencouragesmallerfinancialinstishy
tutionstoexpandortobecomemorecloselyinterconnected
with other firms so they move under the tooshybigshytoshyfail
umbrellaFirmshaveanincentivetodowhateverittakes
tomakepolicymakersfeartheirfailurecreatingthevery
fragilitythegovernmentwishestoavoidBeliefthatagovshy
ernmentrescuewillprotectafinancial institutionrsquoscredishy
tors inacrisisalsogivesafirmacompetitiveadvantage
loweringitscostoffinancingandallowingittoofferbetter
prices to its customers than its fundamental productivity
warrants
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20 bull CHapTer 1
Thirdinefficientfirmsthatcannotcompeteontheirown
shouldfailotherwisefirmshavelessincentivetobecome
andstayefficientagovernmentpolicythatpropsupinshy
efficientfirmsiswastefulanddestructiveallowingthese
firmstofailfreesupresourcesandprovidesopportunities
formoreefficientandinnovativecompetitorstoflourish
Fourthandmostgenerallycapitalismisunderminedby
policiesthatprivatizegainsbutsocializelossesGovernment
guaranteedinstitutionscanbecomegovernmentruninstishy
tutionsallocatingcreditforexampletomaximizepolitical
gainratherthaneconomicwelfare
The conflictbetween society and theownersoffinanshy
cialfirmsbecomesmoreseriousduringseverecriseswhen
manyfinancialinstitutionsareclosetoinsolventIt isthe
primemotivationforourregulatoryproposalsbutseveral
ofthelowershylevelconflictswehavedescribedarerelevant
becausetheymagnifytheriskbornebysocietyasawhole
Theselfshyservingbehaviorthatmanyofourrecommenshy
dations targetmdashwhether by traders senior management
orthefirmrsquosownersmdashneednotbestrategicintentionally
maliciousorevenconsciousConsideratraderwhoinadshy
vertentlydevelopsaninvestmentstrategywithhighlyprobshy
ablegainsandimprobablebutlargelossesLikeafirmthat
hassoldearthquakeinsurancethestrategymayproducea
longstringofimpressivereturnsbeforeoneyearoflosses
wipesoutmanyyearsofprofits12 Ifsoduringthegood
yearsthetraderwillbecelebratedforhisorherbrilliance
rewarded with large bonuses and given more resources
to manageMany sophisticated traders and hedge funds
Copyrighted Material
InTroDuCT Ion bull 21
werenotawareoftheldquoearthquakerisksrdquoinherentinmany
of theirstrategiesSimilarlywhenfirmstakeactionsthat
increasethelikelihoodofagovernmentbailoutinthenext
financialcrisisthemarketrewardsthemwithalowercost
of capitalas firms become too big to fail for example
the implicit government guarantee reduces the riskiness
of their debt and lowers the interest rate demanded by
theircreditorsaCeoworkingtomaximizefirmvaluemay
notevenrealize the importanceof thegovernmentguarshy
anteebut a Darwinian process will encourage behavior
thatexploitsit
Bankruptcy and Resolution Procedures
Itisimpossibletowriteafinancialcontractthatspecifies
everypossiblecontingencyInsteadcontractsrelyonbankshy
ruptcytodetermineoutcomesincertainbadandunlikely
statesoftheworldInbankruptcycontrolofafirmistransshy
ferredfromtheshareholderswhonolongerhaveastake
inlossesbecausetheirsharesareworthlittletothedebtshy
holders It is in societyrsquos interest to develop bankruptcy
proceduresthatmaximizethepostshybankruptcyvalueofa
firmrsquosassetsInparticularsocietyshouldavoidthedestrucshy
tionofvaluethatoccurswithdisorderlyliquidation
Disorderlyliquidationoffinancialinstitutionsisparticushy
larly costlyFirstvaluableknowledge that the institution
hasaccumulatedaboutitscounterpartiesmdashborrowerstradshy
ingpartnersandsoonmdashcandisappearastheinstitution
losesemployeesandceasestooperatenormallyFinancial
Copyrighted Material
22 bull CHapTer 1
economistshavefoundthatthecollapseofabankhasamashy
terialadverseimpactonmanyofitsborrowers1 Second
the prospect of a disorderly liquidation makes it more
likelythatatroubledfinancialinstitutionwillsufferarun
by creditors who conclude they are better off claiming
whatmoney theycan todayrather thanwaiting through
protracted liquidation proceedings Third ldquofire salesrdquo of
specializedassets inadisorderly liquidationcandepress
prices and thereby spread problems to other holders of
theassetclassFourthdisorderlyliquidationincreasesthe
uncertaintyabouttheimpactofafinancialinstitutionrsquosfailshy
ureonitscounterpartiesandotherclaimholdersBecause
financialfirmsaretightlyinterconnectedthisuncertainty
canprecipitateorintensifyafinancialcrisis1
In theunitedStatesthestandardbankruptcycodealshy
lowsbothforliquidationofafirmandthesaleofitsassets
(Chapter7)andforcontinuedoperationofafirmunder
the supervision of a bankruptcy judgewho protects the
firmfromcreditorsrsquoclaimswhileareorganizationplanis
approved(Chapter11)Theseproceduresappeartowork
wellfornonfinancialcorporationsbutnotsowellforfinanshy
cialorganizationsTheChapter11approachofseparatinga
firmrsquosfinancialaffairsfromitsnonfinancialbusinessactivishy
tiesisinfeasiblewhenthebusinessofthefirmisfinancial
transactionsFurthermoremanyfinancialinstitutionsrely
heavily on shortshyterm debtpossibly as a valuable discishy
plineonbankexecutiveswhocanrapidlychangetherisks
theirfirmstakeThismakesfinancialfirmsvulnerabletoa
rapidwithdrawalofshortshytermcreditthatislikelytooccur
beforeanyeventthatwouldtriggerbankruptcy
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InTroDuCT Ion bull 2
Wearguebelowthatthereisaneedforaspecialresolushy
tionprocedurethatcanbeappliedtolargeinsolventfinanshy
cialinstitutionsWealsoadvocateregulatorychangesthat
would push financial firms towardmore resilient capital
structures
Bank Runs
Classicbank runs inwhichdepositors race towithdraw
their funds before a bank failswere one of the central
contributors to theGreatDepressionDeposit insurance
whichwasintroducedaftertheDepressiontocounterthis
destructiveprocessmadedemanddepositsoneofthemost
stableformsofbankfinancingduringtheWorldFinancial
CrisisManyfinancialinstitutionshoweversufferedamodshy
ernversionofbankruns
Banksespeciallythosewithinvestmentbankingactivishy
tiestypicallyfinanceasignificantfractionoftheirbusiness
withovernightcommercialpaperreposandothershortshy
terminstrumentsInnormaltimesbanksrolloverthisdebt
asitmaturestakingnewloanstopayofftheoldInacrishy
sishoweveruncertaintyaboutwhetheratroubledinstitushy
tionwouldbeabletopayoffitscreditorstomorrowcauses
lenderstostopextendingcredittodayThusshortshytermfishy
nancingcanleadtoarunthatissimilartoaclassicrunon
deposits
even some secured creditors participated in runs durshy
ingtheWorldFinancialCrisisBanksoftenuserepurchase
agreements to borrow money securing the loan by givshy
ingthelenderafinancialassetsuchasaTreasurybond
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2 bull CHapTer 1
ascollateralBecausetheyareovershycollateralizedwithasshy
setsworthperhaps$105guaranteeingevery$100inloans
lendersviewldquoreposrdquoasasafewaytoextendcreditWhen
credit markets froze during the Crisis however lenders
worried that retrieving collateral and selling itwouldbe
difficultandnotworththesmallinterestonanovernight
loanasaresultatvarioustimesduringtheCrisismany
investmentbankshaddifficultyrollingovereventheirseshy
cured loanseven relatively healthy financial institutions
werehamperedbythetroubleintherepomarketafteraushy
gust2007asthemarketbecamemoreandmoreuncertain
about the prices securities would fetch in a forced sale
these institutions found they could borrow less and less
withthesamecollateral15
prime brokerage accounts also saw a runshylike withshy
drawalbycustomersManylargebankshaveprimebrokershy
agegroupsthatassisthedgefundsandotherinstitutionalinshy
vestorsbyprovidingfinancingsecuritieslendingclearing
custodial servicesandoperational supportInexchange
thefundspayfeesandcriticallypostcollateraltosecure
theirloansWithsomerestrictionsthatweexplaininChapshy
ter10theprimebrokercanthenusethecollateralinits
ownbusinessinsomecasescomminglingitwiththefirmrsquos
ownassetsDuringtheCrisishedgefundsmonitoredthe
financial wellshybeing of their prime brokers and like deshy
positorsintheDepressionfledwiththeircollateralatthe
firstsignoftroubleBearStearnsforexamplehadalarge
prime brokerage business according to press accounts
oneofthelargesthedgefundsthatusedBearStearnsasa
Copyrighted Material
InTroDuCT Ion bull 25
primebrokerrenaissanceTechnologieswithdrew$5bilshy
lionofcashintheweekthefirmfailedWithsuchoutflows
it is not surprising that Bear Stearns ran out of money
eventhoughithadmorethan$18billionincashaweek
earlier
Likeclassicbankrunsmodernbankrunsarebothdeshy
structiveandselfshyfulfillingConcernthatabankmightbe
in trouble spurs its creditors and counterparties towithshy
draworwithholdtheircapitalasaresultevenrumorsofa
problemmaybeenoughtodestroyaviableinstitutionThe
importanceofmodernbankrunsduringtheWorldFinanshy
cialCrisisisarecurringthemethroughoutthebookand
wemakeseveralproposalsthatareintendedtoreducethe
frequencyofsuchevents
The Inadequacy of the Regulatory Structure
TheWorldFinancialCrisismadeitclearthatfinancialinnoshy
vationhadoverwhelmedexistingfinancialregulationsnoshy
tableexamplesincludeaIGrsquosdecisiontosellanextremely
large amount of credit default swaps on subprime debt
tobanksintheunitedStatesandabroadtheholdingof
Lehmanpaperbymoneymarketfundsparticularlythereshy
serveprimaryFundthecomplexityofthederivativebooks
atLehmanandotherinvestmentbanksandthedifficultyof
simultaneouslyapplyingseveralcountriesrsquobankruptcycodes
tothesubsidiariesofmultinationalfinancialinstitutions1
Thereisatradeshyoffbetweenfinancialinnovationandstashy
bilityInnovationcanimprovethefinancialsystemrsquosability
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2 bull CHapTer 1
toallocateresourcestotheirhighestvaluedusebutitcan
alsoreducethestabilityofthesystemThechallengeisto
developregulationsthatimprovestabilitywithoutstifling
innovation In addition regulation often leads to innoshy
vations designed to evade the regulationswhich makes
thefinancialsystemmorefragileForexamplemanyofthe
specialshypurposevehiclesthatimplodedintheCrisiswere
createdtogetaroundcapitalrequirements
In many countries the response of regulators to the
World Financial Crisis was hampered by the fragmented
nature of their regulatory systems Financial regulations
are typically designed to ensure thehealth of individual
institutionsratherthanthefinancialsystemasawholeIn
thisbookwearguethatsystemicregulationisanimporshy
tantfunctionthatrequiresaspecialmandateandthatthe
central bank is particularly well equipped to fulfill this
function
Finallyeffectivefinancialregulationrequiresthatpolitishy
ciansandultimatelythepublichaveanadequateundershy
standing of the financial system The political turmoil
surroundingtheCrisissuggeststheimportanceofdissemishy
natingexpertknowledgeaboutfinancetoabroaderaudishy
enceThisisoneofourmotivationsforwritingthisbook
What Were the orIgIns oF the World FInancIal crIsIs
LiketheoriginsoftheFirstWorldWarthecausesofthe
Crisiswillbedebatedbyscholarsformanyyears
Copyrighted Material
InTroDuCT Ion bull 27
Most observers agree that the strong runshyup and subshy
sequentsharpdeclineinthepricesofstockshousesand
otherfinancialassetsindevelopedcountrieswasanimporshy
tantcatalystfortheCrisisThereisdisagreementhowever
aboutwhetherthispatterninpricesistheresultofrational
investorbehaviororldquoirrationalbubblesrdquo
SomearguethattherunshyupbeforetheCrisiswasdriven
by investorswhoknowingly acceptedunusually low exshy
pectedreturnsandtheyofferseveralpossiblereasonswhy
Firsttherewasasurgeofsavingsinemergingcountries
drivenbyacombinationofrapideconomicgrowthanddeshy
mographicsperhapsbecauseofadesiretoaccumulateforshy
eignreservesintheaftermathoftheasiacrisisof1997ndash98
muchof thiswealthwas invested indevelopedmarkets
Secondfinancialmarketswereunusually tranquilduring
200to200Withlowvolatilityinvestorsmayhavesettled
for a low risk premiumThird influenced by fears of a
Japaneseshystyledeflation resulting from themarketdownshy
turnof2000ndash2001andbyabeliefthattheyshouldnottry
to usemonetary policy to counteract rising asset prices
central bankers in the united States maintained a loose
monetarypolicythroughouttheperiod17andfromthisrashy
tionalviewofinvestorstheplungeinassetpricesthatacshy
companiedtheCrisiswascausedbybadnewsaboutfuture
cashflowsunexpectedincreasesinthereturnsrequiredby
investorsorboth
otherssuggestamoredirectexplanationThehighprices
before theCrisisweredrivenby an irrational belief that
prices would continue to rise and the collapse of asset
priceswastheinevitableresultofthismistakeWhatever
Copyrighted Material
28 bull CHapTer 1
theexplanationthesharpdropinassetpricesbothconshy
tributedtoandwasasymptomoftheCrisis
other commentators argue that the financial system
becamevulnerablebecausemanymarketparticipantsasshy
sessedrisksinaccuratelyduringtheperiodleadingupto
theWorldFinancialCrisisConsumersbanksandinvestors
ingeneralunderestimatedtheriskofhousepricedeclines
increasingthepricestheywerewillingtopayforrealesshy
tatethecredittheywerewillingtoextendandthevaluashy
tionsofbanksthatextendedsuchcreditBanksputmuch
weight on the recent pastwhen they estimated value at
riskwhichledthemtoconcludethatthelevelofriskwas
lowandthattherewaslittledownsidetohavinghighleshy
verageothermarketparticipantsdidnotfullyappreciate
thathighliquiditywassuppressingvolatilityandthatthe
processmightreversewithliquiditydecreasingandvolatilshy
ityincreasing
More generally the high level of financial innovation
driveninpartbythedecliningcostofinformationtechnolshy
ogymadeithardforriskassessmenttokeeppacewiththe
evolvingfinancialsystem18Thebenignenvironmentofthe
creditboomexacerbatedthisproblembytemptingfinanshy
cialinstitutionstounderinvestinriskmanagement
uSpolicymakersalsocontributedtotheseverityofthe
CrisisbypushingFannieMaeandFreddieMactoincrease
theavailabilityofmortgagefundingtoborrowerswithquesshy
tionableabilitytorepaytheirmortgagesasaresultofthis
pressure both agencies relaxed their standards for the
mortgages they purchased and guaranteedThe demand
Copyrighted Material
InTroDuCT Ion bull 29
forhomesbyborrowerswhoqualifiedformortgagesbeshy
causeoftheselowerstandardspusheduppricesandthe
defaultbymanyofthemduringtherecessioncontributed
tothedropinhomeprices
Thepanicandruninthefallof2008remainthecentral
distinguishingfeaturesoftheWorldFinancialCrisisasset
priceshave risenand fallenbeforeand theworldeconshy
omyhasbornelargefinancial lossesmanytimeswithout
suchasevereeconomicoutcomeConverselylossesfrom
completelydifferentunderlyingsourcesmdashcommercialreal
estateorperhapssovereigndefaultsmdashcouldcauseasimilar
catastrophe if theyagainprovoke tooshybigshytoshyfailchaosor
runs
Thisbookdoesnotseektoprovideacompletediagnosis
oftheWorldFinancialCrisisnordoesittakeastandonthe
relativeimportanceofthecontributingfactorslistedabove
ratherwebelieveourrecommendationswillhelpprevent
ormitigatefuturecriseseventhoughwedonotfullyundershy
standallthecausesofthelastone
CarmenreinhartandKennethrogoff amongothershave
pointedoutthatfinancialcriseshaveoccurredthroughout
thehistoryofcapitalismandthatthesecrisessharemany
commonpatterns19 Thelessonwedrawfromthisisthat
noacceptablesetofregulationscanpreventmarketparticishy
pantsfrommakingmistakesthatcreateeconomicinstability
ourpurposeinthisbookisinsteadtosuggestregulatory
reformsthatwillmakethesystemmorestabledespitethe
mistakesthataresuretocome
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2 bull CHapTer 1
damagingepisodesThoughinformedbythelessonsofthe
Crisisourproposalsareguidedbylongshystandingeconomic
principles
Whendevelopingourrecommendationswethinkcareshy
fully about the incentives of those who will be affected
andaboutunintendedconsequencesWetrytoidentifythe
specificproblemtobesolvedandthedivergencebetween
privateandsocialbenefitsbehindthatproblemwecareshy
fullyexaminethepossibleunintendedeffectsofourproshy
posedsolutionandweconsiderwaysinwhichindividuals
orinstitutionscancircumventtheregulationorcapturethe
regulators
Two central principles support our recommendations
Firstpolicymakersmustconsiderhowregulationswillafshy
fectnotonlyindividualfinancialfirmsbutalsothefinancial
systemasawholeWhensettingcapitalrequirementsfor
exampleregulators shouldconsidernotonly the riskof
individualbanksbutalsotheriskof thewholefinancial
systemSecondregulationsshouldforcefirmstobearthe
costsoffailuretheyhavebeenimposingonsocietyreducshy
ing the conflict between financial firms and society will
causethefirmstoactmoreprudently
Intheremainderofthisbookwepresentaseriesofpolshy
icyproposalseachofwhichcanbereadonitsownorin
combinationwith theothersTheconclusionsummarizes
theseproposalsandshowshow theymighthavehelped
duringtheWorldFinancialCrisis
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InTroDuCT Ion bull
What happened In the World FInancIal crIsIs
The Prelude
ThefirstsymptomsoftheWorldFinancialCrisisappeared
inthesummerof2007asaresultoflossesonmortgage
backed securities For example in august Bnp paribas
suspended the redemption of shares in three funds that
hadinvestedinthesesecuritiesandamericanHomeMortshy
gageInvestmentCorpdeclaredbankruptcyMortgagereshy
latedlossescontinuedthroughoutthefallandindicators
ofstressinthefinancialsystemincludingtheinterestrates
thatbankschargeeachotherwereunusuallyhighDespite
hugeinjectionsofliquiditybytheuSFederalreserveand
theeuropeanCentralBankfinancialinstitutionsbeganto
hoardcashandinterbanklendingdeclinednorthernrock
wasunabletorefinanceitsmaturingdebtandthefirmcolshy
lapsedinSeptember2007becomingthefirstbankfailure
intheunitedKingdominover100years
Thenextbigproblemwasinthemarketforauctionrate
securitiesalthough auction rate securities are longshyterm
bonds shortshyterm investors found them attractive before
theCrisisbecausesponsoringbanksheldauctionsatregushy
larintervalsmdashtypicallyevery728or5daysmdashtoallowthe
securityholderstoselltheirbondsThousandsoftheaucshy
tionsfailedinFebruary2008whenthenumberofowners
whowanted tosell theirbondsexceeded thenumberof
bidderswhowantedtobuythematthemaximumratealshy
lowedby thebondandunlike inpreviousauctionsthe
sponsoringbanksdidnotabsorbthesurplusaftermuch
Copyrighted Material
bull CHapTer 1
litigationthemajorsponsoringbanksagreedtopaymany
oftheirclientsrsquolossesThemarketforauctionratesecurishy
tieshasnotrevived
BearStearnsrsquofailureinMarch2008provedinretrospect
acriticalturningpointThefirmhadfundedmuchofitsopshy
erationswithovernightdebtandwhenitlostalotofmoney
onmortgagebacked securities its lenders refused to reshy
new thatdebtat the same timecustomers ran from its
primebrokeragebusinessaprocesswedescribeindetail
belowovertheweekendofMarch15theuSgovernment
brokeredarescuebyJpMorganthatincludedagenerous
commitmentbytheFederalreserveManyobserversand
officialsthoughtthattheCrisiswascontainedatthispoint
andthatmarketswouldpolicecreditrisksaggressively That
hopeprovedunfounded
The Remarkable Month of September 2008
The World Financial Crisis moved into an acute phase
in September 20081 Fannie Mae and Freddie Mac large
governmentshysponsored enterprises that create sell and
speculateonmortgagebackedsecuritiesfailedduringthe
firstweekofSeptemberandwereplacedundertheconsershy
vatorshipoftheFederalHousingFinanceagency
ThepeakoftheCrisisstartedonMondaySeptember15
2008LehmanBrothersabrokerageandinvestmentbank
headquarteredinnewYorkfailedwitharunbyitsshortshy
term creditors and prime brokerage customers that was
similartotherunexperiencedbyBearStearnsLehmanrsquos
bankruptcy was a surprise since the government had
Copyrighted Material
InTroDuCT Ion bull 5
steppedintopreventthebankruptcyofBearStearnsonly
monthsbefore
WithindaystheuSgovernmentrescuedamericanInshy
ternationalGroupaIGhadwrittenhundredsofbillionsof
dollarsofcreditdefaultswapswhichareessentiallyinsurshy
ancecontractsthatpayoffwhenaspecificborrowersuch
as a corporation or a specific security such as a bond
defaultsaseconomicconditionsworsenedanditbecame
increasingly likely thataIGwouldhave topayoffonat
leastsomeofitscommitmentstheswapcontractsrequired
thefirmtopostcollateralwithitscounterpartiesaIGwas
unable to make the required payments Goldman Sachs
wasaIGrsquosmostprominentcounterpartyandGoldmanrsquosdeshy
mands forcollateralwerean importantpartofaIGrsquosdeshy
miseThecost to taxpayersofgovernmentassistance for
FannieMaeFreddieMacandaIGisnowprojectedathunshy
dredsofbillionsofdollars
ThatsameweekTreasurySecretaryHankpaulsonanshy
nounced thefirstTroubledassetrelief program (Tarp)
askingCongressfor$700billiontobuymortgagebacked
securities Federal reserve Chairman Ben Bernanke and
presidentGeorgeWBush also gave important speeches
warningofgravedangertothefinancialsystemTheSecushy
ritiesandexchangeCommissionbannedtheshortshyselling
of several hundred financial stocks causing pandemoshy
niumintheoptionsmarketwhichreliesonshortshyselling
tohedgepositionsandamonghedgefundsthatemployed
longshyshortstrategies2
Theturmoilof theweekdidnotstopthereInterbank
lending declined sharply the commercial paper market
Copyrighted Material
bull CHapTer 1
slowed to a crawl and there was a run on the reserve
primaryFundamoneymarketmutualfundunlikeother
mutual funds money market funds maintain a constant
sharepricetypically$1byusingprofitsinthefundtopay
interestratherthantoincreasesharevaluesBecausethe
sharepriceisfixedat$1lossesthatpushafundrsquosnetasshy
setvaluebelow$1persharecantriggerarunasinvestors
rushtoclaimtheirfulldollarpaymentsandforcethelosses
ontootherinvestorsThereserveprimaryFundwhichhad
morethan1percentofitsassetsincommercialpaperisshy
suedbyLehmansufferedjustsucharunonSeptember1
2008afterLehmandeclaredbankruptcythefundrsquosnetasshy
setvaluedroppedto$097pershareandinvestorswithshy
drewmorethantwoshythirdsofthereserveFundrsquos$bilshy
lioninassetsbeforethefundsuspendedredemptionson
September17Concernspreadtoinvestorsinothermoney
marketfundsandtheywithdrewalmost10percentofthe
$5trillioninvestedinuSmoneymarketfundsoverthe
nexttendaysTostabilizethemarketthegovernmenttook
theunprecedented stepof offering a guarantee to every
uSmoneymarketfund
In normal timesany one of these eventswould have
beenthefinancialstoryoftheyearyettheyallhappened
inthesameweekinSeptember2008althoughmuchcomshy
mentaryandpopularpresscoverageblamestheWorldFishy
nancialCrisisentirelyonthegovernmentrsquosdecisiontolet
Lehmanfailsuchananalysisignorestheevidentcontribushy
tionsofthemanyothermomentouseventsthatoccurred
duringthatweek
Copyrighted Material
InTroDuCT Ion bull 7
October 2008 The Bank Bailout and Credit Crunch
Byearlyoctober2008theuSgovernmentrealizedthat
theTarpplantobuymortgagebackedsecuritiesonthe
openmarketwasnotfeasibleInsteadtheTreasuryDepartshy
mentusedtheappropriatedmoneytopurchasepreferred
stockinlargebanksandtoprovidecreditguaranteesand
othersupportThoughnowrememberedastheldquobankbailshy
outrdquotheTarppurchaseswerenotsimplyatransfertofailshy
inginstitutionsHealthybankswerealsoforcedtoaccept
capital inanattempt tomask thegovernmentrsquosopinions
aboutwhichbankswereinmoretroublethanothersMany
policymakersseemedtothinkthatbankswerenotlending
becausetheyhadlosttoomuchcapitalandwerenotable
orwillingtoraisemoreThusthegoalseemedtobenotto
savethebanksbuttorecapitalizethemsotheywouldlend
againIn theendthe former resultwasachievedmdashnone
of the large banks that receivedTarp funds failedmdashbut
thelatterarguablywasnotWeanalyzetheseissuesindeshy
tailbelowandrecommendsomealternativestructuresand
policiesthatwebelievewouldhaveworkedbetter
DuringmuchoftheWorldFinancialCrisistheFederal
reserveexperimentedwithawiderangeofnewfacilities
beyonditstraditionaltoolsofinterestratepolicyandopen
market operations The Fed lent broadly to commercial
banksinvestmentbanksandbrokershydealersandendedup
buyingcommercialpapermortgagesassetbackedsecurishy
tiesandlongshytermgovernmentdebtinanefforttolower
interestratesinthesemarketsByDecember2008excess
Copyrighted Material
8 bull CHapTer 1
reservesinthebankingsystemhadgrownfrom$billion
before the Crisis to over $800 billionThese actions are
notafocusofouranalysisbuttheysurelyhelpedprevent
theCrisisfromturningintoanotherGreatDepressionat
aminimumtheyeliminatedmostbanksrsquoconcernsabout
sourcesofcash
Bankfailuresineuropeinthefallof2008ledtomore
directbailoutsThenetherlandsBelgiumandLuxembourg
spent$1billiontopropupFortisamajoreuropeanbank
with about $1 trillion in assets The netherlands spent
$1billiontobailoutInGabankingandinsurancegiant
Germanyprovideda$50billionrescuepackageforHypo
realestateHoldingsSwitzerlandrescueduBSoneofthe
tenlargestbanksintheworldwitha$5billionpackage
Iceland took over its three largest banks and its subseshy
quent difficulties highlight what happens when the cost
ofbailingoutacountryrsquosbanksexceedsthegovernmentrsquos
resources
Throughoutthefallof2008therewasaldquoflighttoqualityrdquo
inmarketsaroundtheworldWheninvestorsareworried
aboutdefaulttheydemandhigherinterestratesYieldson
securitieswithanyhintofdefaultriskrosesharplyespeshy
ciallyinthefinancialsector
Theflighttoqualityisapparentintheinterestrateson
commercialpaperinFigure1Commercialpaperisshortshy
termunsecureddebtissuedbybanksandotherlargecorshy
porationsandisanimportantpartoftheirfinancingThe
commercialpaperratesforfinancialinstitutionsandlowershy
creditqualityborrowers jumped inSeptemberandoctoshy
berbutafterasmallincreasetherateforlargecreditworshy
Copyrighted Material
InTroDuCT Ion bull 9
7
6
5
4
3
2
1
0
A2P2 Nonfinancial
AA Financial
AA Nonfinancial
Jul 2008 Aug 2008 Sep 2008 Oct 2008 Nov 2008 Dec 2008
Figure1annualizedpercentYieldson0shyDayHighshyQuality(aa)FinancialandnonfinancialCommercialpaperandMediumshyQuality(a2p2)nonfinancialCommercialpaperinpercentaugusttoDecember2008SourceFederalreserve
thynonfinancialcompaniesactuallydeclinedTherateon
uSTreasurybillswhichareviewedas themost secure
investmentalsofellthethreeshymonthTreasurybillrateacshy
tuallydroppedtozeroforbriefperiodsinnovemberand
December2008
the run on the shadoW BankIng system
Thepanicthatstruckfinancialmarketsinthefallof2008
hasbeencharacterizedasarunontheshadowbankingsysshy
temandwithgoodreasonBeforetheCrisismanybonds
mortgagebackedsecuritiesandother credit instruments
Copyrighted Material
10 bull CHapTer 1
wereheldbyleveragednonshybankintermediariesincluding
hedgefunds investmentbanksbrokeragefirmsandspecialshy
purposevehiclesManyoftheseintermediarieswereforced
toldquodeleverrdquoduringoctoberandnovembersellingassetsto
repaytheircreditors
Hedgefundsandotherleveragedintermediariesusethe
securitiesintheirportfoliosascollateralwhentheyborrow
moneyDuringtheWorldFinancialCrisismanywarylendshy
ersdecidedthecollateralborrowershadpostedbeforethe
Crisis was no longer sufficient to guarantee repayment
Whenthelendersdemandedeithermoreorbettercollatshy
eralmanyborrowerswereforcedtoselltheirleveredposishy
tionsandrepaytheirloansTheresultwasareductionin
thequantityofassetstheyheldandintheirleverageInadshy
ditionhedgefundsandotherintermediariessufferedlarge
withdrawalsbypanickycustomersagainforcingthemto
sellsecuritiesonthemarketTheassetsbeingsoldweregenshy
erallyacquiredbyindividualinvestorsthefederalgovernshy
mentorcommercialbankswhichasagroupfinancedmost
oftheirpurchasesbyborrowingfromthegovernment
The financing difficulties faced by arbitrageurs and lishy
quidity providers are apparent in a series of fascinating
market pathologies In financialmarkets there are often
manydifferentwaystoobtainthesameoutcomeaninvesshy
torcanusemanydifferentcombinationsofsecuritiesfor
exampletorisklesslyconvertdollarstodayintodollarsin
sixmonthsThe actionsof arbitrageursusuallykeep the
costsof thedifferent approaches closely alignedDuring
thefallof2008thecostsoftendivergedwiththeapproach
thatrequiredmorecapitaltypicallycostingless
Copyrighted Material
InTroDuCT Ion bull 11
Theprincipleofcoveredinterestparityforexamplesays
thataftereliminatingexchangerateriskriskshyfreeinvesting
shouldhavethesamereturnineverycurrencyaninvestor
whowantstoinvestdollarstodayandreceivedollarsinthe
futureusuallybuysauSbondHecouldaccomplishthe
samethingbyconvertinghisdollarsintoeurosinvesting
inarisklesseurobondandlockingintheconversionof
theeuropayoffbackintodollarswithaforwardcontract
Sincebothstrategiesconvertdollarstodayintodollarsin
thefuturetheyshouldhavethesamereturn5 Supposeinshy
steadthereturnontheuSbondislowerThenanarbitrashy
geurcouldborrowmoneyintheunitedStatesatthelower
rateinvestitintheeurotransactionatthehigherrateand
makeaprofit
During the Crisis covered interest parity violations as
largeas20basispoints(020percent)emergedThismay
seemtrivialbutinnormaltimestheseviolationsrarelyexshy
ceed 2 basis pointsMoreover traders can usuallyldquolever
uprdquotransactionslikethisandmakealargeprofitButthatrsquos
thecatchmdashhedgefundsbrokeragesandinvestmentbanks
werebeingforcedtodeleverduringtheCrisisand20basis
points is not enough to enticemany longshyonly investors
to replace theuSbond theyarecurrentlyholdingwith
aforeignbondandsomeseeminglycomplicatedcurrency
transactions
other recent research finds similar disruptions of the
normalpricing relations linking (1)Treasurybondscorshy
poratebondsandcreditshydefault swaps (aTreasurybond
shouldbethesameasacorporatebondplusacreditdefault
swapmdashexceptforliquidityfinancingandCDScounterparty
Copyrighted Material
12 bull CHapTer 1
risk)(2)fixedandfloatingrate investments (asequence
ofshortshyterminvestmentsplusacontractswappingafloatshy
ing interest rate forafixed interest rateshouldhave the
same payoff as a fixed rate investment) () convertible
bondsdebtandequity()newlyissuedldquoonshytheshyrunrdquoand
recently issuedldquooffshytheshyrunrdquoTreasury bondswhich have
essentially the same payoff but differ in liquidity and
(5)stockandoptionpriceswhicharelinkedbywhatfishy
nancialeconomistscalltheputshycallparityrelation7
Thebreakdownofthesenormalpricingrelationsdoes
littledirectharm to the restof theeconomya20shybasisshy
pointviolationofcoveredinterestparityhaslittleeffecton
auSexporterusingcurrencycontractstolockintherate
atwhichitcanconvertfutureJapaneserevenuebackinto
dollarsTheseviolationsshowhoweverthatmarketswere
notfunctioningnormallyInparticulartheysuggestthere
wasnotmuchcapitalavailabletoprovideliquiditytobuyshy
ersandsellersanyoneneedingtosellsecuritiesquicklyin
suchamarketmdashsuchasafinancialinstitutiontryingtoreshy
duceitsriskmdashwasnotlikelytogetagoodprice
lendIng BankIng and the recessIon
Duringthefallof2008outputandfinancingactivityconshy
tracted sharply Commercial paper corporate bond and
equityissuanceallfelldramaticallyasdidmortgageorigishy
nations
originations of most types of asset backed securities
alsoslowedtoatrickleManybanksintheunitedStates
Jan 20
04Ju
l 200
4Ja
n 2005
Jul 2
005
Jan 20
06Ju
l 200
6Ja
n 2007
Jul 2
007
Jan 20
08Ju
l 200
8Ja
n 2009
Jul 2
009
Copyrighted Material
InTroDuCT Ion bull 1
0
50
100
150
200
250
Figure2assetBackedSecuritiesIssuedintheunitedStatesJanushyary200toDecember2009BillionsofDollarsperMonthSourceFederalreserve
and other countries no longer hold much of the credit
theyissueTheyhavemovedinsteadtoanldquooriginateand
sellrdquomodel inwhich theybundle together similar loans
suchasjumbomortgagescommercialloansstudentloans
or credit card debt and sell them to investors as asset
backedsecuritiesnewissuesofthesesecuritiesessentially
stopped inoctoberandnovember2008Figure2shows
that the amount of asset backed securities issued in the
united States rose from$288 billion in January 2000 to
$85billioninJune2007andthenplungedto$102bilshy
lioninSeptember2007IssuanceintheunitedStatesconshy
tinued to decline over the next year eventually falling
to only $87 billion in october 2008 and $ billion in
Copyrighted Material
1 bull CHapTer 1
novembermdashjust2percentofthevolume18monthsearlier
onlymortgagespooledbyFannieMaeandFreddieMac
withanexplicitgovernmentguaranteeandsubjecttohuge
Federalreservepurchasescontinuedtoflowtothemarket
There isplentyof anecdotal and surveyevidence that
banklendingalsodriedupduringtheCrisisForexample
loanofficerssurveyedbytheFederalreservereportedthat
credit conditionsprogressively tightenedduring2008In
asurveyabouttheirperceptionsofcreditconditionsand
corporatedecisionsasoflatenovember2008morethan
halfofthechieffinancialofficersoflargeamericanfirms
whorespondedsaidthattheirfirmswereeitherldquosomewhat
orveryaffectedbythecostoravailabilityofcreditrdquo8
There is a lively and fundamentally important debate
about why the quantity of lending fell Some financial
economists argue that banks wanted to lend more but
wereunable todosobecausetheyfacedbindingcapital
constraintsInthisviewinformationcostsandotherfricshy
tionsintheloanoriginationprocesskeptcustomersfrom
movingtolessconstrainedbanks
othersarguethattheprimaryreasonbankswereunwillshy
ingtolendisthattheircustomershadbecomelesscreditshy
worthyTheseeconomistspointoutthatthehighlevelof
uncertainty about future economic conditionsduring the
Crisisratchetedupthedefaultriskofeventhemostrelishy
ableclientsThisinterpretationofthedeclineinbanklendshy
ingimpliesthatnoamountofcapitalwouldhaveinduced
banksasagrouptolendmorebecauseallthegoodloans
werebeingmade
Figure shows data on the quantity of bank lending
Jan 20
08
Mar
2008
M
ay 20
08Ju
l 200
8Se
p 2008
Nov 20
08Ja
n 2009
Jan 20
09
May
2009
Jul 2
009
Sep 20
09Nov
2009
Copyrighted Material
InTroDuCT Ion bull 15
1050
1100
1150
1200
1250
1300
FigureCommercialandIndustrialLoansbyuSCommercialBanks2008ndash9inBillionsofDollarsSourceFederalreserve
intheunitedStatesin2008and2009Startinginoctober
2008therewasaspikeinlendingfollowedbyaprotracted
declineVVChariLawrenceChristianoandpatrickKehoe
takethespikeatfacevalueinaggregatebankslentmore
ataminimumthebankingsystemasawholemdashasopposed
to individual banksmdashwas not deleveraging to overcome
loss of capital9 Victoria Ivashina and David Scharfstein
notethatmuchoftheincreaseinbanklendingwasinvolshy
untaryonthepartofthebankstheresultofdrawdowns
byborrowersonexistinglinesofcredit10 Theyalsoshow
thatbanks thatweremorevulnerable todrawdownsbeshy
causetheywereinmoresyndicateswithLehmanreduced
subsequent lending more and conclude that there was
indeed a genuine contraction in the effective supply of
bankcredit
Copyrighted Material
1 bull CHapTer 1
economistswillargueabouttheeventsoftheWorldFishy
nancialCrisisforyearstocomeInfactwestillargueabout
theGreatDepressionnoneoftheanalysisbehindourrecshy
ommendationshoweverdepends onhow these debates
aresettledForexamplenomatterhowcapitalshyconstrained
thebankingsystemreallywasinthefallof2008ourproshy
posalsforchangesthatmakesuchconstraintslessbinding
andgivepolicymakersbettertoolswhentheyfearcapital
constraintsremainvalid
What Was Wrong WIth the FInancIal system durIng the crIsIs
The Crisis revealed a number of serious problems with
ourfinancialsystemSomehadbeeninthebackgroundall
alongothersdidnotappearuntiltheCrisisInthisbook
weemphasizefourcategoriesofproblemsconflictsofinshy
terestknowntoeconomistsasagencyproblemsthediffishy
cultyofapplyingstandardbankruptcyprocedurestofinanshy
cialinstitutionstheemergenceofamodernformofbank
runsandtheinadequacyoftheregulatorystructurewhich
hadnotkeptupwithrecentfinancialinnovation(Infact
muchinnovationservedtoescaperegulations)
Conflicts of Interest Agency Problems
Conflictsofinterestthatcannotberesolvedeasilybyconshy
tractsormarketsoccurthroughouttheeconomybutthey
Copyrighted Material
InTroDuCT Ion bull 17
canbeparticularlyharmfulinthefinancialsystemThere
areseveralreasonsFirstmanyfinancialtransactionsand
contractsinvolveaprincipalsuchasaninvestororshareshy
holderaskingatradermanagerorotheragenttoacton
hisorherbehalfSecondmostfinancial transactions inshy
volvehighlyuncertainfuturepayoffsandinmanytransacshy
tionsonepartyisbetterinformedaboutthepayoffsthan
the otherThird the high volatility of the future payoffs
oftenmakesithardtoassesswhethertheoutcomeofafishy
nancialtransactionisduetotheagentrsquoseffortsorluckand
fourththesumsinvolvedcanbehuge
Someproprietarytradersforexampleearnalotwhen
their tradesdowellbuttheirpersonal lossesare limited
whentheirtradesdopoorlyBecauseoftheasymmetricnashy
tureoftheircompensationthesetraderscanincreasetheir
expectedincomebytakingriskierpositionsThisproblem
isdramaticallyillustratedbyperiodiccasesinwhichldquorogue
tradersrdquoincurlossesthatarebigenoughtodamageoreven
destroy large financial institutions In 1995 nick Leeson
broughtdownBaringsBankwitha$1billionlossandin
2008itwasrevealedthatJeacuterocircmeKervielhadseverelydamshy
agedSocieacuteteacuteGeacuteneacuteralewithalossofover$7billion
Conflictsofinterestorldquoagencyproblemsrdquoalsoexistat
manyotherlevelswithinthefinancialsystemShareholders
offinancialinstitutionshaveaconflictofinterestwiththe
bankrsquosseniorexecutivesespeciallywhenthoseexecutives
arerewardedforgoodperformancebutdonothavealarge
fractionoftheirwealthtiedupinthesharesofthebank
Manyfinancialinstitutionshavelargequantitiesofdebt
Copyrighted Material
18 bull CHapTer 1
which creates a conflict of interest between the bankrsquos
creditorsanditsshareholdersShareholdershaveanincenshy
tivetoauthorizeexcessivelyriskyinvestmentsforexample
especiallyafterabankhasincurredlossesthaterodethe
valueoftheshareholdersrsquoclaimThegainsontheserisky
investmentswillaccruelargelytoshareholderswhilethe
losseswillmostlybebornebycreditorsTheconflictwith
creditorsalsoreducestheincentivesfortheshareholders
of troubled institutions to raisenewcapitalbecause that
wouldstrengthen thepositionofcreditorswhilediluting
theshareholdersrsquopositionThisldquodebtoverhangrdquoproblem
waswidelycitedduringtheWorldFinancialCrisiswhen
many banks that were insolvent or close to insolvency
seemedreluctanteithertoraisenewcapitalortoreduce
theirrisksbysellingdistressedsecurities11
atthehighestlevelthereisaconflictofinterestbetween
societyasawholeandtheprivateownersoffinancialinshy
stitutions Because robust financial institutions promote
economicgrowthandemploymentduringfinancialcrises
governmentsoftenrescuetroubledfirmstheyperceiveto
be systemically importantThe result is privatized gains
andsocializedlossesIfthingsgowellthefirmsrsquoowners
andmanagersclaimtheprofitsbutifthingsgopoorlysoshy
cietysubsidizesthelosses
The candidates for government bailouts are popularly
describedasldquotoobigtofailrdquoMorepreciselytheargument
for government supportmdashwhich many economists chalshy
lengemdashisaboutfirmsthataretoosystemicallyimportantto
failInits200annualreporttheeuropeanCentralBank
describedsystemicriskasldquoTheriskthattheinabilityofone
Copyrighted Material
InTroDuCT Ion bull 19
institutiontomeetitsobligationswhenduewillcauseother
institutions to be unable tomeet their obligationswhen
dueSuchafailuremaycausesignificantliquidityorcredit
problemsandas a resultcould threaten the stabilityof
or confidence in marketsrdquo Systemically important firms
arethosewhosefailurecouldposealargethreattothestashy
bilityoforconfidenceinmarketsThesefirmsarelikelyto
belargebuttheyalsotendtohavecomplexinterconnecshy
tionswithotherfinancialinstitutions
Tooshybigshytoshyfailpoliciesoffersystemicallyimportantfirms
theexplicitorimplicitpromiseofabailoutwhenthingsgo
wrongThesepoliciesaredestructiveforseveralreasons
Firstbecause the possibility of a bailoutmeans a firmrsquos
stakeholders claim all the profits but only some of the
lossesfinancialfirmsthatmightreceivegovernmentsupshy
porthaveanincentivetotakeextrariskThefirmrsquosshareshy
holderscreditorsemployeesandmanagement all share
thetemptationTheresultisanincreaseintherisksborne
bysocietyasawhole
Secondthesepoliciesencouragesmallerfinancialinstishy
tutionstoexpandortobecomemorecloselyinterconnected
with other firms so they move under the tooshybigshytoshyfail
umbrellaFirmshaveanincentivetodowhateverittakes
tomakepolicymakersfeartheirfailurecreatingthevery
fragilitythegovernmentwishestoavoidBeliefthatagovshy
ernmentrescuewillprotectafinancial institutionrsquoscredishy
tors inacrisisalsogivesafirmacompetitiveadvantage
loweringitscostoffinancingandallowingittoofferbetter
prices to its customers than its fundamental productivity
warrants
Copyrighted Material
20 bull CHapTer 1
Thirdinefficientfirmsthatcannotcompeteontheirown
shouldfailotherwisefirmshavelessincentivetobecome
andstayefficientagovernmentpolicythatpropsupinshy
efficientfirmsiswastefulanddestructiveallowingthese
firmstofailfreesupresourcesandprovidesopportunities
formoreefficientandinnovativecompetitorstoflourish
Fourthandmostgenerallycapitalismisunderminedby
policiesthatprivatizegainsbutsocializelossesGovernment
guaranteedinstitutionscanbecomegovernmentruninstishy
tutionsallocatingcreditforexampletomaximizepolitical
gainratherthaneconomicwelfare
The conflictbetween society and theownersoffinanshy
cialfirmsbecomesmoreseriousduringseverecriseswhen
manyfinancialinstitutionsareclosetoinsolventIt isthe
primemotivationforourregulatoryproposalsbutseveral
ofthelowershylevelconflictswehavedescribedarerelevant
becausetheymagnifytheriskbornebysocietyasawhole
Theselfshyservingbehaviorthatmanyofourrecommenshy
dations targetmdashwhether by traders senior management
orthefirmrsquosownersmdashneednotbestrategicintentionally
maliciousorevenconsciousConsideratraderwhoinadshy
vertentlydevelopsaninvestmentstrategywithhighlyprobshy
ablegainsandimprobablebutlargelossesLikeafirmthat
hassoldearthquakeinsurancethestrategymayproducea
longstringofimpressivereturnsbeforeoneyearoflosses
wipesoutmanyyearsofprofits12 Ifsoduringthegood
yearsthetraderwillbecelebratedforhisorherbrilliance
rewarded with large bonuses and given more resources
to manageMany sophisticated traders and hedge funds
Copyrighted Material
InTroDuCT Ion bull 21
werenotawareoftheldquoearthquakerisksrdquoinherentinmany
of theirstrategiesSimilarlywhenfirmstakeactionsthat
increasethelikelihoodofagovernmentbailoutinthenext
financialcrisisthemarketrewardsthemwithalowercost
of capitalas firms become too big to fail for example
the implicit government guarantee reduces the riskiness
of their debt and lowers the interest rate demanded by
theircreditorsaCeoworkingtomaximizefirmvaluemay
notevenrealize the importanceof thegovernmentguarshy
anteebut a Darwinian process will encourage behavior
thatexploitsit
Bankruptcy and Resolution Procedures
Itisimpossibletowriteafinancialcontractthatspecifies
everypossiblecontingencyInsteadcontractsrelyonbankshy
ruptcytodetermineoutcomesincertainbadandunlikely
statesoftheworldInbankruptcycontrolofafirmistransshy
ferredfromtheshareholderswhonolongerhaveastake
inlossesbecausetheirsharesareworthlittletothedebtshy
holders It is in societyrsquos interest to develop bankruptcy
proceduresthatmaximizethepostshybankruptcyvalueofa
firmrsquosassetsInparticularsocietyshouldavoidthedestrucshy
tionofvaluethatoccurswithdisorderlyliquidation
Disorderlyliquidationoffinancialinstitutionsisparticushy
larly costlyFirstvaluableknowledge that the institution
hasaccumulatedaboutitscounterpartiesmdashborrowerstradshy
ingpartnersandsoonmdashcandisappearastheinstitution
losesemployeesandceasestooperatenormallyFinancial
Copyrighted Material
22 bull CHapTer 1
economistshavefoundthatthecollapseofabankhasamashy
terialadverseimpactonmanyofitsborrowers1 Second
the prospect of a disorderly liquidation makes it more
likelythatatroubledfinancialinstitutionwillsufferarun
by creditors who conclude they are better off claiming
whatmoney theycan todayrather thanwaiting through
protracted liquidation proceedings Third ldquofire salesrdquo of
specializedassets inadisorderly liquidationcandepress
prices and thereby spread problems to other holders of
theassetclassFourthdisorderlyliquidationincreasesthe
uncertaintyabouttheimpactofafinancialinstitutionrsquosfailshy
ureonitscounterpartiesandotherclaimholdersBecause
financialfirmsaretightlyinterconnectedthisuncertainty
canprecipitateorintensifyafinancialcrisis1
In theunitedStatesthestandardbankruptcycodealshy
lowsbothforliquidationofafirmandthesaleofitsassets
(Chapter7)andforcontinuedoperationofafirmunder
the supervision of a bankruptcy judgewho protects the
firmfromcreditorsrsquoclaimswhileareorganizationplanis
approved(Chapter11)Theseproceduresappeartowork
wellfornonfinancialcorporationsbutnotsowellforfinanshy
cialorganizationsTheChapter11approachofseparatinga
firmrsquosfinancialaffairsfromitsnonfinancialbusinessactivishy
tiesisinfeasiblewhenthebusinessofthefirmisfinancial
transactionsFurthermoremanyfinancialinstitutionsrely
heavily on shortshyterm debtpossibly as a valuable discishy
plineonbankexecutiveswhocanrapidlychangetherisks
theirfirmstakeThismakesfinancialfirmsvulnerabletoa
rapidwithdrawalofshortshytermcreditthatislikelytooccur
beforeanyeventthatwouldtriggerbankruptcy
Copyrighted Material
InTroDuCT Ion bull 2
Wearguebelowthatthereisaneedforaspecialresolushy
tionprocedurethatcanbeappliedtolargeinsolventfinanshy
cialinstitutionsWealsoadvocateregulatorychangesthat
would push financial firms towardmore resilient capital
structures
Bank Runs
Classicbank runs inwhichdepositors race towithdraw
their funds before a bank failswere one of the central
contributors to theGreatDepressionDeposit insurance
whichwasintroducedaftertheDepressiontocounterthis
destructiveprocessmadedemanddepositsoneofthemost
stableformsofbankfinancingduringtheWorldFinancial
CrisisManyfinancialinstitutionshoweversufferedamodshy
ernversionofbankruns
Banksespeciallythosewithinvestmentbankingactivishy
tiestypicallyfinanceasignificantfractionoftheirbusiness
withovernightcommercialpaperreposandothershortshy
terminstrumentsInnormaltimesbanksrolloverthisdebt
asitmaturestakingnewloanstopayofftheoldInacrishy
sishoweveruncertaintyaboutwhetheratroubledinstitushy
tionwouldbeabletopayoffitscreditorstomorrowcauses
lenderstostopextendingcredittodayThusshortshytermfishy
nancingcanleadtoarunthatissimilartoaclassicrunon
deposits
even some secured creditors participated in runs durshy
ingtheWorldFinancialCrisisBanksoftenuserepurchase
agreements to borrow money securing the loan by givshy
ingthelenderafinancialassetsuchasaTreasurybond
Copyrighted Material
2 bull CHapTer 1
ascollateralBecausetheyareovershycollateralizedwithasshy
setsworthperhaps$105guaranteeingevery$100inloans
lendersviewldquoreposrdquoasasafewaytoextendcreditWhen
credit markets froze during the Crisis however lenders
worried that retrieving collateral and selling itwouldbe
difficultandnotworththesmallinterestonanovernight
loanasaresultatvarioustimesduringtheCrisismany
investmentbankshaddifficultyrollingovereventheirseshy
cured loanseven relatively healthy financial institutions
werehamperedbythetroubleintherepomarketafteraushy
gust2007asthemarketbecamemoreandmoreuncertain
about the prices securities would fetch in a forced sale
these institutions found they could borrow less and less
withthesamecollateral15
prime brokerage accounts also saw a runshylike withshy
drawalbycustomersManylargebankshaveprimebrokershy
agegroupsthatassisthedgefundsandotherinstitutionalinshy
vestorsbyprovidingfinancingsecuritieslendingclearing
custodial servicesandoperational supportInexchange
thefundspayfeesandcriticallypostcollateraltosecure
theirloansWithsomerestrictionsthatweexplaininChapshy
ter10theprimebrokercanthenusethecollateralinits
ownbusinessinsomecasescomminglingitwiththefirmrsquos
ownassetsDuringtheCrisishedgefundsmonitoredthe
financial wellshybeing of their prime brokers and like deshy
positorsintheDepressionfledwiththeircollateralatthe
firstsignoftroubleBearStearnsforexamplehadalarge
prime brokerage business according to press accounts
oneofthelargesthedgefundsthatusedBearStearnsasa
Copyrighted Material
InTroDuCT Ion bull 25
primebrokerrenaissanceTechnologieswithdrew$5bilshy
lionofcashintheweekthefirmfailedWithsuchoutflows
it is not surprising that Bear Stearns ran out of money
eventhoughithadmorethan$18billionincashaweek
earlier
Likeclassicbankrunsmodernbankrunsarebothdeshy
structiveandselfshyfulfillingConcernthatabankmightbe
in trouble spurs its creditors and counterparties towithshy
draworwithholdtheircapitalasaresultevenrumorsofa
problemmaybeenoughtodestroyaviableinstitutionThe
importanceofmodernbankrunsduringtheWorldFinanshy
cialCrisisisarecurringthemethroughoutthebookand
wemakeseveralproposalsthatareintendedtoreducethe
frequencyofsuchevents
The Inadequacy of the Regulatory Structure
TheWorldFinancialCrisismadeitclearthatfinancialinnoshy
vationhadoverwhelmedexistingfinancialregulationsnoshy
tableexamplesincludeaIGrsquosdecisiontosellanextremely
large amount of credit default swaps on subprime debt
tobanksintheunitedStatesandabroadtheholdingof
Lehmanpaperbymoneymarketfundsparticularlythereshy
serveprimaryFundthecomplexityofthederivativebooks
atLehmanandotherinvestmentbanksandthedifficultyof
simultaneouslyapplyingseveralcountriesrsquobankruptcycodes
tothesubsidiariesofmultinationalfinancialinstitutions1
Thereisatradeshyoffbetweenfinancialinnovationandstashy
bilityInnovationcanimprovethefinancialsystemrsquosability
Copyrighted Material
2 bull CHapTer 1
toallocateresourcestotheirhighestvaluedusebutitcan
alsoreducethestabilityofthesystemThechallengeisto
developregulationsthatimprovestabilitywithoutstifling
innovation In addition regulation often leads to innoshy
vations designed to evade the regulationswhich makes
thefinancialsystemmorefragileForexamplemanyofthe
specialshypurposevehiclesthatimplodedintheCrisiswere
createdtogetaroundcapitalrequirements
In many countries the response of regulators to the
World Financial Crisis was hampered by the fragmented
nature of their regulatory systems Financial regulations
are typically designed to ensure thehealth of individual
institutionsratherthanthefinancialsystemasawholeIn
thisbookwearguethatsystemicregulationisanimporshy
tantfunctionthatrequiresaspecialmandateandthatthe
central bank is particularly well equipped to fulfill this
function
Finallyeffectivefinancialregulationrequiresthatpolitishy
ciansandultimatelythepublichaveanadequateundershy
standing of the financial system The political turmoil
surroundingtheCrisissuggeststheimportanceofdissemishy
natingexpertknowledgeaboutfinancetoabroaderaudishy
enceThisisoneofourmotivationsforwritingthisbook
What Were the orIgIns oF the World FInancIal crIsIs
LiketheoriginsoftheFirstWorldWarthecausesofthe
Crisiswillbedebatedbyscholarsformanyyears
Copyrighted Material
InTroDuCT Ion bull 27
Most observers agree that the strong runshyup and subshy
sequentsharpdeclineinthepricesofstockshousesand
otherfinancialassetsindevelopedcountrieswasanimporshy
tantcatalystfortheCrisisThereisdisagreementhowever
aboutwhetherthispatterninpricesistheresultofrational
investorbehaviororldquoirrationalbubblesrdquo
SomearguethattherunshyupbeforetheCrisiswasdriven
by investorswhoknowingly acceptedunusually low exshy
pectedreturnsandtheyofferseveralpossiblereasonswhy
Firsttherewasasurgeofsavingsinemergingcountries
drivenbyacombinationofrapideconomicgrowthanddeshy
mographicsperhapsbecauseofadesiretoaccumulateforshy
eignreservesintheaftermathoftheasiacrisisof1997ndash98
muchof thiswealthwas invested indevelopedmarkets
Secondfinancialmarketswereunusually tranquilduring
200to200Withlowvolatilityinvestorsmayhavesettled
for a low risk premiumThird influenced by fears of a
Japaneseshystyledeflation resulting from themarketdownshy
turnof2000ndash2001andbyabeliefthattheyshouldnottry
to usemonetary policy to counteract rising asset prices
central bankers in the united States maintained a loose
monetarypolicythroughouttheperiod17andfromthisrashy
tionalviewofinvestorstheplungeinassetpricesthatacshy
companiedtheCrisiswascausedbybadnewsaboutfuture
cashflowsunexpectedincreasesinthereturnsrequiredby
investorsorboth
otherssuggestamoredirectexplanationThehighprices
before theCrisisweredrivenby an irrational belief that
prices would continue to rise and the collapse of asset
priceswastheinevitableresultofthismistakeWhatever
Copyrighted Material
28 bull CHapTer 1
theexplanationthesharpdropinassetpricesbothconshy
tributedtoandwasasymptomoftheCrisis
other commentators argue that the financial system
becamevulnerablebecausemanymarketparticipantsasshy
sessedrisksinaccuratelyduringtheperiodleadingupto
theWorldFinancialCrisisConsumersbanksandinvestors
ingeneralunderestimatedtheriskofhousepricedeclines
increasingthepricestheywerewillingtopayforrealesshy
tatethecredittheywerewillingtoextendandthevaluashy
tionsofbanksthatextendedsuchcreditBanksputmuch
weight on the recent pastwhen they estimated value at
riskwhichledthemtoconcludethatthelevelofriskwas
lowandthattherewaslittledownsidetohavinghighleshy
verageothermarketparticipantsdidnotfullyappreciate
thathighliquiditywassuppressingvolatilityandthatthe
processmightreversewithliquiditydecreasingandvolatilshy
ityincreasing
More generally the high level of financial innovation
driveninpartbythedecliningcostofinformationtechnolshy
ogymadeithardforriskassessmenttokeeppacewiththe
evolvingfinancialsystem18Thebenignenvironmentofthe
creditboomexacerbatedthisproblembytemptingfinanshy
cialinstitutionstounderinvestinriskmanagement
uSpolicymakersalsocontributedtotheseverityofthe
CrisisbypushingFannieMaeandFreddieMactoincrease
theavailabilityofmortgagefundingtoborrowerswithquesshy
tionableabilitytorepaytheirmortgagesasaresultofthis
pressure both agencies relaxed their standards for the
mortgages they purchased and guaranteedThe demand
Copyrighted Material
InTroDuCT Ion bull 29
forhomesbyborrowerswhoqualifiedformortgagesbeshy
causeoftheselowerstandardspusheduppricesandthe
defaultbymanyofthemduringtherecessioncontributed
tothedropinhomeprices
Thepanicandruninthefallof2008remainthecentral
distinguishingfeaturesoftheWorldFinancialCrisisasset
priceshave risenand fallenbeforeand theworldeconshy
omyhasbornelargefinancial lossesmanytimeswithout
suchasevereeconomicoutcomeConverselylossesfrom
completelydifferentunderlyingsourcesmdashcommercialreal
estateorperhapssovereigndefaultsmdashcouldcauseasimilar
catastrophe if theyagainprovoke tooshybigshytoshyfailchaosor
runs
Thisbookdoesnotseektoprovideacompletediagnosis
oftheWorldFinancialCrisisnordoesittakeastandonthe
relativeimportanceofthecontributingfactorslistedabove
ratherwebelieveourrecommendationswillhelpprevent
ormitigatefuturecriseseventhoughwedonotfullyundershy
standallthecausesofthelastone
CarmenreinhartandKennethrogoff amongothershave
pointedoutthatfinancialcriseshaveoccurredthroughout
thehistoryofcapitalismandthatthesecrisessharemany
commonpatterns19 Thelessonwedrawfromthisisthat
noacceptablesetofregulationscanpreventmarketparticishy
pantsfrommakingmistakesthatcreateeconomicinstability
ourpurposeinthisbookisinsteadtosuggestregulatory
reformsthatwillmakethesystemmorestabledespitethe
mistakesthataresuretocome
Copyrighted Material
InTroDuCT Ion bull
What happened In the World FInancIal crIsIs
The Prelude
ThefirstsymptomsoftheWorldFinancialCrisisappeared
inthesummerof2007asaresultoflossesonmortgage
backed securities For example in august Bnp paribas
suspended the redemption of shares in three funds that
hadinvestedinthesesecuritiesandamericanHomeMortshy
gageInvestmentCorpdeclaredbankruptcyMortgagereshy
latedlossescontinuedthroughoutthefallandindicators
ofstressinthefinancialsystemincludingtheinterestrates
thatbankschargeeachotherwereunusuallyhighDespite
hugeinjectionsofliquiditybytheuSFederalreserveand
theeuropeanCentralBankfinancialinstitutionsbeganto
hoardcashandinterbanklendingdeclinednorthernrock
wasunabletorefinanceitsmaturingdebtandthefirmcolshy
lapsedinSeptember2007becomingthefirstbankfailure
intheunitedKingdominover100years
Thenextbigproblemwasinthemarketforauctionrate
securitiesalthough auction rate securities are longshyterm
bonds shortshyterm investors found them attractive before
theCrisisbecausesponsoringbanksheldauctionsatregushy
larintervalsmdashtypicallyevery728or5daysmdashtoallowthe
securityholderstoselltheirbondsThousandsoftheaucshy
tionsfailedinFebruary2008whenthenumberofowners
whowanted tosell theirbondsexceeded thenumberof
bidderswhowantedtobuythematthemaximumratealshy
lowedby thebondandunlike inpreviousauctionsthe
sponsoringbanksdidnotabsorbthesurplusaftermuch
Copyrighted Material
bull CHapTer 1
litigationthemajorsponsoringbanksagreedtopaymany
oftheirclientsrsquolossesThemarketforauctionratesecurishy
tieshasnotrevived
BearStearnsrsquofailureinMarch2008provedinretrospect
acriticalturningpointThefirmhadfundedmuchofitsopshy
erationswithovernightdebtandwhenitlostalotofmoney
onmortgagebacked securities its lenders refused to reshy
new thatdebtat the same timecustomers ran from its
primebrokeragebusinessaprocesswedescribeindetail
belowovertheweekendofMarch15theuSgovernment
brokeredarescuebyJpMorganthatincludedagenerous
commitmentbytheFederalreserveManyobserversand
officialsthoughtthattheCrisiswascontainedatthispoint
andthatmarketswouldpolicecreditrisksaggressively That
hopeprovedunfounded
The Remarkable Month of September 2008
The World Financial Crisis moved into an acute phase
in September 20081 Fannie Mae and Freddie Mac large
governmentshysponsored enterprises that create sell and
speculateonmortgagebackedsecuritiesfailedduringthe
firstweekofSeptemberandwereplacedundertheconsershy
vatorshipoftheFederalHousingFinanceagency
ThepeakoftheCrisisstartedonMondaySeptember15
2008LehmanBrothersabrokerageandinvestmentbank
headquarteredinnewYorkfailedwitharunbyitsshortshy
term creditors and prime brokerage customers that was
similartotherunexperiencedbyBearStearnsLehmanrsquos
bankruptcy was a surprise since the government had
Copyrighted Material
InTroDuCT Ion bull 5
steppedintopreventthebankruptcyofBearStearnsonly
monthsbefore
WithindaystheuSgovernmentrescuedamericanInshy
ternationalGroupaIGhadwrittenhundredsofbillionsof
dollarsofcreditdefaultswapswhichareessentiallyinsurshy
ancecontractsthatpayoffwhenaspecificborrowersuch
as a corporation or a specific security such as a bond
defaultsaseconomicconditionsworsenedanditbecame
increasingly likely thataIGwouldhave topayoffonat
leastsomeofitscommitmentstheswapcontractsrequired
thefirmtopostcollateralwithitscounterpartiesaIGwas
unable to make the required payments Goldman Sachs
wasaIGrsquosmostprominentcounterpartyandGoldmanrsquosdeshy
mands forcollateralwerean importantpartofaIGrsquosdeshy
miseThecost to taxpayersofgovernmentassistance for
FannieMaeFreddieMacandaIGisnowprojectedathunshy
dredsofbillionsofdollars
ThatsameweekTreasurySecretaryHankpaulsonanshy
nounced thefirstTroubledassetrelief program (Tarp)
askingCongressfor$700billiontobuymortgagebacked
securities Federal reserve Chairman Ben Bernanke and
presidentGeorgeWBush also gave important speeches
warningofgravedangertothefinancialsystemTheSecushy
ritiesandexchangeCommissionbannedtheshortshyselling
of several hundred financial stocks causing pandemoshy
niumintheoptionsmarketwhichreliesonshortshyselling
tohedgepositionsandamonghedgefundsthatemployed
longshyshortstrategies2
Theturmoilof theweekdidnotstopthereInterbank
lending declined sharply the commercial paper market
Copyrighted Material
bull CHapTer 1
slowed to a crawl and there was a run on the reserve
primaryFundamoneymarketmutualfundunlikeother
mutual funds money market funds maintain a constant
sharepricetypically$1byusingprofitsinthefundtopay
interestratherthantoincreasesharevaluesBecausethe
sharepriceisfixedat$1lossesthatpushafundrsquosnetasshy
setvaluebelow$1persharecantriggerarunasinvestors
rushtoclaimtheirfulldollarpaymentsandforcethelosses
ontootherinvestorsThereserveprimaryFundwhichhad
morethan1percentofitsassetsincommercialpaperisshy
suedbyLehmansufferedjustsucharunonSeptember1
2008afterLehmandeclaredbankruptcythefundrsquosnetasshy
setvaluedroppedto$097pershareandinvestorswithshy
drewmorethantwoshythirdsofthereserveFundrsquos$bilshy
lioninassetsbeforethefundsuspendedredemptionson
September17Concernspreadtoinvestorsinothermoney
marketfundsandtheywithdrewalmost10percentofthe
$5trillioninvestedinuSmoneymarketfundsoverthe
nexttendaysTostabilizethemarketthegovernmenttook
theunprecedented stepof offering a guarantee to every
uSmoneymarketfund
In normal timesany one of these eventswould have
beenthefinancialstoryoftheyearyettheyallhappened
inthesameweekinSeptember2008althoughmuchcomshy
mentaryandpopularpresscoverageblamestheWorldFishy
nancialCrisisentirelyonthegovernmentrsquosdecisiontolet
Lehmanfailsuchananalysisignorestheevidentcontribushy
tionsofthemanyothermomentouseventsthatoccurred
duringthatweek
Copyrighted Material
InTroDuCT Ion bull 7
October 2008 The Bank Bailout and Credit Crunch
Byearlyoctober2008theuSgovernmentrealizedthat
theTarpplantobuymortgagebackedsecuritiesonthe
openmarketwasnotfeasibleInsteadtheTreasuryDepartshy
mentusedtheappropriatedmoneytopurchasepreferred
stockinlargebanksandtoprovidecreditguaranteesand
othersupportThoughnowrememberedastheldquobankbailshy
outrdquotheTarppurchaseswerenotsimplyatransfertofailshy
inginstitutionsHealthybankswerealsoforcedtoaccept
capital inanattempt tomask thegovernmentrsquosopinions
aboutwhichbankswereinmoretroublethanothersMany
policymakersseemedtothinkthatbankswerenotlending
becausetheyhadlosttoomuchcapitalandwerenotable
orwillingtoraisemoreThusthegoalseemedtobenotto
savethebanksbuttorecapitalizethemsotheywouldlend
againIn theendthe former resultwasachievedmdashnone
of the large banks that receivedTarp funds failedmdashbut
thelatterarguablywasnotWeanalyzetheseissuesindeshy
tailbelowandrecommendsomealternativestructuresand
policiesthatwebelievewouldhaveworkedbetter
DuringmuchoftheWorldFinancialCrisistheFederal
reserveexperimentedwithawiderangeofnewfacilities
beyonditstraditionaltoolsofinterestratepolicyandopen
market operations The Fed lent broadly to commercial
banksinvestmentbanksandbrokershydealersandendedup
buyingcommercialpapermortgagesassetbackedsecurishy
tiesandlongshytermgovernmentdebtinanefforttolower
interestratesinthesemarketsByDecember2008excess
Copyrighted Material
8 bull CHapTer 1
reservesinthebankingsystemhadgrownfrom$billion
before the Crisis to over $800 billionThese actions are
notafocusofouranalysisbuttheysurelyhelpedprevent
theCrisisfromturningintoanotherGreatDepressionat
aminimumtheyeliminatedmostbanksrsquoconcernsabout
sourcesofcash
Bankfailuresineuropeinthefallof2008ledtomore
directbailoutsThenetherlandsBelgiumandLuxembourg
spent$1billiontopropupFortisamajoreuropeanbank
with about $1 trillion in assets The netherlands spent
$1billiontobailoutInGabankingandinsurancegiant
Germanyprovideda$50billionrescuepackageforHypo
realestateHoldingsSwitzerlandrescueduBSoneofthe
tenlargestbanksintheworldwitha$5billionpackage
Iceland took over its three largest banks and its subseshy
quent difficulties highlight what happens when the cost
ofbailingoutacountryrsquosbanksexceedsthegovernmentrsquos
resources
Throughoutthefallof2008therewasaldquoflighttoqualityrdquo
inmarketsaroundtheworldWheninvestorsareworried
aboutdefaulttheydemandhigherinterestratesYieldson
securitieswithanyhintofdefaultriskrosesharplyespeshy
ciallyinthefinancialsector
Theflighttoqualityisapparentintheinterestrateson
commercialpaperinFigure1Commercialpaperisshortshy
termunsecureddebtissuedbybanksandotherlargecorshy
porationsandisanimportantpartoftheirfinancingThe
commercialpaperratesforfinancialinstitutionsandlowershy
creditqualityborrowers jumped inSeptemberandoctoshy
berbutafterasmallincreasetherateforlargecreditworshy
Copyrighted Material
InTroDuCT Ion bull 9
7
6
5
4
3
2
1
0
A2P2 Nonfinancial
AA Financial
AA Nonfinancial
Jul 2008 Aug 2008 Sep 2008 Oct 2008 Nov 2008 Dec 2008
Figure1annualizedpercentYieldson0shyDayHighshyQuality(aa)FinancialandnonfinancialCommercialpaperandMediumshyQuality(a2p2)nonfinancialCommercialpaperinpercentaugusttoDecember2008SourceFederalreserve
thynonfinancialcompaniesactuallydeclinedTherateon
uSTreasurybillswhichareviewedas themost secure
investmentalsofellthethreeshymonthTreasurybillrateacshy
tuallydroppedtozeroforbriefperiodsinnovemberand
December2008
the run on the shadoW BankIng system
Thepanicthatstruckfinancialmarketsinthefallof2008
hasbeencharacterizedasarunontheshadowbankingsysshy
temandwithgoodreasonBeforetheCrisismanybonds
mortgagebackedsecuritiesandother credit instruments
Copyrighted Material
10 bull CHapTer 1
wereheldbyleveragednonshybankintermediariesincluding
hedgefunds investmentbanksbrokeragefirmsandspecialshy
purposevehiclesManyoftheseintermediarieswereforced
toldquodeleverrdquoduringoctoberandnovembersellingassetsto
repaytheircreditors
Hedgefundsandotherleveragedintermediariesusethe
securitiesintheirportfoliosascollateralwhentheyborrow
moneyDuringtheWorldFinancialCrisismanywarylendshy
ersdecidedthecollateralborrowershadpostedbeforethe
Crisis was no longer sufficient to guarantee repayment
Whenthelendersdemandedeithermoreorbettercollatshy
eralmanyborrowerswereforcedtoselltheirleveredposishy
tionsandrepaytheirloansTheresultwasareductionin
thequantityofassetstheyheldandintheirleverageInadshy
ditionhedgefundsandotherintermediariessufferedlarge
withdrawalsbypanickycustomersagainforcingthemto
sellsecuritiesonthemarketTheassetsbeingsoldweregenshy
erallyacquiredbyindividualinvestorsthefederalgovernshy
mentorcommercialbankswhichasagroupfinancedmost
oftheirpurchasesbyborrowingfromthegovernment
The financing difficulties faced by arbitrageurs and lishy
quidity providers are apparent in a series of fascinating
market pathologies In financialmarkets there are often
manydifferentwaystoobtainthesameoutcomeaninvesshy
torcanusemanydifferentcombinationsofsecuritiesfor
exampletorisklesslyconvertdollarstodayintodollarsin
sixmonthsThe actionsof arbitrageursusuallykeep the
costsof thedifferent approaches closely alignedDuring
thefallof2008thecostsoftendivergedwiththeapproach
thatrequiredmorecapitaltypicallycostingless
Copyrighted Material
InTroDuCT Ion bull 11
Theprincipleofcoveredinterestparityforexamplesays
thataftereliminatingexchangerateriskriskshyfreeinvesting
shouldhavethesamereturnineverycurrencyaninvestor
whowantstoinvestdollarstodayandreceivedollarsinthe
futureusuallybuysauSbondHecouldaccomplishthe
samethingbyconvertinghisdollarsintoeurosinvesting
inarisklesseurobondandlockingintheconversionof
theeuropayoffbackintodollarswithaforwardcontract
Sincebothstrategiesconvertdollarstodayintodollarsin
thefuturetheyshouldhavethesamereturn5 Supposeinshy
steadthereturnontheuSbondislowerThenanarbitrashy
geurcouldborrowmoneyintheunitedStatesatthelower
rateinvestitintheeurotransactionatthehigherrateand
makeaprofit
During the Crisis covered interest parity violations as
largeas20basispoints(020percent)emergedThismay
seemtrivialbutinnormaltimestheseviolationsrarelyexshy
ceed 2 basis pointsMoreover traders can usuallyldquolever
uprdquotransactionslikethisandmakealargeprofitButthatrsquos
thecatchmdashhedgefundsbrokeragesandinvestmentbanks
werebeingforcedtodeleverduringtheCrisisand20basis
points is not enough to enticemany longshyonly investors
to replace theuSbond theyarecurrentlyholdingwith
aforeignbondandsomeseeminglycomplicatedcurrency
transactions
other recent research finds similar disruptions of the
normalpricing relations linking (1)Treasurybondscorshy
poratebondsandcreditshydefault swaps (aTreasurybond
shouldbethesameasacorporatebondplusacreditdefault
swapmdashexceptforliquidityfinancingandCDScounterparty
Copyrighted Material
12 bull CHapTer 1
risk)(2)fixedandfloatingrate investments (asequence
ofshortshyterminvestmentsplusacontractswappingafloatshy
ing interest rate forafixed interest rateshouldhave the
same payoff as a fixed rate investment) () convertible
bondsdebtandequity()newlyissuedldquoonshytheshyrunrdquoand
recently issuedldquooffshytheshyrunrdquoTreasury bondswhich have
essentially the same payoff but differ in liquidity and
(5)stockandoptionpriceswhicharelinkedbywhatfishy
nancialeconomistscalltheputshycallparityrelation7
Thebreakdownofthesenormalpricingrelationsdoes
littledirectharm to the restof theeconomya20shybasisshy
pointviolationofcoveredinterestparityhaslittleeffecton
auSexporterusingcurrencycontractstolockintherate
atwhichitcanconvertfutureJapaneserevenuebackinto
dollarsTheseviolationsshowhoweverthatmarketswere
notfunctioningnormallyInparticulartheysuggestthere
wasnotmuchcapitalavailabletoprovideliquiditytobuyshy
ersandsellersanyoneneedingtosellsecuritiesquicklyin
suchamarketmdashsuchasafinancialinstitutiontryingtoreshy
duceitsriskmdashwasnotlikelytogetagoodprice
lendIng BankIng and the recessIon
Duringthefallof2008outputandfinancingactivityconshy
tracted sharply Commercial paper corporate bond and
equityissuanceallfelldramaticallyasdidmortgageorigishy
nations
originations of most types of asset backed securities
alsoslowedtoatrickleManybanksintheunitedStates
Jan 20
04Ju
l 200
4Ja
n 2005
Jul 2
005
Jan 20
06Ju
l 200
6Ja
n 2007
Jul 2
007
Jan 20
08Ju
l 200
8Ja
n 2009
Jul 2
009
Copyrighted Material
InTroDuCT Ion bull 1
0
50
100
150
200
250
Figure2assetBackedSecuritiesIssuedintheunitedStatesJanushyary200toDecember2009BillionsofDollarsperMonthSourceFederalreserve
and other countries no longer hold much of the credit
theyissueTheyhavemovedinsteadtoanldquooriginateand
sellrdquomodel inwhich theybundle together similar loans
suchasjumbomortgagescommercialloansstudentloans
or credit card debt and sell them to investors as asset
backedsecuritiesnewissuesofthesesecuritiesessentially
stopped inoctoberandnovember2008Figure2shows
that the amount of asset backed securities issued in the
united States rose from$288 billion in January 2000 to
$85billioninJune2007andthenplungedto$102bilshy
lioninSeptember2007IssuanceintheunitedStatesconshy
tinued to decline over the next year eventually falling
to only $87 billion in october 2008 and $ billion in
Copyrighted Material
1 bull CHapTer 1
novembermdashjust2percentofthevolume18monthsearlier
onlymortgagespooledbyFannieMaeandFreddieMac
withanexplicitgovernmentguaranteeandsubjecttohuge
Federalreservepurchasescontinuedtoflowtothemarket
There isplentyof anecdotal and surveyevidence that
banklendingalsodriedupduringtheCrisisForexample
loanofficerssurveyedbytheFederalreservereportedthat
credit conditionsprogressively tightenedduring2008In
asurveyabouttheirperceptionsofcreditconditionsand
corporatedecisionsasoflatenovember2008morethan
halfofthechieffinancialofficersoflargeamericanfirms
whorespondedsaidthattheirfirmswereeitherldquosomewhat
orveryaffectedbythecostoravailabilityofcreditrdquo8
There is a lively and fundamentally important debate
about why the quantity of lending fell Some financial
economists argue that banks wanted to lend more but
wereunable todosobecausetheyfacedbindingcapital
constraintsInthisviewinformationcostsandotherfricshy
tionsintheloanoriginationprocesskeptcustomersfrom
movingtolessconstrainedbanks
othersarguethattheprimaryreasonbankswereunwillshy
ingtolendisthattheircustomershadbecomelesscreditshy
worthyTheseeconomistspointoutthatthehighlevelof
uncertainty about future economic conditionsduring the
Crisisratchetedupthedefaultriskofeventhemostrelishy
ableclientsThisinterpretationofthedeclineinbanklendshy
ingimpliesthatnoamountofcapitalwouldhaveinduced
banksasagrouptolendmorebecauseallthegoodloans
werebeingmade
Figure shows data on the quantity of bank lending
Jan 20
08
Mar
2008
M
ay 20
08Ju
l 200
8Se
p 2008
Nov 20
08Ja
n 2009
Jan 20
09
May
2009
Jul 2
009
Sep 20
09Nov
2009
Copyrighted Material
InTroDuCT Ion bull 15
1050
1100
1150
1200
1250
1300
FigureCommercialandIndustrialLoansbyuSCommercialBanks2008ndash9inBillionsofDollarsSourceFederalreserve
intheunitedStatesin2008and2009Startinginoctober
2008therewasaspikeinlendingfollowedbyaprotracted
declineVVChariLawrenceChristianoandpatrickKehoe
takethespikeatfacevalueinaggregatebankslentmore
ataminimumthebankingsystemasawholemdashasopposed
to individual banksmdashwas not deleveraging to overcome
loss of capital9 Victoria Ivashina and David Scharfstein
notethatmuchoftheincreaseinbanklendingwasinvolshy
untaryonthepartofthebankstheresultofdrawdowns
byborrowersonexistinglinesofcredit10 Theyalsoshow
thatbanks thatweremorevulnerable todrawdownsbeshy
causetheywereinmoresyndicateswithLehmanreduced
subsequent lending more and conclude that there was
indeed a genuine contraction in the effective supply of
bankcredit
Copyrighted Material
1 bull CHapTer 1
economistswillargueabouttheeventsoftheWorldFishy
nancialCrisisforyearstocomeInfactwestillargueabout
theGreatDepressionnoneoftheanalysisbehindourrecshy
ommendationshoweverdepends onhow these debates
aresettledForexamplenomatterhowcapitalshyconstrained
thebankingsystemreallywasinthefallof2008ourproshy
posalsforchangesthatmakesuchconstraintslessbinding
andgivepolicymakersbettertoolswhentheyfearcapital
constraintsremainvalid
What Was Wrong WIth the FInancIal system durIng the crIsIs
The Crisis revealed a number of serious problems with
ourfinancialsystemSomehadbeeninthebackgroundall
alongothersdidnotappearuntiltheCrisisInthisbook
weemphasizefourcategoriesofproblemsconflictsofinshy
terestknowntoeconomistsasagencyproblemsthediffishy
cultyofapplyingstandardbankruptcyprocedurestofinanshy
cialinstitutionstheemergenceofamodernformofbank
runsandtheinadequacyoftheregulatorystructurewhich
hadnotkeptupwithrecentfinancialinnovation(Infact
muchinnovationservedtoescaperegulations)
Conflicts of Interest Agency Problems
Conflictsofinterestthatcannotberesolvedeasilybyconshy
tractsormarketsoccurthroughouttheeconomybutthey
Copyrighted Material
InTroDuCT Ion bull 17
canbeparticularlyharmfulinthefinancialsystemThere
areseveralreasonsFirstmanyfinancialtransactionsand
contractsinvolveaprincipalsuchasaninvestororshareshy
holderaskingatradermanagerorotheragenttoacton
hisorherbehalfSecondmostfinancial transactions inshy
volvehighlyuncertainfuturepayoffsandinmanytransacshy
tionsonepartyisbetterinformedaboutthepayoffsthan
the otherThird the high volatility of the future payoffs
oftenmakesithardtoassesswhethertheoutcomeofafishy
nancialtransactionisduetotheagentrsquoseffortsorluckand
fourththesumsinvolvedcanbehuge
Someproprietarytradersforexampleearnalotwhen
their tradesdowellbuttheirpersonal lossesare limited
whentheirtradesdopoorlyBecauseoftheasymmetricnashy
tureoftheircompensationthesetraderscanincreasetheir
expectedincomebytakingriskierpositionsThisproblem
isdramaticallyillustratedbyperiodiccasesinwhichldquorogue
tradersrdquoincurlossesthatarebigenoughtodamageoreven
destroy large financial institutions In 1995 nick Leeson
broughtdownBaringsBankwitha$1billionlossandin
2008itwasrevealedthatJeacuterocircmeKervielhadseverelydamshy
agedSocieacuteteacuteGeacuteneacuteralewithalossofover$7billion
Conflictsofinterestorldquoagencyproblemsrdquoalsoexistat
manyotherlevelswithinthefinancialsystemShareholders
offinancialinstitutionshaveaconflictofinterestwiththe
bankrsquosseniorexecutivesespeciallywhenthoseexecutives
arerewardedforgoodperformancebutdonothavealarge
fractionoftheirwealthtiedupinthesharesofthebank
Manyfinancialinstitutionshavelargequantitiesofdebt
Copyrighted Material
18 bull CHapTer 1
which creates a conflict of interest between the bankrsquos
creditorsanditsshareholdersShareholdershaveanincenshy
tivetoauthorizeexcessivelyriskyinvestmentsforexample
especiallyafterabankhasincurredlossesthaterodethe
valueoftheshareholdersrsquoclaimThegainsontheserisky
investmentswillaccruelargelytoshareholderswhilethe
losseswillmostlybebornebycreditorsTheconflictwith
creditorsalsoreducestheincentivesfortheshareholders
of troubled institutions to raisenewcapitalbecause that
wouldstrengthen thepositionofcreditorswhilediluting
theshareholdersrsquopositionThisldquodebtoverhangrdquoproblem
waswidelycitedduringtheWorldFinancialCrisiswhen
many banks that were insolvent or close to insolvency
seemedreluctanteithertoraisenewcapitalortoreduce
theirrisksbysellingdistressedsecurities11
atthehighestlevelthereisaconflictofinterestbetween
societyasawholeandtheprivateownersoffinancialinshy
stitutions Because robust financial institutions promote
economicgrowthandemploymentduringfinancialcrises
governmentsoftenrescuetroubledfirmstheyperceiveto
be systemically importantThe result is privatized gains
andsocializedlossesIfthingsgowellthefirmsrsquoowners
andmanagersclaimtheprofitsbutifthingsgopoorlysoshy
cietysubsidizesthelosses
The candidates for government bailouts are popularly
describedasldquotoobigtofailrdquoMorepreciselytheargument
for government supportmdashwhich many economists chalshy
lengemdashisaboutfirmsthataretoosystemicallyimportantto
failInits200annualreporttheeuropeanCentralBank
describedsystemicriskasldquoTheriskthattheinabilityofone
Copyrighted Material
InTroDuCT Ion bull 19
institutiontomeetitsobligationswhenduewillcauseother
institutions to be unable tomeet their obligationswhen
dueSuchafailuremaycausesignificantliquidityorcredit
problemsandas a resultcould threaten the stabilityof
or confidence in marketsrdquo Systemically important firms
arethosewhosefailurecouldposealargethreattothestashy
bilityoforconfidenceinmarketsThesefirmsarelikelyto
belargebuttheyalsotendtohavecomplexinterconnecshy
tionswithotherfinancialinstitutions
Tooshybigshytoshyfailpoliciesoffersystemicallyimportantfirms
theexplicitorimplicitpromiseofabailoutwhenthingsgo
wrongThesepoliciesaredestructiveforseveralreasons
Firstbecause the possibility of a bailoutmeans a firmrsquos
stakeholders claim all the profits but only some of the
lossesfinancialfirmsthatmightreceivegovernmentsupshy
porthaveanincentivetotakeextrariskThefirmrsquosshareshy
holderscreditorsemployeesandmanagement all share
thetemptationTheresultisanincreaseintherisksborne
bysocietyasawhole
Secondthesepoliciesencouragesmallerfinancialinstishy
tutionstoexpandortobecomemorecloselyinterconnected
with other firms so they move under the tooshybigshytoshyfail
umbrellaFirmshaveanincentivetodowhateverittakes
tomakepolicymakersfeartheirfailurecreatingthevery
fragilitythegovernmentwishestoavoidBeliefthatagovshy
ernmentrescuewillprotectafinancial institutionrsquoscredishy
tors inacrisisalsogivesafirmacompetitiveadvantage
loweringitscostoffinancingandallowingittoofferbetter
prices to its customers than its fundamental productivity
warrants
Copyrighted Material
20 bull CHapTer 1
Thirdinefficientfirmsthatcannotcompeteontheirown
shouldfailotherwisefirmshavelessincentivetobecome
andstayefficientagovernmentpolicythatpropsupinshy
efficientfirmsiswastefulanddestructiveallowingthese
firmstofailfreesupresourcesandprovidesopportunities
formoreefficientandinnovativecompetitorstoflourish
Fourthandmostgenerallycapitalismisunderminedby
policiesthatprivatizegainsbutsocializelossesGovernment
guaranteedinstitutionscanbecomegovernmentruninstishy
tutionsallocatingcreditforexampletomaximizepolitical
gainratherthaneconomicwelfare
The conflictbetween society and theownersoffinanshy
cialfirmsbecomesmoreseriousduringseverecriseswhen
manyfinancialinstitutionsareclosetoinsolventIt isthe
primemotivationforourregulatoryproposalsbutseveral
ofthelowershylevelconflictswehavedescribedarerelevant
becausetheymagnifytheriskbornebysocietyasawhole
Theselfshyservingbehaviorthatmanyofourrecommenshy
dations targetmdashwhether by traders senior management
orthefirmrsquosownersmdashneednotbestrategicintentionally
maliciousorevenconsciousConsideratraderwhoinadshy
vertentlydevelopsaninvestmentstrategywithhighlyprobshy
ablegainsandimprobablebutlargelossesLikeafirmthat
hassoldearthquakeinsurancethestrategymayproducea
longstringofimpressivereturnsbeforeoneyearoflosses
wipesoutmanyyearsofprofits12 Ifsoduringthegood
yearsthetraderwillbecelebratedforhisorherbrilliance
rewarded with large bonuses and given more resources
to manageMany sophisticated traders and hedge funds
Copyrighted Material
InTroDuCT Ion bull 21
werenotawareoftheldquoearthquakerisksrdquoinherentinmany
of theirstrategiesSimilarlywhenfirmstakeactionsthat
increasethelikelihoodofagovernmentbailoutinthenext
financialcrisisthemarketrewardsthemwithalowercost
of capitalas firms become too big to fail for example
the implicit government guarantee reduces the riskiness
of their debt and lowers the interest rate demanded by
theircreditorsaCeoworkingtomaximizefirmvaluemay
notevenrealize the importanceof thegovernmentguarshy
anteebut a Darwinian process will encourage behavior
thatexploitsit
Bankruptcy and Resolution Procedures
Itisimpossibletowriteafinancialcontractthatspecifies
everypossiblecontingencyInsteadcontractsrelyonbankshy
ruptcytodetermineoutcomesincertainbadandunlikely
statesoftheworldInbankruptcycontrolofafirmistransshy
ferredfromtheshareholderswhonolongerhaveastake
inlossesbecausetheirsharesareworthlittletothedebtshy
holders It is in societyrsquos interest to develop bankruptcy
proceduresthatmaximizethepostshybankruptcyvalueofa
firmrsquosassetsInparticularsocietyshouldavoidthedestrucshy
tionofvaluethatoccurswithdisorderlyliquidation
Disorderlyliquidationoffinancialinstitutionsisparticushy
larly costlyFirstvaluableknowledge that the institution
hasaccumulatedaboutitscounterpartiesmdashborrowerstradshy
ingpartnersandsoonmdashcandisappearastheinstitution
losesemployeesandceasestooperatenormallyFinancial
Copyrighted Material
22 bull CHapTer 1
economistshavefoundthatthecollapseofabankhasamashy
terialadverseimpactonmanyofitsborrowers1 Second
the prospect of a disorderly liquidation makes it more
likelythatatroubledfinancialinstitutionwillsufferarun
by creditors who conclude they are better off claiming
whatmoney theycan todayrather thanwaiting through
protracted liquidation proceedings Third ldquofire salesrdquo of
specializedassets inadisorderly liquidationcandepress
prices and thereby spread problems to other holders of
theassetclassFourthdisorderlyliquidationincreasesthe
uncertaintyabouttheimpactofafinancialinstitutionrsquosfailshy
ureonitscounterpartiesandotherclaimholdersBecause
financialfirmsaretightlyinterconnectedthisuncertainty
canprecipitateorintensifyafinancialcrisis1
In theunitedStatesthestandardbankruptcycodealshy
lowsbothforliquidationofafirmandthesaleofitsassets
(Chapter7)andforcontinuedoperationofafirmunder
the supervision of a bankruptcy judgewho protects the
firmfromcreditorsrsquoclaimswhileareorganizationplanis
approved(Chapter11)Theseproceduresappeartowork
wellfornonfinancialcorporationsbutnotsowellforfinanshy
cialorganizationsTheChapter11approachofseparatinga
firmrsquosfinancialaffairsfromitsnonfinancialbusinessactivishy
tiesisinfeasiblewhenthebusinessofthefirmisfinancial
transactionsFurthermoremanyfinancialinstitutionsrely
heavily on shortshyterm debtpossibly as a valuable discishy
plineonbankexecutiveswhocanrapidlychangetherisks
theirfirmstakeThismakesfinancialfirmsvulnerabletoa
rapidwithdrawalofshortshytermcreditthatislikelytooccur
beforeanyeventthatwouldtriggerbankruptcy
Copyrighted Material
InTroDuCT Ion bull 2
Wearguebelowthatthereisaneedforaspecialresolushy
tionprocedurethatcanbeappliedtolargeinsolventfinanshy
cialinstitutionsWealsoadvocateregulatorychangesthat
would push financial firms towardmore resilient capital
structures
Bank Runs
Classicbank runs inwhichdepositors race towithdraw
their funds before a bank failswere one of the central
contributors to theGreatDepressionDeposit insurance
whichwasintroducedaftertheDepressiontocounterthis
destructiveprocessmadedemanddepositsoneofthemost
stableformsofbankfinancingduringtheWorldFinancial
CrisisManyfinancialinstitutionshoweversufferedamodshy
ernversionofbankruns
Banksespeciallythosewithinvestmentbankingactivishy
tiestypicallyfinanceasignificantfractionoftheirbusiness
withovernightcommercialpaperreposandothershortshy
terminstrumentsInnormaltimesbanksrolloverthisdebt
asitmaturestakingnewloanstopayofftheoldInacrishy
sishoweveruncertaintyaboutwhetheratroubledinstitushy
tionwouldbeabletopayoffitscreditorstomorrowcauses
lenderstostopextendingcredittodayThusshortshytermfishy
nancingcanleadtoarunthatissimilartoaclassicrunon
deposits
even some secured creditors participated in runs durshy
ingtheWorldFinancialCrisisBanksoftenuserepurchase
agreements to borrow money securing the loan by givshy
ingthelenderafinancialassetsuchasaTreasurybond
Copyrighted Material
2 bull CHapTer 1
ascollateralBecausetheyareovershycollateralizedwithasshy
setsworthperhaps$105guaranteeingevery$100inloans
lendersviewldquoreposrdquoasasafewaytoextendcreditWhen
credit markets froze during the Crisis however lenders
worried that retrieving collateral and selling itwouldbe
difficultandnotworththesmallinterestonanovernight
loanasaresultatvarioustimesduringtheCrisismany
investmentbankshaddifficultyrollingovereventheirseshy
cured loanseven relatively healthy financial institutions
werehamperedbythetroubleintherepomarketafteraushy
gust2007asthemarketbecamemoreandmoreuncertain
about the prices securities would fetch in a forced sale
these institutions found they could borrow less and less
withthesamecollateral15
prime brokerage accounts also saw a runshylike withshy
drawalbycustomersManylargebankshaveprimebrokershy
agegroupsthatassisthedgefundsandotherinstitutionalinshy
vestorsbyprovidingfinancingsecuritieslendingclearing
custodial servicesandoperational supportInexchange
thefundspayfeesandcriticallypostcollateraltosecure
theirloansWithsomerestrictionsthatweexplaininChapshy
ter10theprimebrokercanthenusethecollateralinits
ownbusinessinsomecasescomminglingitwiththefirmrsquos
ownassetsDuringtheCrisishedgefundsmonitoredthe
financial wellshybeing of their prime brokers and like deshy
positorsintheDepressionfledwiththeircollateralatthe
firstsignoftroubleBearStearnsforexamplehadalarge
prime brokerage business according to press accounts
oneofthelargesthedgefundsthatusedBearStearnsasa
Copyrighted Material
InTroDuCT Ion bull 25
primebrokerrenaissanceTechnologieswithdrew$5bilshy
lionofcashintheweekthefirmfailedWithsuchoutflows
it is not surprising that Bear Stearns ran out of money
eventhoughithadmorethan$18billionincashaweek
earlier
Likeclassicbankrunsmodernbankrunsarebothdeshy
structiveandselfshyfulfillingConcernthatabankmightbe
in trouble spurs its creditors and counterparties towithshy
draworwithholdtheircapitalasaresultevenrumorsofa
problemmaybeenoughtodestroyaviableinstitutionThe
importanceofmodernbankrunsduringtheWorldFinanshy
cialCrisisisarecurringthemethroughoutthebookand
wemakeseveralproposalsthatareintendedtoreducethe
frequencyofsuchevents
The Inadequacy of the Regulatory Structure
TheWorldFinancialCrisismadeitclearthatfinancialinnoshy
vationhadoverwhelmedexistingfinancialregulationsnoshy
tableexamplesincludeaIGrsquosdecisiontosellanextremely
large amount of credit default swaps on subprime debt
tobanksintheunitedStatesandabroadtheholdingof
Lehmanpaperbymoneymarketfundsparticularlythereshy
serveprimaryFundthecomplexityofthederivativebooks
atLehmanandotherinvestmentbanksandthedifficultyof
simultaneouslyapplyingseveralcountriesrsquobankruptcycodes
tothesubsidiariesofmultinationalfinancialinstitutions1
Thereisatradeshyoffbetweenfinancialinnovationandstashy
bilityInnovationcanimprovethefinancialsystemrsquosability
Copyrighted Material
2 bull CHapTer 1
toallocateresourcestotheirhighestvaluedusebutitcan
alsoreducethestabilityofthesystemThechallengeisto
developregulationsthatimprovestabilitywithoutstifling
innovation In addition regulation often leads to innoshy
vations designed to evade the regulationswhich makes
thefinancialsystemmorefragileForexamplemanyofthe
specialshypurposevehiclesthatimplodedintheCrisiswere
createdtogetaroundcapitalrequirements
In many countries the response of regulators to the
World Financial Crisis was hampered by the fragmented
nature of their regulatory systems Financial regulations
are typically designed to ensure thehealth of individual
institutionsratherthanthefinancialsystemasawholeIn
thisbookwearguethatsystemicregulationisanimporshy
tantfunctionthatrequiresaspecialmandateandthatthe
central bank is particularly well equipped to fulfill this
function
Finallyeffectivefinancialregulationrequiresthatpolitishy
ciansandultimatelythepublichaveanadequateundershy
standing of the financial system The political turmoil
surroundingtheCrisissuggeststheimportanceofdissemishy
natingexpertknowledgeaboutfinancetoabroaderaudishy
enceThisisoneofourmotivationsforwritingthisbook
What Were the orIgIns oF the World FInancIal crIsIs
LiketheoriginsoftheFirstWorldWarthecausesofthe
Crisiswillbedebatedbyscholarsformanyyears
Copyrighted Material
InTroDuCT Ion bull 27
Most observers agree that the strong runshyup and subshy
sequentsharpdeclineinthepricesofstockshousesand
otherfinancialassetsindevelopedcountrieswasanimporshy
tantcatalystfortheCrisisThereisdisagreementhowever
aboutwhetherthispatterninpricesistheresultofrational
investorbehaviororldquoirrationalbubblesrdquo
SomearguethattherunshyupbeforetheCrisiswasdriven
by investorswhoknowingly acceptedunusually low exshy
pectedreturnsandtheyofferseveralpossiblereasonswhy
Firsttherewasasurgeofsavingsinemergingcountries
drivenbyacombinationofrapideconomicgrowthanddeshy
mographicsperhapsbecauseofadesiretoaccumulateforshy
eignreservesintheaftermathoftheasiacrisisof1997ndash98
muchof thiswealthwas invested indevelopedmarkets
Secondfinancialmarketswereunusually tranquilduring
200to200Withlowvolatilityinvestorsmayhavesettled
for a low risk premiumThird influenced by fears of a
Japaneseshystyledeflation resulting from themarketdownshy
turnof2000ndash2001andbyabeliefthattheyshouldnottry
to usemonetary policy to counteract rising asset prices
central bankers in the united States maintained a loose
monetarypolicythroughouttheperiod17andfromthisrashy
tionalviewofinvestorstheplungeinassetpricesthatacshy
companiedtheCrisiswascausedbybadnewsaboutfuture
cashflowsunexpectedincreasesinthereturnsrequiredby
investorsorboth
otherssuggestamoredirectexplanationThehighprices
before theCrisisweredrivenby an irrational belief that
prices would continue to rise and the collapse of asset
priceswastheinevitableresultofthismistakeWhatever
Copyrighted Material
28 bull CHapTer 1
theexplanationthesharpdropinassetpricesbothconshy
tributedtoandwasasymptomoftheCrisis
other commentators argue that the financial system
becamevulnerablebecausemanymarketparticipantsasshy
sessedrisksinaccuratelyduringtheperiodleadingupto
theWorldFinancialCrisisConsumersbanksandinvestors
ingeneralunderestimatedtheriskofhousepricedeclines
increasingthepricestheywerewillingtopayforrealesshy
tatethecredittheywerewillingtoextendandthevaluashy
tionsofbanksthatextendedsuchcreditBanksputmuch
weight on the recent pastwhen they estimated value at
riskwhichledthemtoconcludethatthelevelofriskwas
lowandthattherewaslittledownsidetohavinghighleshy
verageothermarketparticipantsdidnotfullyappreciate
thathighliquiditywassuppressingvolatilityandthatthe
processmightreversewithliquiditydecreasingandvolatilshy
ityincreasing
More generally the high level of financial innovation
driveninpartbythedecliningcostofinformationtechnolshy
ogymadeithardforriskassessmenttokeeppacewiththe
evolvingfinancialsystem18Thebenignenvironmentofthe
creditboomexacerbatedthisproblembytemptingfinanshy
cialinstitutionstounderinvestinriskmanagement
uSpolicymakersalsocontributedtotheseverityofthe
CrisisbypushingFannieMaeandFreddieMactoincrease
theavailabilityofmortgagefundingtoborrowerswithquesshy
tionableabilitytorepaytheirmortgagesasaresultofthis
pressure both agencies relaxed their standards for the
mortgages they purchased and guaranteedThe demand
Copyrighted Material
InTroDuCT Ion bull 29
forhomesbyborrowerswhoqualifiedformortgagesbeshy
causeoftheselowerstandardspusheduppricesandthe
defaultbymanyofthemduringtherecessioncontributed
tothedropinhomeprices
Thepanicandruninthefallof2008remainthecentral
distinguishingfeaturesoftheWorldFinancialCrisisasset
priceshave risenand fallenbeforeand theworldeconshy
omyhasbornelargefinancial lossesmanytimeswithout
suchasevereeconomicoutcomeConverselylossesfrom
completelydifferentunderlyingsourcesmdashcommercialreal
estateorperhapssovereigndefaultsmdashcouldcauseasimilar
catastrophe if theyagainprovoke tooshybigshytoshyfailchaosor
runs
Thisbookdoesnotseektoprovideacompletediagnosis
oftheWorldFinancialCrisisnordoesittakeastandonthe
relativeimportanceofthecontributingfactorslistedabove
ratherwebelieveourrecommendationswillhelpprevent
ormitigatefuturecriseseventhoughwedonotfullyundershy
standallthecausesofthelastone
CarmenreinhartandKennethrogoff amongothershave
pointedoutthatfinancialcriseshaveoccurredthroughout
thehistoryofcapitalismandthatthesecrisessharemany
commonpatterns19 Thelessonwedrawfromthisisthat
noacceptablesetofregulationscanpreventmarketparticishy
pantsfrommakingmistakesthatcreateeconomicinstability
ourpurposeinthisbookisinsteadtosuggestregulatory
reformsthatwillmakethesystemmorestabledespitethe
mistakesthataresuretocome
Copyrighted Material
bull CHapTer 1
litigationthemajorsponsoringbanksagreedtopaymany
oftheirclientsrsquolossesThemarketforauctionratesecurishy
tieshasnotrevived
BearStearnsrsquofailureinMarch2008provedinretrospect
acriticalturningpointThefirmhadfundedmuchofitsopshy
erationswithovernightdebtandwhenitlostalotofmoney
onmortgagebacked securities its lenders refused to reshy
new thatdebtat the same timecustomers ran from its
primebrokeragebusinessaprocesswedescribeindetail
belowovertheweekendofMarch15theuSgovernment
brokeredarescuebyJpMorganthatincludedagenerous
commitmentbytheFederalreserveManyobserversand
officialsthoughtthattheCrisiswascontainedatthispoint
andthatmarketswouldpolicecreditrisksaggressively That
hopeprovedunfounded
The Remarkable Month of September 2008
The World Financial Crisis moved into an acute phase
in September 20081 Fannie Mae and Freddie Mac large
governmentshysponsored enterprises that create sell and
speculateonmortgagebackedsecuritiesfailedduringthe
firstweekofSeptemberandwereplacedundertheconsershy
vatorshipoftheFederalHousingFinanceagency
ThepeakoftheCrisisstartedonMondaySeptember15
2008LehmanBrothersabrokerageandinvestmentbank
headquarteredinnewYorkfailedwitharunbyitsshortshy
term creditors and prime brokerage customers that was
similartotherunexperiencedbyBearStearnsLehmanrsquos
bankruptcy was a surprise since the government had
Copyrighted Material
InTroDuCT Ion bull 5
steppedintopreventthebankruptcyofBearStearnsonly
monthsbefore
WithindaystheuSgovernmentrescuedamericanInshy
ternationalGroupaIGhadwrittenhundredsofbillionsof
dollarsofcreditdefaultswapswhichareessentiallyinsurshy
ancecontractsthatpayoffwhenaspecificborrowersuch
as a corporation or a specific security such as a bond
defaultsaseconomicconditionsworsenedanditbecame
increasingly likely thataIGwouldhave topayoffonat
leastsomeofitscommitmentstheswapcontractsrequired
thefirmtopostcollateralwithitscounterpartiesaIGwas
unable to make the required payments Goldman Sachs
wasaIGrsquosmostprominentcounterpartyandGoldmanrsquosdeshy
mands forcollateralwerean importantpartofaIGrsquosdeshy
miseThecost to taxpayersofgovernmentassistance for
FannieMaeFreddieMacandaIGisnowprojectedathunshy
dredsofbillionsofdollars
ThatsameweekTreasurySecretaryHankpaulsonanshy
nounced thefirstTroubledassetrelief program (Tarp)
askingCongressfor$700billiontobuymortgagebacked
securities Federal reserve Chairman Ben Bernanke and
presidentGeorgeWBush also gave important speeches
warningofgravedangertothefinancialsystemTheSecushy
ritiesandexchangeCommissionbannedtheshortshyselling
of several hundred financial stocks causing pandemoshy
niumintheoptionsmarketwhichreliesonshortshyselling
tohedgepositionsandamonghedgefundsthatemployed
longshyshortstrategies2
Theturmoilof theweekdidnotstopthereInterbank
lending declined sharply the commercial paper market
Copyrighted Material
bull CHapTer 1
slowed to a crawl and there was a run on the reserve
primaryFundamoneymarketmutualfundunlikeother
mutual funds money market funds maintain a constant
sharepricetypically$1byusingprofitsinthefundtopay
interestratherthantoincreasesharevaluesBecausethe
sharepriceisfixedat$1lossesthatpushafundrsquosnetasshy
setvaluebelow$1persharecantriggerarunasinvestors
rushtoclaimtheirfulldollarpaymentsandforcethelosses
ontootherinvestorsThereserveprimaryFundwhichhad
morethan1percentofitsassetsincommercialpaperisshy
suedbyLehmansufferedjustsucharunonSeptember1
2008afterLehmandeclaredbankruptcythefundrsquosnetasshy
setvaluedroppedto$097pershareandinvestorswithshy
drewmorethantwoshythirdsofthereserveFundrsquos$bilshy
lioninassetsbeforethefundsuspendedredemptionson
September17Concernspreadtoinvestorsinothermoney
marketfundsandtheywithdrewalmost10percentofthe
$5trillioninvestedinuSmoneymarketfundsoverthe
nexttendaysTostabilizethemarketthegovernmenttook
theunprecedented stepof offering a guarantee to every
uSmoneymarketfund
In normal timesany one of these eventswould have
beenthefinancialstoryoftheyearyettheyallhappened
inthesameweekinSeptember2008althoughmuchcomshy
mentaryandpopularpresscoverageblamestheWorldFishy
nancialCrisisentirelyonthegovernmentrsquosdecisiontolet
Lehmanfailsuchananalysisignorestheevidentcontribushy
tionsofthemanyothermomentouseventsthatoccurred
duringthatweek
Copyrighted Material
InTroDuCT Ion bull 7
October 2008 The Bank Bailout and Credit Crunch
Byearlyoctober2008theuSgovernmentrealizedthat
theTarpplantobuymortgagebackedsecuritiesonthe
openmarketwasnotfeasibleInsteadtheTreasuryDepartshy
mentusedtheappropriatedmoneytopurchasepreferred
stockinlargebanksandtoprovidecreditguaranteesand
othersupportThoughnowrememberedastheldquobankbailshy
outrdquotheTarppurchaseswerenotsimplyatransfertofailshy
inginstitutionsHealthybankswerealsoforcedtoaccept
capital inanattempt tomask thegovernmentrsquosopinions
aboutwhichbankswereinmoretroublethanothersMany
policymakersseemedtothinkthatbankswerenotlending
becausetheyhadlosttoomuchcapitalandwerenotable
orwillingtoraisemoreThusthegoalseemedtobenotto
savethebanksbuttorecapitalizethemsotheywouldlend
againIn theendthe former resultwasachievedmdashnone
of the large banks that receivedTarp funds failedmdashbut
thelatterarguablywasnotWeanalyzetheseissuesindeshy
tailbelowandrecommendsomealternativestructuresand
policiesthatwebelievewouldhaveworkedbetter
DuringmuchoftheWorldFinancialCrisistheFederal
reserveexperimentedwithawiderangeofnewfacilities
beyonditstraditionaltoolsofinterestratepolicyandopen
market operations The Fed lent broadly to commercial
banksinvestmentbanksandbrokershydealersandendedup
buyingcommercialpapermortgagesassetbackedsecurishy
tiesandlongshytermgovernmentdebtinanefforttolower
interestratesinthesemarketsByDecember2008excess
Copyrighted Material
8 bull CHapTer 1
reservesinthebankingsystemhadgrownfrom$billion
before the Crisis to over $800 billionThese actions are
notafocusofouranalysisbuttheysurelyhelpedprevent
theCrisisfromturningintoanotherGreatDepressionat
aminimumtheyeliminatedmostbanksrsquoconcernsabout
sourcesofcash
Bankfailuresineuropeinthefallof2008ledtomore
directbailoutsThenetherlandsBelgiumandLuxembourg
spent$1billiontopropupFortisamajoreuropeanbank
with about $1 trillion in assets The netherlands spent
$1billiontobailoutInGabankingandinsurancegiant
Germanyprovideda$50billionrescuepackageforHypo
realestateHoldingsSwitzerlandrescueduBSoneofthe
tenlargestbanksintheworldwitha$5billionpackage
Iceland took over its three largest banks and its subseshy
quent difficulties highlight what happens when the cost
ofbailingoutacountryrsquosbanksexceedsthegovernmentrsquos
resources
Throughoutthefallof2008therewasaldquoflighttoqualityrdquo
inmarketsaroundtheworldWheninvestorsareworried
aboutdefaulttheydemandhigherinterestratesYieldson
securitieswithanyhintofdefaultriskrosesharplyespeshy
ciallyinthefinancialsector
Theflighttoqualityisapparentintheinterestrateson
commercialpaperinFigure1Commercialpaperisshortshy
termunsecureddebtissuedbybanksandotherlargecorshy
porationsandisanimportantpartoftheirfinancingThe
commercialpaperratesforfinancialinstitutionsandlowershy
creditqualityborrowers jumped inSeptemberandoctoshy
berbutafterasmallincreasetherateforlargecreditworshy
Copyrighted Material
InTroDuCT Ion bull 9
7
6
5
4
3
2
1
0
A2P2 Nonfinancial
AA Financial
AA Nonfinancial
Jul 2008 Aug 2008 Sep 2008 Oct 2008 Nov 2008 Dec 2008
Figure1annualizedpercentYieldson0shyDayHighshyQuality(aa)FinancialandnonfinancialCommercialpaperandMediumshyQuality(a2p2)nonfinancialCommercialpaperinpercentaugusttoDecember2008SourceFederalreserve
thynonfinancialcompaniesactuallydeclinedTherateon
uSTreasurybillswhichareviewedas themost secure
investmentalsofellthethreeshymonthTreasurybillrateacshy
tuallydroppedtozeroforbriefperiodsinnovemberand
December2008
the run on the shadoW BankIng system
Thepanicthatstruckfinancialmarketsinthefallof2008
hasbeencharacterizedasarunontheshadowbankingsysshy
temandwithgoodreasonBeforetheCrisismanybonds
mortgagebackedsecuritiesandother credit instruments
Copyrighted Material
10 bull CHapTer 1
wereheldbyleveragednonshybankintermediariesincluding
hedgefunds investmentbanksbrokeragefirmsandspecialshy
purposevehiclesManyoftheseintermediarieswereforced
toldquodeleverrdquoduringoctoberandnovembersellingassetsto
repaytheircreditors
Hedgefundsandotherleveragedintermediariesusethe
securitiesintheirportfoliosascollateralwhentheyborrow
moneyDuringtheWorldFinancialCrisismanywarylendshy
ersdecidedthecollateralborrowershadpostedbeforethe
Crisis was no longer sufficient to guarantee repayment
Whenthelendersdemandedeithermoreorbettercollatshy
eralmanyborrowerswereforcedtoselltheirleveredposishy
tionsandrepaytheirloansTheresultwasareductionin
thequantityofassetstheyheldandintheirleverageInadshy
ditionhedgefundsandotherintermediariessufferedlarge
withdrawalsbypanickycustomersagainforcingthemto
sellsecuritiesonthemarketTheassetsbeingsoldweregenshy
erallyacquiredbyindividualinvestorsthefederalgovernshy
mentorcommercialbankswhichasagroupfinancedmost
oftheirpurchasesbyborrowingfromthegovernment
The financing difficulties faced by arbitrageurs and lishy
quidity providers are apparent in a series of fascinating
market pathologies In financialmarkets there are often
manydifferentwaystoobtainthesameoutcomeaninvesshy
torcanusemanydifferentcombinationsofsecuritiesfor
exampletorisklesslyconvertdollarstodayintodollarsin
sixmonthsThe actionsof arbitrageursusuallykeep the
costsof thedifferent approaches closely alignedDuring
thefallof2008thecostsoftendivergedwiththeapproach
thatrequiredmorecapitaltypicallycostingless
Copyrighted Material
InTroDuCT Ion bull 11
Theprincipleofcoveredinterestparityforexamplesays
thataftereliminatingexchangerateriskriskshyfreeinvesting
shouldhavethesamereturnineverycurrencyaninvestor
whowantstoinvestdollarstodayandreceivedollarsinthe
futureusuallybuysauSbondHecouldaccomplishthe
samethingbyconvertinghisdollarsintoeurosinvesting
inarisklesseurobondandlockingintheconversionof
theeuropayoffbackintodollarswithaforwardcontract
Sincebothstrategiesconvertdollarstodayintodollarsin
thefuturetheyshouldhavethesamereturn5 Supposeinshy
steadthereturnontheuSbondislowerThenanarbitrashy
geurcouldborrowmoneyintheunitedStatesatthelower
rateinvestitintheeurotransactionatthehigherrateand
makeaprofit
During the Crisis covered interest parity violations as
largeas20basispoints(020percent)emergedThismay
seemtrivialbutinnormaltimestheseviolationsrarelyexshy
ceed 2 basis pointsMoreover traders can usuallyldquolever
uprdquotransactionslikethisandmakealargeprofitButthatrsquos
thecatchmdashhedgefundsbrokeragesandinvestmentbanks
werebeingforcedtodeleverduringtheCrisisand20basis
points is not enough to enticemany longshyonly investors
to replace theuSbond theyarecurrentlyholdingwith
aforeignbondandsomeseeminglycomplicatedcurrency
transactions
other recent research finds similar disruptions of the
normalpricing relations linking (1)Treasurybondscorshy
poratebondsandcreditshydefault swaps (aTreasurybond
shouldbethesameasacorporatebondplusacreditdefault
swapmdashexceptforliquidityfinancingandCDScounterparty
Copyrighted Material
12 bull CHapTer 1
risk)(2)fixedandfloatingrate investments (asequence
ofshortshyterminvestmentsplusacontractswappingafloatshy
ing interest rate forafixed interest rateshouldhave the
same payoff as a fixed rate investment) () convertible
bondsdebtandequity()newlyissuedldquoonshytheshyrunrdquoand
recently issuedldquooffshytheshyrunrdquoTreasury bondswhich have
essentially the same payoff but differ in liquidity and
(5)stockandoptionpriceswhicharelinkedbywhatfishy
nancialeconomistscalltheputshycallparityrelation7
Thebreakdownofthesenormalpricingrelationsdoes
littledirectharm to the restof theeconomya20shybasisshy
pointviolationofcoveredinterestparityhaslittleeffecton
auSexporterusingcurrencycontractstolockintherate
atwhichitcanconvertfutureJapaneserevenuebackinto
dollarsTheseviolationsshowhoweverthatmarketswere
notfunctioningnormallyInparticulartheysuggestthere
wasnotmuchcapitalavailabletoprovideliquiditytobuyshy
ersandsellersanyoneneedingtosellsecuritiesquicklyin
suchamarketmdashsuchasafinancialinstitutiontryingtoreshy
duceitsriskmdashwasnotlikelytogetagoodprice
lendIng BankIng and the recessIon
Duringthefallof2008outputandfinancingactivityconshy
tracted sharply Commercial paper corporate bond and
equityissuanceallfelldramaticallyasdidmortgageorigishy
nations
originations of most types of asset backed securities
alsoslowedtoatrickleManybanksintheunitedStates
Jan 20
04Ju
l 200
4Ja
n 2005
Jul 2
005
Jan 20
06Ju
l 200
6Ja
n 2007
Jul 2
007
Jan 20
08Ju
l 200
8Ja
n 2009
Jul 2
009
Copyrighted Material
InTroDuCT Ion bull 1
0
50
100
150
200
250
Figure2assetBackedSecuritiesIssuedintheunitedStatesJanushyary200toDecember2009BillionsofDollarsperMonthSourceFederalreserve
and other countries no longer hold much of the credit
theyissueTheyhavemovedinsteadtoanldquooriginateand
sellrdquomodel inwhich theybundle together similar loans
suchasjumbomortgagescommercialloansstudentloans
or credit card debt and sell them to investors as asset
backedsecuritiesnewissuesofthesesecuritiesessentially
stopped inoctoberandnovember2008Figure2shows
that the amount of asset backed securities issued in the
united States rose from$288 billion in January 2000 to
$85billioninJune2007andthenplungedto$102bilshy
lioninSeptember2007IssuanceintheunitedStatesconshy
tinued to decline over the next year eventually falling
to only $87 billion in october 2008 and $ billion in
Copyrighted Material
1 bull CHapTer 1
novembermdashjust2percentofthevolume18monthsearlier
onlymortgagespooledbyFannieMaeandFreddieMac
withanexplicitgovernmentguaranteeandsubjecttohuge
Federalreservepurchasescontinuedtoflowtothemarket
There isplentyof anecdotal and surveyevidence that
banklendingalsodriedupduringtheCrisisForexample
loanofficerssurveyedbytheFederalreservereportedthat
credit conditionsprogressively tightenedduring2008In
asurveyabouttheirperceptionsofcreditconditionsand
corporatedecisionsasoflatenovember2008morethan
halfofthechieffinancialofficersoflargeamericanfirms
whorespondedsaidthattheirfirmswereeitherldquosomewhat
orveryaffectedbythecostoravailabilityofcreditrdquo8
There is a lively and fundamentally important debate
about why the quantity of lending fell Some financial
economists argue that banks wanted to lend more but
wereunable todosobecausetheyfacedbindingcapital
constraintsInthisviewinformationcostsandotherfricshy
tionsintheloanoriginationprocesskeptcustomersfrom
movingtolessconstrainedbanks
othersarguethattheprimaryreasonbankswereunwillshy
ingtolendisthattheircustomershadbecomelesscreditshy
worthyTheseeconomistspointoutthatthehighlevelof
uncertainty about future economic conditionsduring the
Crisisratchetedupthedefaultriskofeventhemostrelishy
ableclientsThisinterpretationofthedeclineinbanklendshy
ingimpliesthatnoamountofcapitalwouldhaveinduced
banksasagrouptolendmorebecauseallthegoodloans
werebeingmade
Figure shows data on the quantity of bank lending
Jan 20
08
Mar
2008
M
ay 20
08Ju
l 200
8Se
p 2008
Nov 20
08Ja
n 2009
Jan 20
09
May
2009
Jul 2
009
Sep 20
09Nov
2009
Copyrighted Material
InTroDuCT Ion bull 15
1050
1100
1150
1200
1250
1300
FigureCommercialandIndustrialLoansbyuSCommercialBanks2008ndash9inBillionsofDollarsSourceFederalreserve
intheunitedStatesin2008and2009Startinginoctober
2008therewasaspikeinlendingfollowedbyaprotracted
declineVVChariLawrenceChristianoandpatrickKehoe
takethespikeatfacevalueinaggregatebankslentmore
ataminimumthebankingsystemasawholemdashasopposed
to individual banksmdashwas not deleveraging to overcome
loss of capital9 Victoria Ivashina and David Scharfstein
notethatmuchoftheincreaseinbanklendingwasinvolshy
untaryonthepartofthebankstheresultofdrawdowns
byborrowersonexistinglinesofcredit10 Theyalsoshow
thatbanks thatweremorevulnerable todrawdownsbeshy
causetheywereinmoresyndicateswithLehmanreduced
subsequent lending more and conclude that there was
indeed a genuine contraction in the effective supply of
bankcredit
Copyrighted Material
1 bull CHapTer 1
economistswillargueabouttheeventsoftheWorldFishy
nancialCrisisforyearstocomeInfactwestillargueabout
theGreatDepressionnoneoftheanalysisbehindourrecshy
ommendationshoweverdepends onhow these debates
aresettledForexamplenomatterhowcapitalshyconstrained
thebankingsystemreallywasinthefallof2008ourproshy
posalsforchangesthatmakesuchconstraintslessbinding
andgivepolicymakersbettertoolswhentheyfearcapital
constraintsremainvalid
What Was Wrong WIth the FInancIal system durIng the crIsIs
The Crisis revealed a number of serious problems with
ourfinancialsystemSomehadbeeninthebackgroundall
alongothersdidnotappearuntiltheCrisisInthisbook
weemphasizefourcategoriesofproblemsconflictsofinshy
terestknowntoeconomistsasagencyproblemsthediffishy
cultyofapplyingstandardbankruptcyprocedurestofinanshy
cialinstitutionstheemergenceofamodernformofbank
runsandtheinadequacyoftheregulatorystructurewhich
hadnotkeptupwithrecentfinancialinnovation(Infact
muchinnovationservedtoescaperegulations)
Conflicts of Interest Agency Problems
Conflictsofinterestthatcannotberesolvedeasilybyconshy
tractsormarketsoccurthroughouttheeconomybutthey
Copyrighted Material
InTroDuCT Ion bull 17
canbeparticularlyharmfulinthefinancialsystemThere
areseveralreasonsFirstmanyfinancialtransactionsand
contractsinvolveaprincipalsuchasaninvestororshareshy
holderaskingatradermanagerorotheragenttoacton
hisorherbehalfSecondmostfinancial transactions inshy
volvehighlyuncertainfuturepayoffsandinmanytransacshy
tionsonepartyisbetterinformedaboutthepayoffsthan
the otherThird the high volatility of the future payoffs
oftenmakesithardtoassesswhethertheoutcomeofafishy
nancialtransactionisduetotheagentrsquoseffortsorluckand
fourththesumsinvolvedcanbehuge
Someproprietarytradersforexampleearnalotwhen
their tradesdowellbuttheirpersonal lossesare limited
whentheirtradesdopoorlyBecauseoftheasymmetricnashy
tureoftheircompensationthesetraderscanincreasetheir
expectedincomebytakingriskierpositionsThisproblem
isdramaticallyillustratedbyperiodiccasesinwhichldquorogue
tradersrdquoincurlossesthatarebigenoughtodamageoreven
destroy large financial institutions In 1995 nick Leeson
broughtdownBaringsBankwitha$1billionlossandin
2008itwasrevealedthatJeacuterocircmeKervielhadseverelydamshy
agedSocieacuteteacuteGeacuteneacuteralewithalossofover$7billion
Conflictsofinterestorldquoagencyproblemsrdquoalsoexistat
manyotherlevelswithinthefinancialsystemShareholders
offinancialinstitutionshaveaconflictofinterestwiththe
bankrsquosseniorexecutivesespeciallywhenthoseexecutives
arerewardedforgoodperformancebutdonothavealarge
fractionoftheirwealthtiedupinthesharesofthebank
Manyfinancialinstitutionshavelargequantitiesofdebt
Copyrighted Material
18 bull CHapTer 1
which creates a conflict of interest between the bankrsquos
creditorsanditsshareholdersShareholdershaveanincenshy
tivetoauthorizeexcessivelyriskyinvestmentsforexample
especiallyafterabankhasincurredlossesthaterodethe
valueoftheshareholdersrsquoclaimThegainsontheserisky
investmentswillaccruelargelytoshareholderswhilethe
losseswillmostlybebornebycreditorsTheconflictwith
creditorsalsoreducestheincentivesfortheshareholders
of troubled institutions to raisenewcapitalbecause that
wouldstrengthen thepositionofcreditorswhilediluting
theshareholdersrsquopositionThisldquodebtoverhangrdquoproblem
waswidelycitedduringtheWorldFinancialCrisiswhen
many banks that were insolvent or close to insolvency
seemedreluctanteithertoraisenewcapitalortoreduce
theirrisksbysellingdistressedsecurities11
atthehighestlevelthereisaconflictofinterestbetween
societyasawholeandtheprivateownersoffinancialinshy
stitutions Because robust financial institutions promote
economicgrowthandemploymentduringfinancialcrises
governmentsoftenrescuetroubledfirmstheyperceiveto
be systemically importantThe result is privatized gains
andsocializedlossesIfthingsgowellthefirmsrsquoowners
andmanagersclaimtheprofitsbutifthingsgopoorlysoshy
cietysubsidizesthelosses
The candidates for government bailouts are popularly
describedasldquotoobigtofailrdquoMorepreciselytheargument
for government supportmdashwhich many economists chalshy
lengemdashisaboutfirmsthataretoosystemicallyimportantto
failInits200annualreporttheeuropeanCentralBank
describedsystemicriskasldquoTheriskthattheinabilityofone
Copyrighted Material
InTroDuCT Ion bull 19
institutiontomeetitsobligationswhenduewillcauseother
institutions to be unable tomeet their obligationswhen
dueSuchafailuremaycausesignificantliquidityorcredit
problemsandas a resultcould threaten the stabilityof
or confidence in marketsrdquo Systemically important firms
arethosewhosefailurecouldposealargethreattothestashy
bilityoforconfidenceinmarketsThesefirmsarelikelyto
belargebuttheyalsotendtohavecomplexinterconnecshy
tionswithotherfinancialinstitutions
Tooshybigshytoshyfailpoliciesoffersystemicallyimportantfirms
theexplicitorimplicitpromiseofabailoutwhenthingsgo
wrongThesepoliciesaredestructiveforseveralreasons
Firstbecause the possibility of a bailoutmeans a firmrsquos
stakeholders claim all the profits but only some of the
lossesfinancialfirmsthatmightreceivegovernmentsupshy
porthaveanincentivetotakeextrariskThefirmrsquosshareshy
holderscreditorsemployeesandmanagement all share
thetemptationTheresultisanincreaseintherisksborne
bysocietyasawhole
Secondthesepoliciesencouragesmallerfinancialinstishy
tutionstoexpandortobecomemorecloselyinterconnected
with other firms so they move under the tooshybigshytoshyfail
umbrellaFirmshaveanincentivetodowhateverittakes
tomakepolicymakersfeartheirfailurecreatingthevery
fragilitythegovernmentwishestoavoidBeliefthatagovshy
ernmentrescuewillprotectafinancial institutionrsquoscredishy
tors inacrisisalsogivesafirmacompetitiveadvantage
loweringitscostoffinancingandallowingittoofferbetter
prices to its customers than its fundamental productivity
warrants
Copyrighted Material
20 bull CHapTer 1
Thirdinefficientfirmsthatcannotcompeteontheirown
shouldfailotherwisefirmshavelessincentivetobecome
andstayefficientagovernmentpolicythatpropsupinshy
efficientfirmsiswastefulanddestructiveallowingthese
firmstofailfreesupresourcesandprovidesopportunities
formoreefficientandinnovativecompetitorstoflourish
Fourthandmostgenerallycapitalismisunderminedby
policiesthatprivatizegainsbutsocializelossesGovernment
guaranteedinstitutionscanbecomegovernmentruninstishy
tutionsallocatingcreditforexampletomaximizepolitical
gainratherthaneconomicwelfare
The conflictbetween society and theownersoffinanshy
cialfirmsbecomesmoreseriousduringseverecriseswhen
manyfinancialinstitutionsareclosetoinsolventIt isthe
primemotivationforourregulatoryproposalsbutseveral
ofthelowershylevelconflictswehavedescribedarerelevant
becausetheymagnifytheriskbornebysocietyasawhole
Theselfshyservingbehaviorthatmanyofourrecommenshy
dations targetmdashwhether by traders senior management
orthefirmrsquosownersmdashneednotbestrategicintentionally
maliciousorevenconsciousConsideratraderwhoinadshy
vertentlydevelopsaninvestmentstrategywithhighlyprobshy
ablegainsandimprobablebutlargelossesLikeafirmthat
hassoldearthquakeinsurancethestrategymayproducea
longstringofimpressivereturnsbeforeoneyearoflosses
wipesoutmanyyearsofprofits12 Ifsoduringthegood
yearsthetraderwillbecelebratedforhisorherbrilliance
rewarded with large bonuses and given more resources
to manageMany sophisticated traders and hedge funds
Copyrighted Material
InTroDuCT Ion bull 21
werenotawareoftheldquoearthquakerisksrdquoinherentinmany
of theirstrategiesSimilarlywhenfirmstakeactionsthat
increasethelikelihoodofagovernmentbailoutinthenext
financialcrisisthemarketrewardsthemwithalowercost
of capitalas firms become too big to fail for example
the implicit government guarantee reduces the riskiness
of their debt and lowers the interest rate demanded by
theircreditorsaCeoworkingtomaximizefirmvaluemay
notevenrealize the importanceof thegovernmentguarshy
anteebut a Darwinian process will encourage behavior
thatexploitsit
Bankruptcy and Resolution Procedures
Itisimpossibletowriteafinancialcontractthatspecifies
everypossiblecontingencyInsteadcontractsrelyonbankshy
ruptcytodetermineoutcomesincertainbadandunlikely
statesoftheworldInbankruptcycontrolofafirmistransshy
ferredfromtheshareholderswhonolongerhaveastake
inlossesbecausetheirsharesareworthlittletothedebtshy
holders It is in societyrsquos interest to develop bankruptcy
proceduresthatmaximizethepostshybankruptcyvalueofa
firmrsquosassetsInparticularsocietyshouldavoidthedestrucshy
tionofvaluethatoccurswithdisorderlyliquidation
Disorderlyliquidationoffinancialinstitutionsisparticushy
larly costlyFirstvaluableknowledge that the institution
hasaccumulatedaboutitscounterpartiesmdashborrowerstradshy
ingpartnersandsoonmdashcandisappearastheinstitution
losesemployeesandceasestooperatenormallyFinancial
Copyrighted Material
22 bull CHapTer 1
economistshavefoundthatthecollapseofabankhasamashy
terialadverseimpactonmanyofitsborrowers1 Second
the prospect of a disorderly liquidation makes it more
likelythatatroubledfinancialinstitutionwillsufferarun
by creditors who conclude they are better off claiming
whatmoney theycan todayrather thanwaiting through
protracted liquidation proceedings Third ldquofire salesrdquo of
specializedassets inadisorderly liquidationcandepress
prices and thereby spread problems to other holders of
theassetclassFourthdisorderlyliquidationincreasesthe
uncertaintyabouttheimpactofafinancialinstitutionrsquosfailshy
ureonitscounterpartiesandotherclaimholdersBecause
financialfirmsaretightlyinterconnectedthisuncertainty
canprecipitateorintensifyafinancialcrisis1
In theunitedStatesthestandardbankruptcycodealshy
lowsbothforliquidationofafirmandthesaleofitsassets
(Chapter7)andforcontinuedoperationofafirmunder
the supervision of a bankruptcy judgewho protects the
firmfromcreditorsrsquoclaimswhileareorganizationplanis
approved(Chapter11)Theseproceduresappeartowork
wellfornonfinancialcorporationsbutnotsowellforfinanshy
cialorganizationsTheChapter11approachofseparatinga
firmrsquosfinancialaffairsfromitsnonfinancialbusinessactivishy
tiesisinfeasiblewhenthebusinessofthefirmisfinancial
transactionsFurthermoremanyfinancialinstitutionsrely
heavily on shortshyterm debtpossibly as a valuable discishy
plineonbankexecutiveswhocanrapidlychangetherisks
theirfirmstakeThismakesfinancialfirmsvulnerabletoa
rapidwithdrawalofshortshytermcreditthatislikelytooccur
beforeanyeventthatwouldtriggerbankruptcy
Copyrighted Material
InTroDuCT Ion bull 2
Wearguebelowthatthereisaneedforaspecialresolushy
tionprocedurethatcanbeappliedtolargeinsolventfinanshy
cialinstitutionsWealsoadvocateregulatorychangesthat
would push financial firms towardmore resilient capital
structures
Bank Runs
Classicbank runs inwhichdepositors race towithdraw
their funds before a bank failswere one of the central
contributors to theGreatDepressionDeposit insurance
whichwasintroducedaftertheDepressiontocounterthis
destructiveprocessmadedemanddepositsoneofthemost
stableformsofbankfinancingduringtheWorldFinancial
CrisisManyfinancialinstitutionshoweversufferedamodshy
ernversionofbankruns
Banksespeciallythosewithinvestmentbankingactivishy
tiestypicallyfinanceasignificantfractionoftheirbusiness
withovernightcommercialpaperreposandothershortshy
terminstrumentsInnormaltimesbanksrolloverthisdebt
asitmaturestakingnewloanstopayofftheoldInacrishy
sishoweveruncertaintyaboutwhetheratroubledinstitushy
tionwouldbeabletopayoffitscreditorstomorrowcauses
lenderstostopextendingcredittodayThusshortshytermfishy
nancingcanleadtoarunthatissimilartoaclassicrunon
deposits
even some secured creditors participated in runs durshy
ingtheWorldFinancialCrisisBanksoftenuserepurchase
agreements to borrow money securing the loan by givshy
ingthelenderafinancialassetsuchasaTreasurybond
Copyrighted Material
2 bull CHapTer 1
ascollateralBecausetheyareovershycollateralizedwithasshy
setsworthperhaps$105guaranteeingevery$100inloans
lendersviewldquoreposrdquoasasafewaytoextendcreditWhen
credit markets froze during the Crisis however lenders
worried that retrieving collateral and selling itwouldbe
difficultandnotworththesmallinterestonanovernight
loanasaresultatvarioustimesduringtheCrisismany
investmentbankshaddifficultyrollingovereventheirseshy
cured loanseven relatively healthy financial institutions
werehamperedbythetroubleintherepomarketafteraushy
gust2007asthemarketbecamemoreandmoreuncertain
about the prices securities would fetch in a forced sale
these institutions found they could borrow less and less
withthesamecollateral15
prime brokerage accounts also saw a runshylike withshy
drawalbycustomersManylargebankshaveprimebrokershy
agegroupsthatassisthedgefundsandotherinstitutionalinshy
vestorsbyprovidingfinancingsecuritieslendingclearing
custodial servicesandoperational supportInexchange
thefundspayfeesandcriticallypostcollateraltosecure
theirloansWithsomerestrictionsthatweexplaininChapshy
ter10theprimebrokercanthenusethecollateralinits
ownbusinessinsomecasescomminglingitwiththefirmrsquos
ownassetsDuringtheCrisishedgefundsmonitoredthe
financial wellshybeing of their prime brokers and like deshy
positorsintheDepressionfledwiththeircollateralatthe
firstsignoftroubleBearStearnsforexamplehadalarge
prime brokerage business according to press accounts
oneofthelargesthedgefundsthatusedBearStearnsasa
Copyrighted Material
InTroDuCT Ion bull 25
primebrokerrenaissanceTechnologieswithdrew$5bilshy
lionofcashintheweekthefirmfailedWithsuchoutflows
it is not surprising that Bear Stearns ran out of money
eventhoughithadmorethan$18billionincashaweek
earlier
Likeclassicbankrunsmodernbankrunsarebothdeshy
structiveandselfshyfulfillingConcernthatabankmightbe
in trouble spurs its creditors and counterparties towithshy
draworwithholdtheircapitalasaresultevenrumorsofa
problemmaybeenoughtodestroyaviableinstitutionThe
importanceofmodernbankrunsduringtheWorldFinanshy
cialCrisisisarecurringthemethroughoutthebookand
wemakeseveralproposalsthatareintendedtoreducethe
frequencyofsuchevents
The Inadequacy of the Regulatory Structure
TheWorldFinancialCrisismadeitclearthatfinancialinnoshy
vationhadoverwhelmedexistingfinancialregulationsnoshy
tableexamplesincludeaIGrsquosdecisiontosellanextremely
large amount of credit default swaps on subprime debt
tobanksintheunitedStatesandabroadtheholdingof
Lehmanpaperbymoneymarketfundsparticularlythereshy
serveprimaryFundthecomplexityofthederivativebooks
atLehmanandotherinvestmentbanksandthedifficultyof
simultaneouslyapplyingseveralcountriesrsquobankruptcycodes
tothesubsidiariesofmultinationalfinancialinstitutions1
Thereisatradeshyoffbetweenfinancialinnovationandstashy
bilityInnovationcanimprovethefinancialsystemrsquosability
Copyrighted Material
2 bull CHapTer 1
toallocateresourcestotheirhighestvaluedusebutitcan
alsoreducethestabilityofthesystemThechallengeisto
developregulationsthatimprovestabilitywithoutstifling
innovation In addition regulation often leads to innoshy
vations designed to evade the regulationswhich makes
thefinancialsystemmorefragileForexamplemanyofthe
specialshypurposevehiclesthatimplodedintheCrisiswere
createdtogetaroundcapitalrequirements
In many countries the response of regulators to the
World Financial Crisis was hampered by the fragmented
nature of their regulatory systems Financial regulations
are typically designed to ensure thehealth of individual
institutionsratherthanthefinancialsystemasawholeIn
thisbookwearguethatsystemicregulationisanimporshy
tantfunctionthatrequiresaspecialmandateandthatthe
central bank is particularly well equipped to fulfill this
function
Finallyeffectivefinancialregulationrequiresthatpolitishy
ciansandultimatelythepublichaveanadequateundershy
standing of the financial system The political turmoil
surroundingtheCrisissuggeststheimportanceofdissemishy
natingexpertknowledgeaboutfinancetoabroaderaudishy
enceThisisoneofourmotivationsforwritingthisbook
What Were the orIgIns oF the World FInancIal crIsIs
LiketheoriginsoftheFirstWorldWarthecausesofthe
Crisiswillbedebatedbyscholarsformanyyears
Copyrighted Material
InTroDuCT Ion bull 27
Most observers agree that the strong runshyup and subshy
sequentsharpdeclineinthepricesofstockshousesand
otherfinancialassetsindevelopedcountrieswasanimporshy
tantcatalystfortheCrisisThereisdisagreementhowever
aboutwhetherthispatterninpricesistheresultofrational
investorbehaviororldquoirrationalbubblesrdquo
SomearguethattherunshyupbeforetheCrisiswasdriven
by investorswhoknowingly acceptedunusually low exshy
pectedreturnsandtheyofferseveralpossiblereasonswhy
Firsttherewasasurgeofsavingsinemergingcountries
drivenbyacombinationofrapideconomicgrowthanddeshy
mographicsperhapsbecauseofadesiretoaccumulateforshy
eignreservesintheaftermathoftheasiacrisisof1997ndash98
muchof thiswealthwas invested indevelopedmarkets
Secondfinancialmarketswereunusually tranquilduring
200to200Withlowvolatilityinvestorsmayhavesettled
for a low risk premiumThird influenced by fears of a
Japaneseshystyledeflation resulting from themarketdownshy
turnof2000ndash2001andbyabeliefthattheyshouldnottry
to usemonetary policy to counteract rising asset prices
central bankers in the united States maintained a loose
monetarypolicythroughouttheperiod17andfromthisrashy
tionalviewofinvestorstheplungeinassetpricesthatacshy
companiedtheCrisiswascausedbybadnewsaboutfuture
cashflowsunexpectedincreasesinthereturnsrequiredby
investorsorboth
otherssuggestamoredirectexplanationThehighprices
before theCrisisweredrivenby an irrational belief that
prices would continue to rise and the collapse of asset
priceswastheinevitableresultofthismistakeWhatever
Copyrighted Material
28 bull CHapTer 1
theexplanationthesharpdropinassetpricesbothconshy
tributedtoandwasasymptomoftheCrisis
other commentators argue that the financial system
becamevulnerablebecausemanymarketparticipantsasshy
sessedrisksinaccuratelyduringtheperiodleadingupto
theWorldFinancialCrisisConsumersbanksandinvestors
ingeneralunderestimatedtheriskofhousepricedeclines
increasingthepricestheywerewillingtopayforrealesshy
tatethecredittheywerewillingtoextendandthevaluashy
tionsofbanksthatextendedsuchcreditBanksputmuch
weight on the recent pastwhen they estimated value at
riskwhichledthemtoconcludethatthelevelofriskwas
lowandthattherewaslittledownsidetohavinghighleshy
verageothermarketparticipantsdidnotfullyappreciate
thathighliquiditywassuppressingvolatilityandthatthe
processmightreversewithliquiditydecreasingandvolatilshy
ityincreasing
More generally the high level of financial innovation
driveninpartbythedecliningcostofinformationtechnolshy
ogymadeithardforriskassessmenttokeeppacewiththe
evolvingfinancialsystem18Thebenignenvironmentofthe
creditboomexacerbatedthisproblembytemptingfinanshy
cialinstitutionstounderinvestinriskmanagement
uSpolicymakersalsocontributedtotheseverityofthe
CrisisbypushingFannieMaeandFreddieMactoincrease
theavailabilityofmortgagefundingtoborrowerswithquesshy
tionableabilitytorepaytheirmortgagesasaresultofthis
pressure both agencies relaxed their standards for the
mortgages they purchased and guaranteedThe demand
Copyrighted Material
InTroDuCT Ion bull 29
forhomesbyborrowerswhoqualifiedformortgagesbeshy
causeoftheselowerstandardspusheduppricesandthe
defaultbymanyofthemduringtherecessioncontributed
tothedropinhomeprices
Thepanicandruninthefallof2008remainthecentral
distinguishingfeaturesoftheWorldFinancialCrisisasset
priceshave risenand fallenbeforeand theworldeconshy
omyhasbornelargefinancial lossesmanytimeswithout
suchasevereeconomicoutcomeConverselylossesfrom
completelydifferentunderlyingsourcesmdashcommercialreal
estateorperhapssovereigndefaultsmdashcouldcauseasimilar
catastrophe if theyagainprovoke tooshybigshytoshyfailchaosor
runs
Thisbookdoesnotseektoprovideacompletediagnosis
oftheWorldFinancialCrisisnordoesittakeastandonthe
relativeimportanceofthecontributingfactorslistedabove
ratherwebelieveourrecommendationswillhelpprevent
ormitigatefuturecriseseventhoughwedonotfullyundershy
standallthecausesofthelastone
CarmenreinhartandKennethrogoff amongothershave
pointedoutthatfinancialcriseshaveoccurredthroughout
thehistoryofcapitalismandthatthesecrisessharemany
commonpatterns19 Thelessonwedrawfromthisisthat
noacceptablesetofregulationscanpreventmarketparticishy
pantsfrommakingmistakesthatcreateeconomicinstability
ourpurposeinthisbookisinsteadtosuggestregulatory
reformsthatwillmakethesystemmorestabledespitethe
mistakesthataresuretocome
Copyrighted Material
InTroDuCT Ion bull 5
steppedintopreventthebankruptcyofBearStearnsonly
monthsbefore
WithindaystheuSgovernmentrescuedamericanInshy
ternationalGroupaIGhadwrittenhundredsofbillionsof
dollarsofcreditdefaultswapswhichareessentiallyinsurshy
ancecontractsthatpayoffwhenaspecificborrowersuch
as a corporation or a specific security such as a bond
defaultsaseconomicconditionsworsenedanditbecame
increasingly likely thataIGwouldhave topayoffonat
leastsomeofitscommitmentstheswapcontractsrequired
thefirmtopostcollateralwithitscounterpartiesaIGwas
unable to make the required payments Goldman Sachs
wasaIGrsquosmostprominentcounterpartyandGoldmanrsquosdeshy
mands forcollateralwerean importantpartofaIGrsquosdeshy
miseThecost to taxpayersofgovernmentassistance for
FannieMaeFreddieMacandaIGisnowprojectedathunshy
dredsofbillionsofdollars
ThatsameweekTreasurySecretaryHankpaulsonanshy
nounced thefirstTroubledassetrelief program (Tarp)
askingCongressfor$700billiontobuymortgagebacked
securities Federal reserve Chairman Ben Bernanke and
presidentGeorgeWBush also gave important speeches
warningofgravedangertothefinancialsystemTheSecushy
ritiesandexchangeCommissionbannedtheshortshyselling
of several hundred financial stocks causing pandemoshy
niumintheoptionsmarketwhichreliesonshortshyselling
tohedgepositionsandamonghedgefundsthatemployed
longshyshortstrategies2
Theturmoilof theweekdidnotstopthereInterbank
lending declined sharply the commercial paper market
Copyrighted Material
bull CHapTer 1
slowed to a crawl and there was a run on the reserve
primaryFundamoneymarketmutualfundunlikeother
mutual funds money market funds maintain a constant
sharepricetypically$1byusingprofitsinthefundtopay
interestratherthantoincreasesharevaluesBecausethe
sharepriceisfixedat$1lossesthatpushafundrsquosnetasshy
setvaluebelow$1persharecantriggerarunasinvestors
rushtoclaimtheirfulldollarpaymentsandforcethelosses
ontootherinvestorsThereserveprimaryFundwhichhad
morethan1percentofitsassetsincommercialpaperisshy
suedbyLehmansufferedjustsucharunonSeptember1
2008afterLehmandeclaredbankruptcythefundrsquosnetasshy
setvaluedroppedto$097pershareandinvestorswithshy
drewmorethantwoshythirdsofthereserveFundrsquos$bilshy
lioninassetsbeforethefundsuspendedredemptionson
September17Concernspreadtoinvestorsinothermoney
marketfundsandtheywithdrewalmost10percentofthe
$5trillioninvestedinuSmoneymarketfundsoverthe
nexttendaysTostabilizethemarketthegovernmenttook
theunprecedented stepof offering a guarantee to every
uSmoneymarketfund
In normal timesany one of these eventswould have
beenthefinancialstoryoftheyearyettheyallhappened
inthesameweekinSeptember2008althoughmuchcomshy
mentaryandpopularpresscoverageblamestheWorldFishy
nancialCrisisentirelyonthegovernmentrsquosdecisiontolet
Lehmanfailsuchananalysisignorestheevidentcontribushy
tionsofthemanyothermomentouseventsthatoccurred
duringthatweek
Copyrighted Material
InTroDuCT Ion bull 7
October 2008 The Bank Bailout and Credit Crunch
Byearlyoctober2008theuSgovernmentrealizedthat
theTarpplantobuymortgagebackedsecuritiesonthe
openmarketwasnotfeasibleInsteadtheTreasuryDepartshy
mentusedtheappropriatedmoneytopurchasepreferred
stockinlargebanksandtoprovidecreditguaranteesand
othersupportThoughnowrememberedastheldquobankbailshy
outrdquotheTarppurchaseswerenotsimplyatransfertofailshy
inginstitutionsHealthybankswerealsoforcedtoaccept
capital inanattempt tomask thegovernmentrsquosopinions
aboutwhichbankswereinmoretroublethanothersMany
policymakersseemedtothinkthatbankswerenotlending
becausetheyhadlosttoomuchcapitalandwerenotable
orwillingtoraisemoreThusthegoalseemedtobenotto
savethebanksbuttorecapitalizethemsotheywouldlend
againIn theendthe former resultwasachievedmdashnone
of the large banks that receivedTarp funds failedmdashbut
thelatterarguablywasnotWeanalyzetheseissuesindeshy
tailbelowandrecommendsomealternativestructuresand
policiesthatwebelievewouldhaveworkedbetter
DuringmuchoftheWorldFinancialCrisistheFederal
reserveexperimentedwithawiderangeofnewfacilities
beyonditstraditionaltoolsofinterestratepolicyandopen
market operations The Fed lent broadly to commercial
banksinvestmentbanksandbrokershydealersandendedup
buyingcommercialpapermortgagesassetbackedsecurishy
tiesandlongshytermgovernmentdebtinanefforttolower
interestratesinthesemarketsByDecember2008excess
Copyrighted Material
8 bull CHapTer 1
reservesinthebankingsystemhadgrownfrom$billion
before the Crisis to over $800 billionThese actions are
notafocusofouranalysisbuttheysurelyhelpedprevent
theCrisisfromturningintoanotherGreatDepressionat
aminimumtheyeliminatedmostbanksrsquoconcernsabout
sourcesofcash
Bankfailuresineuropeinthefallof2008ledtomore
directbailoutsThenetherlandsBelgiumandLuxembourg
spent$1billiontopropupFortisamajoreuropeanbank
with about $1 trillion in assets The netherlands spent
$1billiontobailoutInGabankingandinsurancegiant
Germanyprovideda$50billionrescuepackageforHypo
realestateHoldingsSwitzerlandrescueduBSoneofthe
tenlargestbanksintheworldwitha$5billionpackage
Iceland took over its three largest banks and its subseshy
quent difficulties highlight what happens when the cost
ofbailingoutacountryrsquosbanksexceedsthegovernmentrsquos
resources
Throughoutthefallof2008therewasaldquoflighttoqualityrdquo
inmarketsaroundtheworldWheninvestorsareworried
aboutdefaulttheydemandhigherinterestratesYieldson
securitieswithanyhintofdefaultriskrosesharplyespeshy
ciallyinthefinancialsector
Theflighttoqualityisapparentintheinterestrateson
commercialpaperinFigure1Commercialpaperisshortshy
termunsecureddebtissuedbybanksandotherlargecorshy
porationsandisanimportantpartoftheirfinancingThe
commercialpaperratesforfinancialinstitutionsandlowershy
creditqualityborrowers jumped inSeptemberandoctoshy
berbutafterasmallincreasetherateforlargecreditworshy
Copyrighted Material
InTroDuCT Ion bull 9
7
6
5
4
3
2
1
0
A2P2 Nonfinancial
AA Financial
AA Nonfinancial
Jul 2008 Aug 2008 Sep 2008 Oct 2008 Nov 2008 Dec 2008
Figure1annualizedpercentYieldson0shyDayHighshyQuality(aa)FinancialandnonfinancialCommercialpaperandMediumshyQuality(a2p2)nonfinancialCommercialpaperinpercentaugusttoDecember2008SourceFederalreserve
thynonfinancialcompaniesactuallydeclinedTherateon
uSTreasurybillswhichareviewedas themost secure
investmentalsofellthethreeshymonthTreasurybillrateacshy
tuallydroppedtozeroforbriefperiodsinnovemberand
December2008
the run on the shadoW BankIng system
Thepanicthatstruckfinancialmarketsinthefallof2008
hasbeencharacterizedasarunontheshadowbankingsysshy
temandwithgoodreasonBeforetheCrisismanybonds
mortgagebackedsecuritiesandother credit instruments
Copyrighted Material
10 bull CHapTer 1
wereheldbyleveragednonshybankintermediariesincluding
hedgefunds investmentbanksbrokeragefirmsandspecialshy
purposevehiclesManyoftheseintermediarieswereforced
toldquodeleverrdquoduringoctoberandnovembersellingassetsto
repaytheircreditors
Hedgefundsandotherleveragedintermediariesusethe
securitiesintheirportfoliosascollateralwhentheyborrow
moneyDuringtheWorldFinancialCrisismanywarylendshy
ersdecidedthecollateralborrowershadpostedbeforethe
Crisis was no longer sufficient to guarantee repayment
Whenthelendersdemandedeithermoreorbettercollatshy
eralmanyborrowerswereforcedtoselltheirleveredposishy
tionsandrepaytheirloansTheresultwasareductionin
thequantityofassetstheyheldandintheirleverageInadshy
ditionhedgefundsandotherintermediariessufferedlarge
withdrawalsbypanickycustomersagainforcingthemto
sellsecuritiesonthemarketTheassetsbeingsoldweregenshy
erallyacquiredbyindividualinvestorsthefederalgovernshy
mentorcommercialbankswhichasagroupfinancedmost
oftheirpurchasesbyborrowingfromthegovernment
The financing difficulties faced by arbitrageurs and lishy
quidity providers are apparent in a series of fascinating
market pathologies In financialmarkets there are often
manydifferentwaystoobtainthesameoutcomeaninvesshy
torcanusemanydifferentcombinationsofsecuritiesfor
exampletorisklesslyconvertdollarstodayintodollarsin
sixmonthsThe actionsof arbitrageursusuallykeep the
costsof thedifferent approaches closely alignedDuring
thefallof2008thecostsoftendivergedwiththeapproach
thatrequiredmorecapitaltypicallycostingless
Copyrighted Material
InTroDuCT Ion bull 11
Theprincipleofcoveredinterestparityforexamplesays
thataftereliminatingexchangerateriskriskshyfreeinvesting
shouldhavethesamereturnineverycurrencyaninvestor
whowantstoinvestdollarstodayandreceivedollarsinthe
futureusuallybuysauSbondHecouldaccomplishthe
samethingbyconvertinghisdollarsintoeurosinvesting
inarisklesseurobondandlockingintheconversionof
theeuropayoffbackintodollarswithaforwardcontract
Sincebothstrategiesconvertdollarstodayintodollarsin
thefuturetheyshouldhavethesamereturn5 Supposeinshy
steadthereturnontheuSbondislowerThenanarbitrashy
geurcouldborrowmoneyintheunitedStatesatthelower
rateinvestitintheeurotransactionatthehigherrateand
makeaprofit
During the Crisis covered interest parity violations as
largeas20basispoints(020percent)emergedThismay
seemtrivialbutinnormaltimestheseviolationsrarelyexshy
ceed 2 basis pointsMoreover traders can usuallyldquolever
uprdquotransactionslikethisandmakealargeprofitButthatrsquos
thecatchmdashhedgefundsbrokeragesandinvestmentbanks
werebeingforcedtodeleverduringtheCrisisand20basis
points is not enough to enticemany longshyonly investors
to replace theuSbond theyarecurrentlyholdingwith
aforeignbondandsomeseeminglycomplicatedcurrency
transactions
other recent research finds similar disruptions of the
normalpricing relations linking (1)Treasurybondscorshy
poratebondsandcreditshydefault swaps (aTreasurybond
shouldbethesameasacorporatebondplusacreditdefault
swapmdashexceptforliquidityfinancingandCDScounterparty
Copyrighted Material
12 bull CHapTer 1
risk)(2)fixedandfloatingrate investments (asequence
ofshortshyterminvestmentsplusacontractswappingafloatshy
ing interest rate forafixed interest rateshouldhave the
same payoff as a fixed rate investment) () convertible
bondsdebtandequity()newlyissuedldquoonshytheshyrunrdquoand
recently issuedldquooffshytheshyrunrdquoTreasury bondswhich have
essentially the same payoff but differ in liquidity and
(5)stockandoptionpriceswhicharelinkedbywhatfishy
nancialeconomistscalltheputshycallparityrelation7
Thebreakdownofthesenormalpricingrelationsdoes
littledirectharm to the restof theeconomya20shybasisshy
pointviolationofcoveredinterestparityhaslittleeffecton
auSexporterusingcurrencycontractstolockintherate
atwhichitcanconvertfutureJapaneserevenuebackinto
dollarsTheseviolationsshowhoweverthatmarketswere
notfunctioningnormallyInparticulartheysuggestthere
wasnotmuchcapitalavailabletoprovideliquiditytobuyshy
ersandsellersanyoneneedingtosellsecuritiesquicklyin
suchamarketmdashsuchasafinancialinstitutiontryingtoreshy
duceitsriskmdashwasnotlikelytogetagoodprice
lendIng BankIng and the recessIon
Duringthefallof2008outputandfinancingactivityconshy
tracted sharply Commercial paper corporate bond and
equityissuanceallfelldramaticallyasdidmortgageorigishy
nations
originations of most types of asset backed securities
alsoslowedtoatrickleManybanksintheunitedStates
Jan 20
04Ju
l 200
4Ja
n 2005
Jul 2
005
Jan 20
06Ju
l 200
6Ja
n 2007
Jul 2
007
Jan 20
08Ju
l 200
8Ja
n 2009
Jul 2
009
Copyrighted Material
InTroDuCT Ion bull 1
0
50
100
150
200
250
Figure2assetBackedSecuritiesIssuedintheunitedStatesJanushyary200toDecember2009BillionsofDollarsperMonthSourceFederalreserve
and other countries no longer hold much of the credit
theyissueTheyhavemovedinsteadtoanldquooriginateand
sellrdquomodel inwhich theybundle together similar loans
suchasjumbomortgagescommercialloansstudentloans
or credit card debt and sell them to investors as asset
backedsecuritiesnewissuesofthesesecuritiesessentially
stopped inoctoberandnovember2008Figure2shows
that the amount of asset backed securities issued in the
united States rose from$288 billion in January 2000 to
$85billioninJune2007andthenplungedto$102bilshy
lioninSeptember2007IssuanceintheunitedStatesconshy
tinued to decline over the next year eventually falling
to only $87 billion in october 2008 and $ billion in
Copyrighted Material
1 bull CHapTer 1
novembermdashjust2percentofthevolume18monthsearlier
onlymortgagespooledbyFannieMaeandFreddieMac
withanexplicitgovernmentguaranteeandsubjecttohuge
Federalreservepurchasescontinuedtoflowtothemarket
There isplentyof anecdotal and surveyevidence that
banklendingalsodriedupduringtheCrisisForexample
loanofficerssurveyedbytheFederalreservereportedthat
credit conditionsprogressively tightenedduring2008In
asurveyabouttheirperceptionsofcreditconditionsand
corporatedecisionsasoflatenovember2008morethan
halfofthechieffinancialofficersoflargeamericanfirms
whorespondedsaidthattheirfirmswereeitherldquosomewhat
orveryaffectedbythecostoravailabilityofcreditrdquo8
There is a lively and fundamentally important debate
about why the quantity of lending fell Some financial
economists argue that banks wanted to lend more but
wereunable todosobecausetheyfacedbindingcapital
constraintsInthisviewinformationcostsandotherfricshy
tionsintheloanoriginationprocesskeptcustomersfrom
movingtolessconstrainedbanks
othersarguethattheprimaryreasonbankswereunwillshy
ingtolendisthattheircustomershadbecomelesscreditshy
worthyTheseeconomistspointoutthatthehighlevelof
uncertainty about future economic conditionsduring the
Crisisratchetedupthedefaultriskofeventhemostrelishy
ableclientsThisinterpretationofthedeclineinbanklendshy
ingimpliesthatnoamountofcapitalwouldhaveinduced
banksasagrouptolendmorebecauseallthegoodloans
werebeingmade
Figure shows data on the quantity of bank lending
Jan 20
08
Mar
2008
M
ay 20
08Ju
l 200
8Se
p 2008
Nov 20
08Ja
n 2009
Jan 20
09
May
2009
Jul 2
009
Sep 20
09Nov
2009
Copyrighted Material
InTroDuCT Ion bull 15
1050
1100
1150
1200
1250
1300
FigureCommercialandIndustrialLoansbyuSCommercialBanks2008ndash9inBillionsofDollarsSourceFederalreserve
intheunitedStatesin2008and2009Startinginoctober
2008therewasaspikeinlendingfollowedbyaprotracted
declineVVChariLawrenceChristianoandpatrickKehoe
takethespikeatfacevalueinaggregatebankslentmore
ataminimumthebankingsystemasawholemdashasopposed
to individual banksmdashwas not deleveraging to overcome
loss of capital9 Victoria Ivashina and David Scharfstein
notethatmuchoftheincreaseinbanklendingwasinvolshy
untaryonthepartofthebankstheresultofdrawdowns
byborrowersonexistinglinesofcredit10 Theyalsoshow
thatbanks thatweremorevulnerable todrawdownsbeshy
causetheywereinmoresyndicateswithLehmanreduced
subsequent lending more and conclude that there was
indeed a genuine contraction in the effective supply of
bankcredit
Copyrighted Material
1 bull CHapTer 1
economistswillargueabouttheeventsoftheWorldFishy
nancialCrisisforyearstocomeInfactwestillargueabout
theGreatDepressionnoneoftheanalysisbehindourrecshy
ommendationshoweverdepends onhow these debates
aresettledForexamplenomatterhowcapitalshyconstrained
thebankingsystemreallywasinthefallof2008ourproshy
posalsforchangesthatmakesuchconstraintslessbinding
andgivepolicymakersbettertoolswhentheyfearcapital
constraintsremainvalid
What Was Wrong WIth the FInancIal system durIng the crIsIs
The Crisis revealed a number of serious problems with
ourfinancialsystemSomehadbeeninthebackgroundall
alongothersdidnotappearuntiltheCrisisInthisbook
weemphasizefourcategoriesofproblemsconflictsofinshy
terestknowntoeconomistsasagencyproblemsthediffishy
cultyofapplyingstandardbankruptcyprocedurestofinanshy
cialinstitutionstheemergenceofamodernformofbank
runsandtheinadequacyoftheregulatorystructurewhich
hadnotkeptupwithrecentfinancialinnovation(Infact
muchinnovationservedtoescaperegulations)
Conflicts of Interest Agency Problems
Conflictsofinterestthatcannotberesolvedeasilybyconshy
tractsormarketsoccurthroughouttheeconomybutthey
Copyrighted Material
InTroDuCT Ion bull 17
canbeparticularlyharmfulinthefinancialsystemThere
areseveralreasonsFirstmanyfinancialtransactionsand
contractsinvolveaprincipalsuchasaninvestororshareshy
holderaskingatradermanagerorotheragenttoacton
hisorherbehalfSecondmostfinancial transactions inshy
volvehighlyuncertainfuturepayoffsandinmanytransacshy
tionsonepartyisbetterinformedaboutthepayoffsthan
the otherThird the high volatility of the future payoffs
oftenmakesithardtoassesswhethertheoutcomeofafishy
nancialtransactionisduetotheagentrsquoseffortsorluckand
fourththesumsinvolvedcanbehuge
Someproprietarytradersforexampleearnalotwhen
their tradesdowellbuttheirpersonal lossesare limited
whentheirtradesdopoorlyBecauseoftheasymmetricnashy
tureoftheircompensationthesetraderscanincreasetheir
expectedincomebytakingriskierpositionsThisproblem
isdramaticallyillustratedbyperiodiccasesinwhichldquorogue
tradersrdquoincurlossesthatarebigenoughtodamageoreven
destroy large financial institutions In 1995 nick Leeson
broughtdownBaringsBankwitha$1billionlossandin
2008itwasrevealedthatJeacuterocircmeKervielhadseverelydamshy
agedSocieacuteteacuteGeacuteneacuteralewithalossofover$7billion
Conflictsofinterestorldquoagencyproblemsrdquoalsoexistat
manyotherlevelswithinthefinancialsystemShareholders
offinancialinstitutionshaveaconflictofinterestwiththe
bankrsquosseniorexecutivesespeciallywhenthoseexecutives
arerewardedforgoodperformancebutdonothavealarge
fractionoftheirwealthtiedupinthesharesofthebank
Manyfinancialinstitutionshavelargequantitiesofdebt
Copyrighted Material
18 bull CHapTer 1
which creates a conflict of interest between the bankrsquos
creditorsanditsshareholdersShareholdershaveanincenshy
tivetoauthorizeexcessivelyriskyinvestmentsforexample
especiallyafterabankhasincurredlossesthaterodethe
valueoftheshareholdersrsquoclaimThegainsontheserisky
investmentswillaccruelargelytoshareholderswhilethe
losseswillmostlybebornebycreditorsTheconflictwith
creditorsalsoreducestheincentivesfortheshareholders
of troubled institutions to raisenewcapitalbecause that
wouldstrengthen thepositionofcreditorswhilediluting
theshareholdersrsquopositionThisldquodebtoverhangrdquoproblem
waswidelycitedduringtheWorldFinancialCrisiswhen
many banks that were insolvent or close to insolvency
seemedreluctanteithertoraisenewcapitalortoreduce
theirrisksbysellingdistressedsecurities11
atthehighestlevelthereisaconflictofinterestbetween
societyasawholeandtheprivateownersoffinancialinshy
stitutions Because robust financial institutions promote
economicgrowthandemploymentduringfinancialcrises
governmentsoftenrescuetroubledfirmstheyperceiveto
be systemically importantThe result is privatized gains
andsocializedlossesIfthingsgowellthefirmsrsquoowners
andmanagersclaimtheprofitsbutifthingsgopoorlysoshy
cietysubsidizesthelosses
The candidates for government bailouts are popularly
describedasldquotoobigtofailrdquoMorepreciselytheargument
for government supportmdashwhich many economists chalshy
lengemdashisaboutfirmsthataretoosystemicallyimportantto
failInits200annualreporttheeuropeanCentralBank
describedsystemicriskasldquoTheriskthattheinabilityofone
Copyrighted Material
InTroDuCT Ion bull 19
institutiontomeetitsobligationswhenduewillcauseother
institutions to be unable tomeet their obligationswhen
dueSuchafailuremaycausesignificantliquidityorcredit
problemsandas a resultcould threaten the stabilityof
or confidence in marketsrdquo Systemically important firms
arethosewhosefailurecouldposealargethreattothestashy
bilityoforconfidenceinmarketsThesefirmsarelikelyto
belargebuttheyalsotendtohavecomplexinterconnecshy
tionswithotherfinancialinstitutions
Tooshybigshytoshyfailpoliciesoffersystemicallyimportantfirms
theexplicitorimplicitpromiseofabailoutwhenthingsgo
wrongThesepoliciesaredestructiveforseveralreasons
Firstbecause the possibility of a bailoutmeans a firmrsquos
stakeholders claim all the profits but only some of the
lossesfinancialfirmsthatmightreceivegovernmentsupshy
porthaveanincentivetotakeextrariskThefirmrsquosshareshy
holderscreditorsemployeesandmanagement all share
thetemptationTheresultisanincreaseintherisksborne
bysocietyasawhole
Secondthesepoliciesencouragesmallerfinancialinstishy
tutionstoexpandortobecomemorecloselyinterconnected
with other firms so they move under the tooshybigshytoshyfail
umbrellaFirmshaveanincentivetodowhateverittakes
tomakepolicymakersfeartheirfailurecreatingthevery
fragilitythegovernmentwishestoavoidBeliefthatagovshy
ernmentrescuewillprotectafinancial institutionrsquoscredishy
tors inacrisisalsogivesafirmacompetitiveadvantage
loweringitscostoffinancingandallowingittoofferbetter
prices to its customers than its fundamental productivity
warrants
Copyrighted Material
20 bull CHapTer 1
Thirdinefficientfirmsthatcannotcompeteontheirown
shouldfailotherwisefirmshavelessincentivetobecome
andstayefficientagovernmentpolicythatpropsupinshy
efficientfirmsiswastefulanddestructiveallowingthese
firmstofailfreesupresourcesandprovidesopportunities
formoreefficientandinnovativecompetitorstoflourish
Fourthandmostgenerallycapitalismisunderminedby
policiesthatprivatizegainsbutsocializelossesGovernment
guaranteedinstitutionscanbecomegovernmentruninstishy
tutionsallocatingcreditforexampletomaximizepolitical
gainratherthaneconomicwelfare
The conflictbetween society and theownersoffinanshy
cialfirmsbecomesmoreseriousduringseverecriseswhen
manyfinancialinstitutionsareclosetoinsolventIt isthe
primemotivationforourregulatoryproposalsbutseveral
ofthelowershylevelconflictswehavedescribedarerelevant
becausetheymagnifytheriskbornebysocietyasawhole
Theselfshyservingbehaviorthatmanyofourrecommenshy
dations targetmdashwhether by traders senior management
orthefirmrsquosownersmdashneednotbestrategicintentionally
maliciousorevenconsciousConsideratraderwhoinadshy
vertentlydevelopsaninvestmentstrategywithhighlyprobshy
ablegainsandimprobablebutlargelossesLikeafirmthat
hassoldearthquakeinsurancethestrategymayproducea
longstringofimpressivereturnsbeforeoneyearoflosses
wipesoutmanyyearsofprofits12 Ifsoduringthegood
yearsthetraderwillbecelebratedforhisorherbrilliance
rewarded with large bonuses and given more resources
to manageMany sophisticated traders and hedge funds
Copyrighted Material
InTroDuCT Ion bull 21
werenotawareoftheldquoearthquakerisksrdquoinherentinmany
of theirstrategiesSimilarlywhenfirmstakeactionsthat
increasethelikelihoodofagovernmentbailoutinthenext
financialcrisisthemarketrewardsthemwithalowercost
of capitalas firms become too big to fail for example
the implicit government guarantee reduces the riskiness
of their debt and lowers the interest rate demanded by
theircreditorsaCeoworkingtomaximizefirmvaluemay
notevenrealize the importanceof thegovernmentguarshy
anteebut a Darwinian process will encourage behavior
thatexploitsit
Bankruptcy and Resolution Procedures
Itisimpossibletowriteafinancialcontractthatspecifies
everypossiblecontingencyInsteadcontractsrelyonbankshy
ruptcytodetermineoutcomesincertainbadandunlikely
statesoftheworldInbankruptcycontrolofafirmistransshy
ferredfromtheshareholderswhonolongerhaveastake
inlossesbecausetheirsharesareworthlittletothedebtshy
holders It is in societyrsquos interest to develop bankruptcy
proceduresthatmaximizethepostshybankruptcyvalueofa
firmrsquosassetsInparticularsocietyshouldavoidthedestrucshy
tionofvaluethatoccurswithdisorderlyliquidation
Disorderlyliquidationoffinancialinstitutionsisparticushy
larly costlyFirstvaluableknowledge that the institution
hasaccumulatedaboutitscounterpartiesmdashborrowerstradshy
ingpartnersandsoonmdashcandisappearastheinstitution
losesemployeesandceasestooperatenormallyFinancial
Copyrighted Material
22 bull CHapTer 1
economistshavefoundthatthecollapseofabankhasamashy
terialadverseimpactonmanyofitsborrowers1 Second
the prospect of a disorderly liquidation makes it more
likelythatatroubledfinancialinstitutionwillsufferarun
by creditors who conclude they are better off claiming
whatmoney theycan todayrather thanwaiting through
protracted liquidation proceedings Third ldquofire salesrdquo of
specializedassets inadisorderly liquidationcandepress
prices and thereby spread problems to other holders of
theassetclassFourthdisorderlyliquidationincreasesthe
uncertaintyabouttheimpactofafinancialinstitutionrsquosfailshy
ureonitscounterpartiesandotherclaimholdersBecause
financialfirmsaretightlyinterconnectedthisuncertainty
canprecipitateorintensifyafinancialcrisis1
In theunitedStatesthestandardbankruptcycodealshy
lowsbothforliquidationofafirmandthesaleofitsassets
(Chapter7)andforcontinuedoperationofafirmunder
the supervision of a bankruptcy judgewho protects the
firmfromcreditorsrsquoclaimswhileareorganizationplanis
approved(Chapter11)Theseproceduresappeartowork
wellfornonfinancialcorporationsbutnotsowellforfinanshy
cialorganizationsTheChapter11approachofseparatinga
firmrsquosfinancialaffairsfromitsnonfinancialbusinessactivishy
tiesisinfeasiblewhenthebusinessofthefirmisfinancial
transactionsFurthermoremanyfinancialinstitutionsrely
heavily on shortshyterm debtpossibly as a valuable discishy
plineonbankexecutiveswhocanrapidlychangetherisks
theirfirmstakeThismakesfinancialfirmsvulnerabletoa
rapidwithdrawalofshortshytermcreditthatislikelytooccur
beforeanyeventthatwouldtriggerbankruptcy
Copyrighted Material
InTroDuCT Ion bull 2
Wearguebelowthatthereisaneedforaspecialresolushy
tionprocedurethatcanbeappliedtolargeinsolventfinanshy
cialinstitutionsWealsoadvocateregulatorychangesthat
would push financial firms towardmore resilient capital
structures
Bank Runs
Classicbank runs inwhichdepositors race towithdraw
their funds before a bank failswere one of the central
contributors to theGreatDepressionDeposit insurance
whichwasintroducedaftertheDepressiontocounterthis
destructiveprocessmadedemanddepositsoneofthemost
stableformsofbankfinancingduringtheWorldFinancial
CrisisManyfinancialinstitutionshoweversufferedamodshy
ernversionofbankruns
Banksespeciallythosewithinvestmentbankingactivishy
tiestypicallyfinanceasignificantfractionoftheirbusiness
withovernightcommercialpaperreposandothershortshy
terminstrumentsInnormaltimesbanksrolloverthisdebt
asitmaturestakingnewloanstopayofftheoldInacrishy
sishoweveruncertaintyaboutwhetheratroubledinstitushy
tionwouldbeabletopayoffitscreditorstomorrowcauses
lenderstostopextendingcredittodayThusshortshytermfishy
nancingcanleadtoarunthatissimilartoaclassicrunon
deposits
even some secured creditors participated in runs durshy
ingtheWorldFinancialCrisisBanksoftenuserepurchase
agreements to borrow money securing the loan by givshy
ingthelenderafinancialassetsuchasaTreasurybond
Copyrighted Material
2 bull CHapTer 1
ascollateralBecausetheyareovershycollateralizedwithasshy
setsworthperhaps$105guaranteeingevery$100inloans
lendersviewldquoreposrdquoasasafewaytoextendcreditWhen
credit markets froze during the Crisis however lenders
worried that retrieving collateral and selling itwouldbe
difficultandnotworththesmallinterestonanovernight
loanasaresultatvarioustimesduringtheCrisismany
investmentbankshaddifficultyrollingovereventheirseshy
cured loanseven relatively healthy financial institutions
werehamperedbythetroubleintherepomarketafteraushy
gust2007asthemarketbecamemoreandmoreuncertain
about the prices securities would fetch in a forced sale
these institutions found they could borrow less and less
withthesamecollateral15
prime brokerage accounts also saw a runshylike withshy
drawalbycustomersManylargebankshaveprimebrokershy
agegroupsthatassisthedgefundsandotherinstitutionalinshy
vestorsbyprovidingfinancingsecuritieslendingclearing
custodial servicesandoperational supportInexchange
thefundspayfeesandcriticallypostcollateraltosecure
theirloansWithsomerestrictionsthatweexplaininChapshy
ter10theprimebrokercanthenusethecollateralinits
ownbusinessinsomecasescomminglingitwiththefirmrsquos
ownassetsDuringtheCrisishedgefundsmonitoredthe
financial wellshybeing of their prime brokers and like deshy
positorsintheDepressionfledwiththeircollateralatthe
firstsignoftroubleBearStearnsforexamplehadalarge
prime brokerage business according to press accounts
oneofthelargesthedgefundsthatusedBearStearnsasa
Copyrighted Material
InTroDuCT Ion bull 25
primebrokerrenaissanceTechnologieswithdrew$5bilshy
lionofcashintheweekthefirmfailedWithsuchoutflows
it is not surprising that Bear Stearns ran out of money
eventhoughithadmorethan$18billionincashaweek
earlier
Likeclassicbankrunsmodernbankrunsarebothdeshy
structiveandselfshyfulfillingConcernthatabankmightbe
in trouble spurs its creditors and counterparties towithshy
draworwithholdtheircapitalasaresultevenrumorsofa
problemmaybeenoughtodestroyaviableinstitutionThe
importanceofmodernbankrunsduringtheWorldFinanshy
cialCrisisisarecurringthemethroughoutthebookand
wemakeseveralproposalsthatareintendedtoreducethe
frequencyofsuchevents
The Inadequacy of the Regulatory Structure
TheWorldFinancialCrisismadeitclearthatfinancialinnoshy
vationhadoverwhelmedexistingfinancialregulationsnoshy
tableexamplesincludeaIGrsquosdecisiontosellanextremely
large amount of credit default swaps on subprime debt
tobanksintheunitedStatesandabroadtheholdingof
Lehmanpaperbymoneymarketfundsparticularlythereshy
serveprimaryFundthecomplexityofthederivativebooks
atLehmanandotherinvestmentbanksandthedifficultyof
simultaneouslyapplyingseveralcountriesrsquobankruptcycodes
tothesubsidiariesofmultinationalfinancialinstitutions1
Thereisatradeshyoffbetweenfinancialinnovationandstashy
bilityInnovationcanimprovethefinancialsystemrsquosability
Copyrighted Material
2 bull CHapTer 1
toallocateresourcestotheirhighestvaluedusebutitcan
alsoreducethestabilityofthesystemThechallengeisto
developregulationsthatimprovestabilitywithoutstifling
innovation In addition regulation often leads to innoshy
vations designed to evade the regulationswhich makes
thefinancialsystemmorefragileForexamplemanyofthe
specialshypurposevehiclesthatimplodedintheCrisiswere
createdtogetaroundcapitalrequirements
In many countries the response of regulators to the
World Financial Crisis was hampered by the fragmented
nature of their regulatory systems Financial regulations
are typically designed to ensure thehealth of individual
institutionsratherthanthefinancialsystemasawholeIn
thisbookwearguethatsystemicregulationisanimporshy
tantfunctionthatrequiresaspecialmandateandthatthe
central bank is particularly well equipped to fulfill this
function
Finallyeffectivefinancialregulationrequiresthatpolitishy
ciansandultimatelythepublichaveanadequateundershy
standing of the financial system The political turmoil
surroundingtheCrisissuggeststheimportanceofdissemishy
natingexpertknowledgeaboutfinancetoabroaderaudishy
enceThisisoneofourmotivationsforwritingthisbook
What Were the orIgIns oF the World FInancIal crIsIs
LiketheoriginsoftheFirstWorldWarthecausesofthe
Crisiswillbedebatedbyscholarsformanyyears
Copyrighted Material
InTroDuCT Ion bull 27
Most observers agree that the strong runshyup and subshy
sequentsharpdeclineinthepricesofstockshousesand
otherfinancialassetsindevelopedcountrieswasanimporshy
tantcatalystfortheCrisisThereisdisagreementhowever
aboutwhetherthispatterninpricesistheresultofrational
investorbehaviororldquoirrationalbubblesrdquo
SomearguethattherunshyupbeforetheCrisiswasdriven
by investorswhoknowingly acceptedunusually low exshy
pectedreturnsandtheyofferseveralpossiblereasonswhy
Firsttherewasasurgeofsavingsinemergingcountries
drivenbyacombinationofrapideconomicgrowthanddeshy
mographicsperhapsbecauseofadesiretoaccumulateforshy
eignreservesintheaftermathoftheasiacrisisof1997ndash98
muchof thiswealthwas invested indevelopedmarkets
Secondfinancialmarketswereunusually tranquilduring
200to200Withlowvolatilityinvestorsmayhavesettled
for a low risk premiumThird influenced by fears of a
Japaneseshystyledeflation resulting from themarketdownshy
turnof2000ndash2001andbyabeliefthattheyshouldnottry
to usemonetary policy to counteract rising asset prices
central bankers in the united States maintained a loose
monetarypolicythroughouttheperiod17andfromthisrashy
tionalviewofinvestorstheplungeinassetpricesthatacshy
companiedtheCrisiswascausedbybadnewsaboutfuture
cashflowsunexpectedincreasesinthereturnsrequiredby
investorsorboth
otherssuggestamoredirectexplanationThehighprices
before theCrisisweredrivenby an irrational belief that
prices would continue to rise and the collapse of asset
priceswastheinevitableresultofthismistakeWhatever
Copyrighted Material
28 bull CHapTer 1
theexplanationthesharpdropinassetpricesbothconshy
tributedtoandwasasymptomoftheCrisis
other commentators argue that the financial system
becamevulnerablebecausemanymarketparticipantsasshy
sessedrisksinaccuratelyduringtheperiodleadingupto
theWorldFinancialCrisisConsumersbanksandinvestors
ingeneralunderestimatedtheriskofhousepricedeclines
increasingthepricestheywerewillingtopayforrealesshy
tatethecredittheywerewillingtoextendandthevaluashy
tionsofbanksthatextendedsuchcreditBanksputmuch
weight on the recent pastwhen they estimated value at
riskwhichledthemtoconcludethatthelevelofriskwas
lowandthattherewaslittledownsidetohavinghighleshy
verageothermarketparticipantsdidnotfullyappreciate
thathighliquiditywassuppressingvolatilityandthatthe
processmightreversewithliquiditydecreasingandvolatilshy
ityincreasing
More generally the high level of financial innovation
driveninpartbythedecliningcostofinformationtechnolshy
ogymadeithardforriskassessmenttokeeppacewiththe
evolvingfinancialsystem18Thebenignenvironmentofthe
creditboomexacerbatedthisproblembytemptingfinanshy
cialinstitutionstounderinvestinriskmanagement
uSpolicymakersalsocontributedtotheseverityofthe
CrisisbypushingFannieMaeandFreddieMactoincrease
theavailabilityofmortgagefundingtoborrowerswithquesshy
tionableabilitytorepaytheirmortgagesasaresultofthis
pressure both agencies relaxed their standards for the
mortgages they purchased and guaranteedThe demand
Copyrighted Material
InTroDuCT Ion bull 29
forhomesbyborrowerswhoqualifiedformortgagesbeshy
causeoftheselowerstandardspusheduppricesandthe
defaultbymanyofthemduringtherecessioncontributed
tothedropinhomeprices
Thepanicandruninthefallof2008remainthecentral
distinguishingfeaturesoftheWorldFinancialCrisisasset
priceshave risenand fallenbeforeand theworldeconshy
omyhasbornelargefinancial lossesmanytimeswithout
suchasevereeconomicoutcomeConverselylossesfrom
completelydifferentunderlyingsourcesmdashcommercialreal
estateorperhapssovereigndefaultsmdashcouldcauseasimilar
catastrophe if theyagainprovoke tooshybigshytoshyfailchaosor
runs
Thisbookdoesnotseektoprovideacompletediagnosis
oftheWorldFinancialCrisisnordoesittakeastandonthe
relativeimportanceofthecontributingfactorslistedabove
ratherwebelieveourrecommendationswillhelpprevent
ormitigatefuturecriseseventhoughwedonotfullyundershy
standallthecausesofthelastone
CarmenreinhartandKennethrogoff amongothershave
pointedoutthatfinancialcriseshaveoccurredthroughout
thehistoryofcapitalismandthatthesecrisessharemany
commonpatterns19 Thelessonwedrawfromthisisthat
noacceptablesetofregulationscanpreventmarketparticishy
pantsfrommakingmistakesthatcreateeconomicinstability
ourpurposeinthisbookisinsteadtosuggestregulatory
reformsthatwillmakethesystemmorestabledespitethe
mistakesthataresuretocome
Copyrighted Material
bull CHapTer 1
slowed to a crawl and there was a run on the reserve
primaryFundamoneymarketmutualfundunlikeother
mutual funds money market funds maintain a constant
sharepricetypically$1byusingprofitsinthefundtopay
interestratherthantoincreasesharevaluesBecausethe
sharepriceisfixedat$1lossesthatpushafundrsquosnetasshy
setvaluebelow$1persharecantriggerarunasinvestors
rushtoclaimtheirfulldollarpaymentsandforcethelosses
ontootherinvestorsThereserveprimaryFundwhichhad
morethan1percentofitsassetsincommercialpaperisshy
suedbyLehmansufferedjustsucharunonSeptember1
2008afterLehmandeclaredbankruptcythefundrsquosnetasshy
setvaluedroppedto$097pershareandinvestorswithshy
drewmorethantwoshythirdsofthereserveFundrsquos$bilshy
lioninassetsbeforethefundsuspendedredemptionson
September17Concernspreadtoinvestorsinothermoney
marketfundsandtheywithdrewalmost10percentofthe
$5trillioninvestedinuSmoneymarketfundsoverthe
nexttendaysTostabilizethemarketthegovernmenttook
theunprecedented stepof offering a guarantee to every
uSmoneymarketfund
In normal timesany one of these eventswould have
beenthefinancialstoryoftheyearyettheyallhappened
inthesameweekinSeptember2008althoughmuchcomshy
mentaryandpopularpresscoverageblamestheWorldFishy
nancialCrisisentirelyonthegovernmentrsquosdecisiontolet
Lehmanfailsuchananalysisignorestheevidentcontribushy
tionsofthemanyothermomentouseventsthatoccurred
duringthatweek
Copyrighted Material
InTroDuCT Ion bull 7
October 2008 The Bank Bailout and Credit Crunch
Byearlyoctober2008theuSgovernmentrealizedthat
theTarpplantobuymortgagebackedsecuritiesonthe
openmarketwasnotfeasibleInsteadtheTreasuryDepartshy
mentusedtheappropriatedmoneytopurchasepreferred
stockinlargebanksandtoprovidecreditguaranteesand
othersupportThoughnowrememberedastheldquobankbailshy
outrdquotheTarppurchaseswerenotsimplyatransfertofailshy
inginstitutionsHealthybankswerealsoforcedtoaccept
capital inanattempt tomask thegovernmentrsquosopinions
aboutwhichbankswereinmoretroublethanothersMany
policymakersseemedtothinkthatbankswerenotlending
becausetheyhadlosttoomuchcapitalandwerenotable
orwillingtoraisemoreThusthegoalseemedtobenotto
savethebanksbuttorecapitalizethemsotheywouldlend
againIn theendthe former resultwasachievedmdashnone
of the large banks that receivedTarp funds failedmdashbut
thelatterarguablywasnotWeanalyzetheseissuesindeshy
tailbelowandrecommendsomealternativestructuresand
policiesthatwebelievewouldhaveworkedbetter
DuringmuchoftheWorldFinancialCrisistheFederal
reserveexperimentedwithawiderangeofnewfacilities
beyonditstraditionaltoolsofinterestratepolicyandopen
market operations The Fed lent broadly to commercial
banksinvestmentbanksandbrokershydealersandendedup
buyingcommercialpapermortgagesassetbackedsecurishy
tiesandlongshytermgovernmentdebtinanefforttolower
interestratesinthesemarketsByDecember2008excess
Copyrighted Material
8 bull CHapTer 1
reservesinthebankingsystemhadgrownfrom$billion
before the Crisis to over $800 billionThese actions are
notafocusofouranalysisbuttheysurelyhelpedprevent
theCrisisfromturningintoanotherGreatDepressionat
aminimumtheyeliminatedmostbanksrsquoconcernsabout
sourcesofcash
Bankfailuresineuropeinthefallof2008ledtomore
directbailoutsThenetherlandsBelgiumandLuxembourg
spent$1billiontopropupFortisamajoreuropeanbank
with about $1 trillion in assets The netherlands spent
$1billiontobailoutInGabankingandinsurancegiant
Germanyprovideda$50billionrescuepackageforHypo
realestateHoldingsSwitzerlandrescueduBSoneofthe
tenlargestbanksintheworldwitha$5billionpackage
Iceland took over its three largest banks and its subseshy
quent difficulties highlight what happens when the cost
ofbailingoutacountryrsquosbanksexceedsthegovernmentrsquos
resources
Throughoutthefallof2008therewasaldquoflighttoqualityrdquo
inmarketsaroundtheworldWheninvestorsareworried
aboutdefaulttheydemandhigherinterestratesYieldson
securitieswithanyhintofdefaultriskrosesharplyespeshy
ciallyinthefinancialsector
Theflighttoqualityisapparentintheinterestrateson
commercialpaperinFigure1Commercialpaperisshortshy
termunsecureddebtissuedbybanksandotherlargecorshy
porationsandisanimportantpartoftheirfinancingThe
commercialpaperratesforfinancialinstitutionsandlowershy
creditqualityborrowers jumped inSeptemberandoctoshy
berbutafterasmallincreasetherateforlargecreditworshy
Copyrighted Material
InTroDuCT Ion bull 9
7
6
5
4
3
2
1
0
A2P2 Nonfinancial
AA Financial
AA Nonfinancial
Jul 2008 Aug 2008 Sep 2008 Oct 2008 Nov 2008 Dec 2008
Figure1annualizedpercentYieldson0shyDayHighshyQuality(aa)FinancialandnonfinancialCommercialpaperandMediumshyQuality(a2p2)nonfinancialCommercialpaperinpercentaugusttoDecember2008SourceFederalreserve
thynonfinancialcompaniesactuallydeclinedTherateon
uSTreasurybillswhichareviewedas themost secure
investmentalsofellthethreeshymonthTreasurybillrateacshy
tuallydroppedtozeroforbriefperiodsinnovemberand
December2008
the run on the shadoW BankIng system
Thepanicthatstruckfinancialmarketsinthefallof2008
hasbeencharacterizedasarunontheshadowbankingsysshy
temandwithgoodreasonBeforetheCrisismanybonds
mortgagebackedsecuritiesandother credit instruments
Copyrighted Material
10 bull CHapTer 1
wereheldbyleveragednonshybankintermediariesincluding
hedgefunds investmentbanksbrokeragefirmsandspecialshy
purposevehiclesManyoftheseintermediarieswereforced
toldquodeleverrdquoduringoctoberandnovembersellingassetsto
repaytheircreditors
Hedgefundsandotherleveragedintermediariesusethe
securitiesintheirportfoliosascollateralwhentheyborrow
moneyDuringtheWorldFinancialCrisismanywarylendshy
ersdecidedthecollateralborrowershadpostedbeforethe
Crisis was no longer sufficient to guarantee repayment
Whenthelendersdemandedeithermoreorbettercollatshy
eralmanyborrowerswereforcedtoselltheirleveredposishy
tionsandrepaytheirloansTheresultwasareductionin
thequantityofassetstheyheldandintheirleverageInadshy
ditionhedgefundsandotherintermediariessufferedlarge
withdrawalsbypanickycustomersagainforcingthemto
sellsecuritiesonthemarketTheassetsbeingsoldweregenshy
erallyacquiredbyindividualinvestorsthefederalgovernshy
mentorcommercialbankswhichasagroupfinancedmost
oftheirpurchasesbyborrowingfromthegovernment
The financing difficulties faced by arbitrageurs and lishy
quidity providers are apparent in a series of fascinating
market pathologies In financialmarkets there are often
manydifferentwaystoobtainthesameoutcomeaninvesshy
torcanusemanydifferentcombinationsofsecuritiesfor
exampletorisklesslyconvertdollarstodayintodollarsin
sixmonthsThe actionsof arbitrageursusuallykeep the
costsof thedifferent approaches closely alignedDuring
thefallof2008thecostsoftendivergedwiththeapproach
thatrequiredmorecapitaltypicallycostingless
Copyrighted Material
InTroDuCT Ion bull 11
Theprincipleofcoveredinterestparityforexamplesays
thataftereliminatingexchangerateriskriskshyfreeinvesting
shouldhavethesamereturnineverycurrencyaninvestor
whowantstoinvestdollarstodayandreceivedollarsinthe
futureusuallybuysauSbondHecouldaccomplishthe
samethingbyconvertinghisdollarsintoeurosinvesting
inarisklesseurobondandlockingintheconversionof
theeuropayoffbackintodollarswithaforwardcontract
Sincebothstrategiesconvertdollarstodayintodollarsin
thefuturetheyshouldhavethesamereturn5 Supposeinshy
steadthereturnontheuSbondislowerThenanarbitrashy
geurcouldborrowmoneyintheunitedStatesatthelower
rateinvestitintheeurotransactionatthehigherrateand
makeaprofit
During the Crisis covered interest parity violations as
largeas20basispoints(020percent)emergedThismay
seemtrivialbutinnormaltimestheseviolationsrarelyexshy
ceed 2 basis pointsMoreover traders can usuallyldquolever
uprdquotransactionslikethisandmakealargeprofitButthatrsquos
thecatchmdashhedgefundsbrokeragesandinvestmentbanks
werebeingforcedtodeleverduringtheCrisisand20basis
points is not enough to enticemany longshyonly investors
to replace theuSbond theyarecurrentlyholdingwith
aforeignbondandsomeseeminglycomplicatedcurrency
transactions
other recent research finds similar disruptions of the
normalpricing relations linking (1)Treasurybondscorshy
poratebondsandcreditshydefault swaps (aTreasurybond
shouldbethesameasacorporatebondplusacreditdefault
swapmdashexceptforliquidityfinancingandCDScounterparty
Copyrighted Material
12 bull CHapTer 1
risk)(2)fixedandfloatingrate investments (asequence
ofshortshyterminvestmentsplusacontractswappingafloatshy
ing interest rate forafixed interest rateshouldhave the
same payoff as a fixed rate investment) () convertible
bondsdebtandequity()newlyissuedldquoonshytheshyrunrdquoand
recently issuedldquooffshytheshyrunrdquoTreasury bondswhich have
essentially the same payoff but differ in liquidity and
(5)stockandoptionpriceswhicharelinkedbywhatfishy
nancialeconomistscalltheputshycallparityrelation7
Thebreakdownofthesenormalpricingrelationsdoes
littledirectharm to the restof theeconomya20shybasisshy
pointviolationofcoveredinterestparityhaslittleeffecton
auSexporterusingcurrencycontractstolockintherate
atwhichitcanconvertfutureJapaneserevenuebackinto
dollarsTheseviolationsshowhoweverthatmarketswere
notfunctioningnormallyInparticulartheysuggestthere
wasnotmuchcapitalavailabletoprovideliquiditytobuyshy
ersandsellersanyoneneedingtosellsecuritiesquicklyin
suchamarketmdashsuchasafinancialinstitutiontryingtoreshy
duceitsriskmdashwasnotlikelytogetagoodprice
lendIng BankIng and the recessIon
Duringthefallof2008outputandfinancingactivityconshy
tracted sharply Commercial paper corporate bond and
equityissuanceallfelldramaticallyasdidmortgageorigishy
nations
originations of most types of asset backed securities
alsoslowedtoatrickleManybanksintheunitedStates
Jan 20
04Ju
l 200
4Ja
n 2005
Jul 2
005
Jan 20
06Ju
l 200
6Ja
n 2007
Jul 2
007
Jan 20
08Ju
l 200
8Ja
n 2009
Jul 2
009
Copyrighted Material
InTroDuCT Ion bull 1
0
50
100
150
200
250
Figure2assetBackedSecuritiesIssuedintheunitedStatesJanushyary200toDecember2009BillionsofDollarsperMonthSourceFederalreserve
and other countries no longer hold much of the credit
theyissueTheyhavemovedinsteadtoanldquooriginateand
sellrdquomodel inwhich theybundle together similar loans
suchasjumbomortgagescommercialloansstudentloans
or credit card debt and sell them to investors as asset
backedsecuritiesnewissuesofthesesecuritiesessentially
stopped inoctoberandnovember2008Figure2shows
that the amount of asset backed securities issued in the
united States rose from$288 billion in January 2000 to
$85billioninJune2007andthenplungedto$102bilshy
lioninSeptember2007IssuanceintheunitedStatesconshy
tinued to decline over the next year eventually falling
to only $87 billion in october 2008 and $ billion in
Copyrighted Material
1 bull CHapTer 1
novembermdashjust2percentofthevolume18monthsearlier
onlymortgagespooledbyFannieMaeandFreddieMac
withanexplicitgovernmentguaranteeandsubjecttohuge
Federalreservepurchasescontinuedtoflowtothemarket
There isplentyof anecdotal and surveyevidence that
banklendingalsodriedupduringtheCrisisForexample
loanofficerssurveyedbytheFederalreservereportedthat
credit conditionsprogressively tightenedduring2008In
asurveyabouttheirperceptionsofcreditconditionsand
corporatedecisionsasoflatenovember2008morethan
halfofthechieffinancialofficersoflargeamericanfirms
whorespondedsaidthattheirfirmswereeitherldquosomewhat
orveryaffectedbythecostoravailabilityofcreditrdquo8
There is a lively and fundamentally important debate
about why the quantity of lending fell Some financial
economists argue that banks wanted to lend more but
wereunable todosobecausetheyfacedbindingcapital
constraintsInthisviewinformationcostsandotherfricshy
tionsintheloanoriginationprocesskeptcustomersfrom
movingtolessconstrainedbanks
othersarguethattheprimaryreasonbankswereunwillshy
ingtolendisthattheircustomershadbecomelesscreditshy
worthyTheseeconomistspointoutthatthehighlevelof
uncertainty about future economic conditionsduring the
Crisisratchetedupthedefaultriskofeventhemostrelishy
ableclientsThisinterpretationofthedeclineinbanklendshy
ingimpliesthatnoamountofcapitalwouldhaveinduced
banksasagrouptolendmorebecauseallthegoodloans
werebeingmade
Figure shows data on the quantity of bank lending
Jan 20
08
Mar
2008
M
ay 20
08Ju
l 200
8Se
p 2008
Nov 20
08Ja
n 2009
Jan 20
09
May
2009
Jul 2
009
Sep 20
09Nov
2009
Copyrighted Material
InTroDuCT Ion bull 15
1050
1100
1150
1200
1250
1300
FigureCommercialandIndustrialLoansbyuSCommercialBanks2008ndash9inBillionsofDollarsSourceFederalreserve
intheunitedStatesin2008and2009Startinginoctober
2008therewasaspikeinlendingfollowedbyaprotracted
declineVVChariLawrenceChristianoandpatrickKehoe
takethespikeatfacevalueinaggregatebankslentmore
ataminimumthebankingsystemasawholemdashasopposed
to individual banksmdashwas not deleveraging to overcome
loss of capital9 Victoria Ivashina and David Scharfstein
notethatmuchoftheincreaseinbanklendingwasinvolshy
untaryonthepartofthebankstheresultofdrawdowns
byborrowersonexistinglinesofcredit10 Theyalsoshow
thatbanks thatweremorevulnerable todrawdownsbeshy
causetheywereinmoresyndicateswithLehmanreduced
subsequent lending more and conclude that there was
indeed a genuine contraction in the effective supply of
bankcredit
Copyrighted Material
1 bull CHapTer 1
economistswillargueabouttheeventsoftheWorldFishy
nancialCrisisforyearstocomeInfactwestillargueabout
theGreatDepressionnoneoftheanalysisbehindourrecshy
ommendationshoweverdepends onhow these debates
aresettledForexamplenomatterhowcapitalshyconstrained
thebankingsystemreallywasinthefallof2008ourproshy
posalsforchangesthatmakesuchconstraintslessbinding
andgivepolicymakersbettertoolswhentheyfearcapital
constraintsremainvalid
What Was Wrong WIth the FInancIal system durIng the crIsIs
The Crisis revealed a number of serious problems with
ourfinancialsystemSomehadbeeninthebackgroundall
alongothersdidnotappearuntiltheCrisisInthisbook
weemphasizefourcategoriesofproblemsconflictsofinshy
terestknowntoeconomistsasagencyproblemsthediffishy
cultyofapplyingstandardbankruptcyprocedurestofinanshy
cialinstitutionstheemergenceofamodernformofbank
runsandtheinadequacyoftheregulatorystructurewhich
hadnotkeptupwithrecentfinancialinnovation(Infact
muchinnovationservedtoescaperegulations)
Conflicts of Interest Agency Problems
Conflictsofinterestthatcannotberesolvedeasilybyconshy
tractsormarketsoccurthroughouttheeconomybutthey
Copyrighted Material
InTroDuCT Ion bull 17
canbeparticularlyharmfulinthefinancialsystemThere
areseveralreasonsFirstmanyfinancialtransactionsand
contractsinvolveaprincipalsuchasaninvestororshareshy
holderaskingatradermanagerorotheragenttoacton
hisorherbehalfSecondmostfinancial transactions inshy
volvehighlyuncertainfuturepayoffsandinmanytransacshy
tionsonepartyisbetterinformedaboutthepayoffsthan
the otherThird the high volatility of the future payoffs
oftenmakesithardtoassesswhethertheoutcomeofafishy
nancialtransactionisduetotheagentrsquoseffortsorluckand
fourththesumsinvolvedcanbehuge
Someproprietarytradersforexampleearnalotwhen
their tradesdowellbuttheirpersonal lossesare limited
whentheirtradesdopoorlyBecauseoftheasymmetricnashy
tureoftheircompensationthesetraderscanincreasetheir
expectedincomebytakingriskierpositionsThisproblem
isdramaticallyillustratedbyperiodiccasesinwhichldquorogue
tradersrdquoincurlossesthatarebigenoughtodamageoreven
destroy large financial institutions In 1995 nick Leeson
broughtdownBaringsBankwitha$1billionlossandin
2008itwasrevealedthatJeacuterocircmeKervielhadseverelydamshy
agedSocieacuteteacuteGeacuteneacuteralewithalossofover$7billion
Conflictsofinterestorldquoagencyproblemsrdquoalsoexistat
manyotherlevelswithinthefinancialsystemShareholders
offinancialinstitutionshaveaconflictofinterestwiththe
bankrsquosseniorexecutivesespeciallywhenthoseexecutives
arerewardedforgoodperformancebutdonothavealarge
fractionoftheirwealthtiedupinthesharesofthebank
Manyfinancialinstitutionshavelargequantitiesofdebt
Copyrighted Material
18 bull CHapTer 1
which creates a conflict of interest between the bankrsquos
creditorsanditsshareholdersShareholdershaveanincenshy
tivetoauthorizeexcessivelyriskyinvestmentsforexample
especiallyafterabankhasincurredlossesthaterodethe
valueoftheshareholdersrsquoclaimThegainsontheserisky
investmentswillaccruelargelytoshareholderswhilethe
losseswillmostlybebornebycreditorsTheconflictwith
creditorsalsoreducestheincentivesfortheshareholders
of troubled institutions to raisenewcapitalbecause that
wouldstrengthen thepositionofcreditorswhilediluting
theshareholdersrsquopositionThisldquodebtoverhangrdquoproblem
waswidelycitedduringtheWorldFinancialCrisiswhen
many banks that were insolvent or close to insolvency
seemedreluctanteithertoraisenewcapitalortoreduce
theirrisksbysellingdistressedsecurities11
atthehighestlevelthereisaconflictofinterestbetween
societyasawholeandtheprivateownersoffinancialinshy
stitutions Because robust financial institutions promote
economicgrowthandemploymentduringfinancialcrises
governmentsoftenrescuetroubledfirmstheyperceiveto
be systemically importantThe result is privatized gains
andsocializedlossesIfthingsgowellthefirmsrsquoowners
andmanagersclaimtheprofitsbutifthingsgopoorlysoshy
cietysubsidizesthelosses
The candidates for government bailouts are popularly
describedasldquotoobigtofailrdquoMorepreciselytheargument
for government supportmdashwhich many economists chalshy
lengemdashisaboutfirmsthataretoosystemicallyimportantto
failInits200annualreporttheeuropeanCentralBank
describedsystemicriskasldquoTheriskthattheinabilityofone
Copyrighted Material
InTroDuCT Ion bull 19
institutiontomeetitsobligationswhenduewillcauseother
institutions to be unable tomeet their obligationswhen
dueSuchafailuremaycausesignificantliquidityorcredit
problemsandas a resultcould threaten the stabilityof
or confidence in marketsrdquo Systemically important firms
arethosewhosefailurecouldposealargethreattothestashy
bilityoforconfidenceinmarketsThesefirmsarelikelyto
belargebuttheyalsotendtohavecomplexinterconnecshy
tionswithotherfinancialinstitutions
Tooshybigshytoshyfailpoliciesoffersystemicallyimportantfirms
theexplicitorimplicitpromiseofabailoutwhenthingsgo
wrongThesepoliciesaredestructiveforseveralreasons
Firstbecause the possibility of a bailoutmeans a firmrsquos
stakeholders claim all the profits but only some of the
lossesfinancialfirmsthatmightreceivegovernmentsupshy
porthaveanincentivetotakeextrariskThefirmrsquosshareshy
holderscreditorsemployeesandmanagement all share
thetemptationTheresultisanincreaseintherisksborne
bysocietyasawhole
Secondthesepoliciesencouragesmallerfinancialinstishy
tutionstoexpandortobecomemorecloselyinterconnected
with other firms so they move under the tooshybigshytoshyfail
umbrellaFirmshaveanincentivetodowhateverittakes
tomakepolicymakersfeartheirfailurecreatingthevery
fragilitythegovernmentwishestoavoidBeliefthatagovshy
ernmentrescuewillprotectafinancial institutionrsquoscredishy
tors inacrisisalsogivesafirmacompetitiveadvantage
loweringitscostoffinancingandallowingittoofferbetter
prices to its customers than its fundamental productivity
warrants
Copyrighted Material
20 bull CHapTer 1
Thirdinefficientfirmsthatcannotcompeteontheirown
shouldfailotherwisefirmshavelessincentivetobecome
andstayefficientagovernmentpolicythatpropsupinshy
efficientfirmsiswastefulanddestructiveallowingthese
firmstofailfreesupresourcesandprovidesopportunities
formoreefficientandinnovativecompetitorstoflourish
Fourthandmostgenerallycapitalismisunderminedby
policiesthatprivatizegainsbutsocializelossesGovernment
guaranteedinstitutionscanbecomegovernmentruninstishy
tutionsallocatingcreditforexampletomaximizepolitical
gainratherthaneconomicwelfare
The conflictbetween society and theownersoffinanshy
cialfirmsbecomesmoreseriousduringseverecriseswhen
manyfinancialinstitutionsareclosetoinsolventIt isthe
primemotivationforourregulatoryproposalsbutseveral
ofthelowershylevelconflictswehavedescribedarerelevant
becausetheymagnifytheriskbornebysocietyasawhole
Theselfshyservingbehaviorthatmanyofourrecommenshy
dations targetmdashwhether by traders senior management
orthefirmrsquosownersmdashneednotbestrategicintentionally
maliciousorevenconsciousConsideratraderwhoinadshy
vertentlydevelopsaninvestmentstrategywithhighlyprobshy
ablegainsandimprobablebutlargelossesLikeafirmthat
hassoldearthquakeinsurancethestrategymayproducea
longstringofimpressivereturnsbeforeoneyearoflosses
wipesoutmanyyearsofprofits12 Ifsoduringthegood
yearsthetraderwillbecelebratedforhisorherbrilliance
rewarded with large bonuses and given more resources
to manageMany sophisticated traders and hedge funds
Copyrighted Material
InTroDuCT Ion bull 21
werenotawareoftheldquoearthquakerisksrdquoinherentinmany
of theirstrategiesSimilarlywhenfirmstakeactionsthat
increasethelikelihoodofagovernmentbailoutinthenext
financialcrisisthemarketrewardsthemwithalowercost
of capitalas firms become too big to fail for example
the implicit government guarantee reduces the riskiness
of their debt and lowers the interest rate demanded by
theircreditorsaCeoworkingtomaximizefirmvaluemay
notevenrealize the importanceof thegovernmentguarshy
anteebut a Darwinian process will encourage behavior
thatexploitsit
Bankruptcy and Resolution Procedures
Itisimpossibletowriteafinancialcontractthatspecifies
everypossiblecontingencyInsteadcontractsrelyonbankshy
ruptcytodetermineoutcomesincertainbadandunlikely
statesoftheworldInbankruptcycontrolofafirmistransshy
ferredfromtheshareholderswhonolongerhaveastake
inlossesbecausetheirsharesareworthlittletothedebtshy
holders It is in societyrsquos interest to develop bankruptcy
proceduresthatmaximizethepostshybankruptcyvalueofa
firmrsquosassetsInparticularsocietyshouldavoidthedestrucshy
tionofvaluethatoccurswithdisorderlyliquidation
Disorderlyliquidationoffinancialinstitutionsisparticushy
larly costlyFirstvaluableknowledge that the institution
hasaccumulatedaboutitscounterpartiesmdashborrowerstradshy
ingpartnersandsoonmdashcandisappearastheinstitution
losesemployeesandceasestooperatenormallyFinancial
Copyrighted Material
22 bull CHapTer 1
economistshavefoundthatthecollapseofabankhasamashy
terialadverseimpactonmanyofitsborrowers1 Second
the prospect of a disorderly liquidation makes it more
likelythatatroubledfinancialinstitutionwillsufferarun
by creditors who conclude they are better off claiming
whatmoney theycan todayrather thanwaiting through
protracted liquidation proceedings Third ldquofire salesrdquo of
specializedassets inadisorderly liquidationcandepress
prices and thereby spread problems to other holders of
theassetclassFourthdisorderlyliquidationincreasesthe
uncertaintyabouttheimpactofafinancialinstitutionrsquosfailshy
ureonitscounterpartiesandotherclaimholdersBecause
financialfirmsaretightlyinterconnectedthisuncertainty
canprecipitateorintensifyafinancialcrisis1
In theunitedStatesthestandardbankruptcycodealshy
lowsbothforliquidationofafirmandthesaleofitsassets
(Chapter7)andforcontinuedoperationofafirmunder
the supervision of a bankruptcy judgewho protects the
firmfromcreditorsrsquoclaimswhileareorganizationplanis
approved(Chapter11)Theseproceduresappeartowork
wellfornonfinancialcorporationsbutnotsowellforfinanshy
cialorganizationsTheChapter11approachofseparatinga
firmrsquosfinancialaffairsfromitsnonfinancialbusinessactivishy
tiesisinfeasiblewhenthebusinessofthefirmisfinancial
transactionsFurthermoremanyfinancialinstitutionsrely
heavily on shortshyterm debtpossibly as a valuable discishy
plineonbankexecutiveswhocanrapidlychangetherisks
theirfirmstakeThismakesfinancialfirmsvulnerabletoa
rapidwithdrawalofshortshytermcreditthatislikelytooccur
beforeanyeventthatwouldtriggerbankruptcy
Copyrighted Material
InTroDuCT Ion bull 2
Wearguebelowthatthereisaneedforaspecialresolushy
tionprocedurethatcanbeappliedtolargeinsolventfinanshy
cialinstitutionsWealsoadvocateregulatorychangesthat
would push financial firms towardmore resilient capital
structures
Bank Runs
Classicbank runs inwhichdepositors race towithdraw
their funds before a bank failswere one of the central
contributors to theGreatDepressionDeposit insurance
whichwasintroducedaftertheDepressiontocounterthis
destructiveprocessmadedemanddepositsoneofthemost
stableformsofbankfinancingduringtheWorldFinancial
CrisisManyfinancialinstitutionshoweversufferedamodshy
ernversionofbankruns
Banksespeciallythosewithinvestmentbankingactivishy
tiestypicallyfinanceasignificantfractionoftheirbusiness
withovernightcommercialpaperreposandothershortshy
terminstrumentsInnormaltimesbanksrolloverthisdebt
asitmaturestakingnewloanstopayofftheoldInacrishy
sishoweveruncertaintyaboutwhetheratroubledinstitushy
tionwouldbeabletopayoffitscreditorstomorrowcauses
lenderstostopextendingcredittodayThusshortshytermfishy
nancingcanleadtoarunthatissimilartoaclassicrunon
deposits
even some secured creditors participated in runs durshy
ingtheWorldFinancialCrisisBanksoftenuserepurchase
agreements to borrow money securing the loan by givshy
ingthelenderafinancialassetsuchasaTreasurybond
Copyrighted Material
2 bull CHapTer 1
ascollateralBecausetheyareovershycollateralizedwithasshy
setsworthperhaps$105guaranteeingevery$100inloans
lendersviewldquoreposrdquoasasafewaytoextendcreditWhen
credit markets froze during the Crisis however lenders
worried that retrieving collateral and selling itwouldbe
difficultandnotworththesmallinterestonanovernight
loanasaresultatvarioustimesduringtheCrisismany
investmentbankshaddifficultyrollingovereventheirseshy
cured loanseven relatively healthy financial institutions
werehamperedbythetroubleintherepomarketafteraushy
gust2007asthemarketbecamemoreandmoreuncertain
about the prices securities would fetch in a forced sale
these institutions found they could borrow less and less
withthesamecollateral15
prime brokerage accounts also saw a runshylike withshy
drawalbycustomersManylargebankshaveprimebrokershy
agegroupsthatassisthedgefundsandotherinstitutionalinshy
vestorsbyprovidingfinancingsecuritieslendingclearing
custodial servicesandoperational supportInexchange
thefundspayfeesandcriticallypostcollateraltosecure
theirloansWithsomerestrictionsthatweexplaininChapshy
ter10theprimebrokercanthenusethecollateralinits
ownbusinessinsomecasescomminglingitwiththefirmrsquos
ownassetsDuringtheCrisishedgefundsmonitoredthe
financial wellshybeing of their prime brokers and like deshy
positorsintheDepressionfledwiththeircollateralatthe
firstsignoftroubleBearStearnsforexamplehadalarge
prime brokerage business according to press accounts
oneofthelargesthedgefundsthatusedBearStearnsasa
Copyrighted Material
InTroDuCT Ion bull 25
primebrokerrenaissanceTechnologieswithdrew$5bilshy
lionofcashintheweekthefirmfailedWithsuchoutflows
it is not surprising that Bear Stearns ran out of money
eventhoughithadmorethan$18billionincashaweek
earlier
Likeclassicbankrunsmodernbankrunsarebothdeshy
structiveandselfshyfulfillingConcernthatabankmightbe
in trouble spurs its creditors and counterparties towithshy
draworwithholdtheircapitalasaresultevenrumorsofa
problemmaybeenoughtodestroyaviableinstitutionThe
importanceofmodernbankrunsduringtheWorldFinanshy
cialCrisisisarecurringthemethroughoutthebookand
wemakeseveralproposalsthatareintendedtoreducethe
frequencyofsuchevents
The Inadequacy of the Regulatory Structure
TheWorldFinancialCrisismadeitclearthatfinancialinnoshy
vationhadoverwhelmedexistingfinancialregulationsnoshy
tableexamplesincludeaIGrsquosdecisiontosellanextremely
large amount of credit default swaps on subprime debt
tobanksintheunitedStatesandabroadtheholdingof
Lehmanpaperbymoneymarketfundsparticularlythereshy
serveprimaryFundthecomplexityofthederivativebooks
atLehmanandotherinvestmentbanksandthedifficultyof
simultaneouslyapplyingseveralcountriesrsquobankruptcycodes
tothesubsidiariesofmultinationalfinancialinstitutions1
Thereisatradeshyoffbetweenfinancialinnovationandstashy
bilityInnovationcanimprovethefinancialsystemrsquosability
Copyrighted Material
2 bull CHapTer 1
toallocateresourcestotheirhighestvaluedusebutitcan
alsoreducethestabilityofthesystemThechallengeisto
developregulationsthatimprovestabilitywithoutstifling
innovation In addition regulation often leads to innoshy
vations designed to evade the regulationswhich makes
thefinancialsystemmorefragileForexamplemanyofthe
specialshypurposevehiclesthatimplodedintheCrisiswere
createdtogetaroundcapitalrequirements
In many countries the response of regulators to the
World Financial Crisis was hampered by the fragmented
nature of their regulatory systems Financial regulations
are typically designed to ensure thehealth of individual
institutionsratherthanthefinancialsystemasawholeIn
thisbookwearguethatsystemicregulationisanimporshy
tantfunctionthatrequiresaspecialmandateandthatthe
central bank is particularly well equipped to fulfill this
function
Finallyeffectivefinancialregulationrequiresthatpolitishy
ciansandultimatelythepublichaveanadequateundershy
standing of the financial system The political turmoil
surroundingtheCrisissuggeststheimportanceofdissemishy
natingexpertknowledgeaboutfinancetoabroaderaudishy
enceThisisoneofourmotivationsforwritingthisbook
What Were the orIgIns oF the World FInancIal crIsIs
LiketheoriginsoftheFirstWorldWarthecausesofthe
Crisiswillbedebatedbyscholarsformanyyears
Copyrighted Material
InTroDuCT Ion bull 27
Most observers agree that the strong runshyup and subshy
sequentsharpdeclineinthepricesofstockshousesand
otherfinancialassetsindevelopedcountrieswasanimporshy
tantcatalystfortheCrisisThereisdisagreementhowever
aboutwhetherthispatterninpricesistheresultofrational
investorbehaviororldquoirrationalbubblesrdquo
SomearguethattherunshyupbeforetheCrisiswasdriven
by investorswhoknowingly acceptedunusually low exshy
pectedreturnsandtheyofferseveralpossiblereasonswhy
Firsttherewasasurgeofsavingsinemergingcountries
drivenbyacombinationofrapideconomicgrowthanddeshy
mographicsperhapsbecauseofadesiretoaccumulateforshy
eignreservesintheaftermathoftheasiacrisisof1997ndash98
muchof thiswealthwas invested indevelopedmarkets
Secondfinancialmarketswereunusually tranquilduring
200to200Withlowvolatilityinvestorsmayhavesettled
for a low risk premiumThird influenced by fears of a
Japaneseshystyledeflation resulting from themarketdownshy
turnof2000ndash2001andbyabeliefthattheyshouldnottry
to usemonetary policy to counteract rising asset prices
central bankers in the united States maintained a loose
monetarypolicythroughouttheperiod17andfromthisrashy
tionalviewofinvestorstheplungeinassetpricesthatacshy
companiedtheCrisiswascausedbybadnewsaboutfuture
cashflowsunexpectedincreasesinthereturnsrequiredby
investorsorboth
otherssuggestamoredirectexplanationThehighprices
before theCrisisweredrivenby an irrational belief that
prices would continue to rise and the collapse of asset
priceswastheinevitableresultofthismistakeWhatever
Copyrighted Material
28 bull CHapTer 1
theexplanationthesharpdropinassetpricesbothconshy
tributedtoandwasasymptomoftheCrisis
other commentators argue that the financial system
becamevulnerablebecausemanymarketparticipantsasshy
sessedrisksinaccuratelyduringtheperiodleadingupto
theWorldFinancialCrisisConsumersbanksandinvestors
ingeneralunderestimatedtheriskofhousepricedeclines
increasingthepricestheywerewillingtopayforrealesshy
tatethecredittheywerewillingtoextendandthevaluashy
tionsofbanksthatextendedsuchcreditBanksputmuch
weight on the recent pastwhen they estimated value at
riskwhichledthemtoconcludethatthelevelofriskwas
lowandthattherewaslittledownsidetohavinghighleshy
verageothermarketparticipantsdidnotfullyappreciate
thathighliquiditywassuppressingvolatilityandthatthe
processmightreversewithliquiditydecreasingandvolatilshy
ityincreasing
More generally the high level of financial innovation
driveninpartbythedecliningcostofinformationtechnolshy
ogymadeithardforriskassessmenttokeeppacewiththe
evolvingfinancialsystem18Thebenignenvironmentofthe
creditboomexacerbatedthisproblembytemptingfinanshy
cialinstitutionstounderinvestinriskmanagement
uSpolicymakersalsocontributedtotheseverityofthe
CrisisbypushingFannieMaeandFreddieMactoincrease
theavailabilityofmortgagefundingtoborrowerswithquesshy
tionableabilitytorepaytheirmortgagesasaresultofthis
pressure both agencies relaxed their standards for the
mortgages they purchased and guaranteedThe demand
Copyrighted Material
InTroDuCT Ion bull 29
forhomesbyborrowerswhoqualifiedformortgagesbeshy
causeoftheselowerstandardspusheduppricesandthe
defaultbymanyofthemduringtherecessioncontributed
tothedropinhomeprices
Thepanicandruninthefallof2008remainthecentral
distinguishingfeaturesoftheWorldFinancialCrisisasset
priceshave risenand fallenbeforeand theworldeconshy
omyhasbornelargefinancial lossesmanytimeswithout
suchasevereeconomicoutcomeConverselylossesfrom
completelydifferentunderlyingsourcesmdashcommercialreal
estateorperhapssovereigndefaultsmdashcouldcauseasimilar
catastrophe if theyagainprovoke tooshybigshytoshyfailchaosor
runs
Thisbookdoesnotseektoprovideacompletediagnosis
oftheWorldFinancialCrisisnordoesittakeastandonthe
relativeimportanceofthecontributingfactorslistedabove
ratherwebelieveourrecommendationswillhelpprevent
ormitigatefuturecriseseventhoughwedonotfullyundershy
standallthecausesofthelastone
CarmenreinhartandKennethrogoff amongothershave
pointedoutthatfinancialcriseshaveoccurredthroughout
thehistoryofcapitalismandthatthesecrisessharemany
commonpatterns19 Thelessonwedrawfromthisisthat
noacceptablesetofregulationscanpreventmarketparticishy
pantsfrommakingmistakesthatcreateeconomicinstability
ourpurposeinthisbookisinsteadtosuggestregulatory
reformsthatwillmakethesystemmorestabledespitethe
mistakesthataresuretocome
Copyrighted Material
InTroDuCT Ion bull 7
October 2008 The Bank Bailout and Credit Crunch
Byearlyoctober2008theuSgovernmentrealizedthat
theTarpplantobuymortgagebackedsecuritiesonthe
openmarketwasnotfeasibleInsteadtheTreasuryDepartshy
mentusedtheappropriatedmoneytopurchasepreferred
stockinlargebanksandtoprovidecreditguaranteesand
othersupportThoughnowrememberedastheldquobankbailshy
outrdquotheTarppurchaseswerenotsimplyatransfertofailshy
inginstitutionsHealthybankswerealsoforcedtoaccept
capital inanattempt tomask thegovernmentrsquosopinions
aboutwhichbankswereinmoretroublethanothersMany
policymakersseemedtothinkthatbankswerenotlending
becausetheyhadlosttoomuchcapitalandwerenotable
orwillingtoraisemoreThusthegoalseemedtobenotto
savethebanksbuttorecapitalizethemsotheywouldlend
againIn theendthe former resultwasachievedmdashnone
of the large banks that receivedTarp funds failedmdashbut
thelatterarguablywasnotWeanalyzetheseissuesindeshy
tailbelowandrecommendsomealternativestructuresand
policiesthatwebelievewouldhaveworkedbetter
DuringmuchoftheWorldFinancialCrisistheFederal
reserveexperimentedwithawiderangeofnewfacilities
beyonditstraditionaltoolsofinterestratepolicyandopen
market operations The Fed lent broadly to commercial
banksinvestmentbanksandbrokershydealersandendedup
buyingcommercialpapermortgagesassetbackedsecurishy
tiesandlongshytermgovernmentdebtinanefforttolower
interestratesinthesemarketsByDecember2008excess
Copyrighted Material
8 bull CHapTer 1
reservesinthebankingsystemhadgrownfrom$billion
before the Crisis to over $800 billionThese actions are
notafocusofouranalysisbuttheysurelyhelpedprevent
theCrisisfromturningintoanotherGreatDepressionat
aminimumtheyeliminatedmostbanksrsquoconcernsabout
sourcesofcash
Bankfailuresineuropeinthefallof2008ledtomore
directbailoutsThenetherlandsBelgiumandLuxembourg
spent$1billiontopropupFortisamajoreuropeanbank
with about $1 trillion in assets The netherlands spent
$1billiontobailoutInGabankingandinsurancegiant
Germanyprovideda$50billionrescuepackageforHypo
realestateHoldingsSwitzerlandrescueduBSoneofthe
tenlargestbanksintheworldwitha$5billionpackage
Iceland took over its three largest banks and its subseshy
quent difficulties highlight what happens when the cost
ofbailingoutacountryrsquosbanksexceedsthegovernmentrsquos
resources
Throughoutthefallof2008therewasaldquoflighttoqualityrdquo
inmarketsaroundtheworldWheninvestorsareworried
aboutdefaulttheydemandhigherinterestratesYieldson
securitieswithanyhintofdefaultriskrosesharplyespeshy
ciallyinthefinancialsector
Theflighttoqualityisapparentintheinterestrateson
commercialpaperinFigure1Commercialpaperisshortshy
termunsecureddebtissuedbybanksandotherlargecorshy
porationsandisanimportantpartoftheirfinancingThe
commercialpaperratesforfinancialinstitutionsandlowershy
creditqualityborrowers jumped inSeptemberandoctoshy
berbutafterasmallincreasetherateforlargecreditworshy
Copyrighted Material
InTroDuCT Ion bull 9
7
6
5
4
3
2
1
0
A2P2 Nonfinancial
AA Financial
AA Nonfinancial
Jul 2008 Aug 2008 Sep 2008 Oct 2008 Nov 2008 Dec 2008
Figure1annualizedpercentYieldson0shyDayHighshyQuality(aa)FinancialandnonfinancialCommercialpaperandMediumshyQuality(a2p2)nonfinancialCommercialpaperinpercentaugusttoDecember2008SourceFederalreserve
thynonfinancialcompaniesactuallydeclinedTherateon
uSTreasurybillswhichareviewedas themost secure
investmentalsofellthethreeshymonthTreasurybillrateacshy
tuallydroppedtozeroforbriefperiodsinnovemberand
December2008
the run on the shadoW BankIng system
Thepanicthatstruckfinancialmarketsinthefallof2008
hasbeencharacterizedasarunontheshadowbankingsysshy
temandwithgoodreasonBeforetheCrisismanybonds
mortgagebackedsecuritiesandother credit instruments
Copyrighted Material
10 bull CHapTer 1
wereheldbyleveragednonshybankintermediariesincluding
hedgefunds investmentbanksbrokeragefirmsandspecialshy
purposevehiclesManyoftheseintermediarieswereforced
toldquodeleverrdquoduringoctoberandnovembersellingassetsto
repaytheircreditors
Hedgefundsandotherleveragedintermediariesusethe
securitiesintheirportfoliosascollateralwhentheyborrow
moneyDuringtheWorldFinancialCrisismanywarylendshy
ersdecidedthecollateralborrowershadpostedbeforethe
Crisis was no longer sufficient to guarantee repayment
Whenthelendersdemandedeithermoreorbettercollatshy
eralmanyborrowerswereforcedtoselltheirleveredposishy
tionsandrepaytheirloansTheresultwasareductionin
thequantityofassetstheyheldandintheirleverageInadshy
ditionhedgefundsandotherintermediariessufferedlarge
withdrawalsbypanickycustomersagainforcingthemto
sellsecuritiesonthemarketTheassetsbeingsoldweregenshy
erallyacquiredbyindividualinvestorsthefederalgovernshy
mentorcommercialbankswhichasagroupfinancedmost
oftheirpurchasesbyborrowingfromthegovernment
The financing difficulties faced by arbitrageurs and lishy
quidity providers are apparent in a series of fascinating
market pathologies In financialmarkets there are often
manydifferentwaystoobtainthesameoutcomeaninvesshy
torcanusemanydifferentcombinationsofsecuritiesfor
exampletorisklesslyconvertdollarstodayintodollarsin
sixmonthsThe actionsof arbitrageursusuallykeep the
costsof thedifferent approaches closely alignedDuring
thefallof2008thecostsoftendivergedwiththeapproach
thatrequiredmorecapitaltypicallycostingless
Copyrighted Material
InTroDuCT Ion bull 11
Theprincipleofcoveredinterestparityforexamplesays
thataftereliminatingexchangerateriskriskshyfreeinvesting
shouldhavethesamereturnineverycurrencyaninvestor
whowantstoinvestdollarstodayandreceivedollarsinthe
futureusuallybuysauSbondHecouldaccomplishthe
samethingbyconvertinghisdollarsintoeurosinvesting
inarisklesseurobondandlockingintheconversionof
theeuropayoffbackintodollarswithaforwardcontract
Sincebothstrategiesconvertdollarstodayintodollarsin
thefuturetheyshouldhavethesamereturn5 Supposeinshy
steadthereturnontheuSbondislowerThenanarbitrashy
geurcouldborrowmoneyintheunitedStatesatthelower
rateinvestitintheeurotransactionatthehigherrateand
makeaprofit
During the Crisis covered interest parity violations as
largeas20basispoints(020percent)emergedThismay
seemtrivialbutinnormaltimestheseviolationsrarelyexshy
ceed 2 basis pointsMoreover traders can usuallyldquolever
uprdquotransactionslikethisandmakealargeprofitButthatrsquos
thecatchmdashhedgefundsbrokeragesandinvestmentbanks
werebeingforcedtodeleverduringtheCrisisand20basis
points is not enough to enticemany longshyonly investors
to replace theuSbond theyarecurrentlyholdingwith
aforeignbondandsomeseeminglycomplicatedcurrency
transactions
other recent research finds similar disruptions of the
normalpricing relations linking (1)Treasurybondscorshy
poratebondsandcreditshydefault swaps (aTreasurybond
shouldbethesameasacorporatebondplusacreditdefault
swapmdashexceptforliquidityfinancingandCDScounterparty
Copyrighted Material
12 bull CHapTer 1
risk)(2)fixedandfloatingrate investments (asequence
ofshortshyterminvestmentsplusacontractswappingafloatshy
ing interest rate forafixed interest rateshouldhave the
same payoff as a fixed rate investment) () convertible
bondsdebtandequity()newlyissuedldquoonshytheshyrunrdquoand
recently issuedldquooffshytheshyrunrdquoTreasury bondswhich have
essentially the same payoff but differ in liquidity and
(5)stockandoptionpriceswhicharelinkedbywhatfishy
nancialeconomistscalltheputshycallparityrelation7
Thebreakdownofthesenormalpricingrelationsdoes
littledirectharm to the restof theeconomya20shybasisshy
pointviolationofcoveredinterestparityhaslittleeffecton
auSexporterusingcurrencycontractstolockintherate
atwhichitcanconvertfutureJapaneserevenuebackinto
dollarsTheseviolationsshowhoweverthatmarketswere
notfunctioningnormallyInparticulartheysuggestthere
wasnotmuchcapitalavailabletoprovideliquiditytobuyshy
ersandsellersanyoneneedingtosellsecuritiesquicklyin
suchamarketmdashsuchasafinancialinstitutiontryingtoreshy
duceitsriskmdashwasnotlikelytogetagoodprice
lendIng BankIng and the recessIon
Duringthefallof2008outputandfinancingactivityconshy
tracted sharply Commercial paper corporate bond and
equityissuanceallfelldramaticallyasdidmortgageorigishy
nations
originations of most types of asset backed securities
alsoslowedtoatrickleManybanksintheunitedStates
Jan 20
04Ju
l 200
4Ja
n 2005
Jul 2
005
Jan 20
06Ju
l 200
6Ja
n 2007
Jul 2
007
Jan 20
08Ju
l 200
8Ja
n 2009
Jul 2
009
Copyrighted Material
InTroDuCT Ion bull 1
0
50
100
150
200
250
Figure2assetBackedSecuritiesIssuedintheunitedStatesJanushyary200toDecember2009BillionsofDollarsperMonthSourceFederalreserve
and other countries no longer hold much of the credit
theyissueTheyhavemovedinsteadtoanldquooriginateand
sellrdquomodel inwhich theybundle together similar loans
suchasjumbomortgagescommercialloansstudentloans
or credit card debt and sell them to investors as asset
backedsecuritiesnewissuesofthesesecuritiesessentially
stopped inoctoberandnovember2008Figure2shows
that the amount of asset backed securities issued in the
united States rose from$288 billion in January 2000 to
$85billioninJune2007andthenplungedto$102bilshy
lioninSeptember2007IssuanceintheunitedStatesconshy
tinued to decline over the next year eventually falling
to only $87 billion in october 2008 and $ billion in
Copyrighted Material
1 bull CHapTer 1
novembermdashjust2percentofthevolume18monthsearlier
onlymortgagespooledbyFannieMaeandFreddieMac
withanexplicitgovernmentguaranteeandsubjecttohuge
Federalreservepurchasescontinuedtoflowtothemarket
There isplentyof anecdotal and surveyevidence that
banklendingalsodriedupduringtheCrisisForexample
loanofficerssurveyedbytheFederalreservereportedthat
credit conditionsprogressively tightenedduring2008In
asurveyabouttheirperceptionsofcreditconditionsand
corporatedecisionsasoflatenovember2008morethan
halfofthechieffinancialofficersoflargeamericanfirms
whorespondedsaidthattheirfirmswereeitherldquosomewhat
orveryaffectedbythecostoravailabilityofcreditrdquo8
There is a lively and fundamentally important debate
about why the quantity of lending fell Some financial
economists argue that banks wanted to lend more but
wereunable todosobecausetheyfacedbindingcapital
constraintsInthisviewinformationcostsandotherfricshy
tionsintheloanoriginationprocesskeptcustomersfrom
movingtolessconstrainedbanks
othersarguethattheprimaryreasonbankswereunwillshy
ingtolendisthattheircustomershadbecomelesscreditshy
worthyTheseeconomistspointoutthatthehighlevelof
uncertainty about future economic conditionsduring the
Crisisratchetedupthedefaultriskofeventhemostrelishy
ableclientsThisinterpretationofthedeclineinbanklendshy
ingimpliesthatnoamountofcapitalwouldhaveinduced
banksasagrouptolendmorebecauseallthegoodloans
werebeingmade
Figure shows data on the quantity of bank lending
Jan 20
08
Mar
2008
M
ay 20
08Ju
l 200
8Se
p 2008
Nov 20
08Ja
n 2009
Jan 20
09
May
2009
Jul 2
009
Sep 20
09Nov
2009
Copyrighted Material
InTroDuCT Ion bull 15
1050
1100
1150
1200
1250
1300
FigureCommercialandIndustrialLoansbyuSCommercialBanks2008ndash9inBillionsofDollarsSourceFederalreserve
intheunitedStatesin2008and2009Startinginoctober
2008therewasaspikeinlendingfollowedbyaprotracted
declineVVChariLawrenceChristianoandpatrickKehoe
takethespikeatfacevalueinaggregatebankslentmore
ataminimumthebankingsystemasawholemdashasopposed
to individual banksmdashwas not deleveraging to overcome
loss of capital9 Victoria Ivashina and David Scharfstein
notethatmuchoftheincreaseinbanklendingwasinvolshy
untaryonthepartofthebankstheresultofdrawdowns
byborrowersonexistinglinesofcredit10 Theyalsoshow
thatbanks thatweremorevulnerable todrawdownsbeshy
causetheywereinmoresyndicateswithLehmanreduced
subsequent lending more and conclude that there was
indeed a genuine contraction in the effective supply of
bankcredit
Copyrighted Material
1 bull CHapTer 1
economistswillargueabouttheeventsoftheWorldFishy
nancialCrisisforyearstocomeInfactwestillargueabout
theGreatDepressionnoneoftheanalysisbehindourrecshy
ommendationshoweverdepends onhow these debates
aresettledForexamplenomatterhowcapitalshyconstrained
thebankingsystemreallywasinthefallof2008ourproshy
posalsforchangesthatmakesuchconstraintslessbinding
andgivepolicymakersbettertoolswhentheyfearcapital
constraintsremainvalid
What Was Wrong WIth the FInancIal system durIng the crIsIs
The Crisis revealed a number of serious problems with
ourfinancialsystemSomehadbeeninthebackgroundall
alongothersdidnotappearuntiltheCrisisInthisbook
weemphasizefourcategoriesofproblemsconflictsofinshy
terestknowntoeconomistsasagencyproblemsthediffishy
cultyofapplyingstandardbankruptcyprocedurestofinanshy
cialinstitutionstheemergenceofamodernformofbank
runsandtheinadequacyoftheregulatorystructurewhich
hadnotkeptupwithrecentfinancialinnovation(Infact
muchinnovationservedtoescaperegulations)
Conflicts of Interest Agency Problems
Conflictsofinterestthatcannotberesolvedeasilybyconshy
tractsormarketsoccurthroughouttheeconomybutthey
Copyrighted Material
InTroDuCT Ion bull 17
canbeparticularlyharmfulinthefinancialsystemThere
areseveralreasonsFirstmanyfinancialtransactionsand
contractsinvolveaprincipalsuchasaninvestororshareshy
holderaskingatradermanagerorotheragenttoacton
hisorherbehalfSecondmostfinancial transactions inshy
volvehighlyuncertainfuturepayoffsandinmanytransacshy
tionsonepartyisbetterinformedaboutthepayoffsthan
the otherThird the high volatility of the future payoffs
oftenmakesithardtoassesswhethertheoutcomeofafishy
nancialtransactionisduetotheagentrsquoseffortsorluckand
fourththesumsinvolvedcanbehuge
Someproprietarytradersforexampleearnalotwhen
their tradesdowellbuttheirpersonal lossesare limited
whentheirtradesdopoorlyBecauseoftheasymmetricnashy
tureoftheircompensationthesetraderscanincreasetheir
expectedincomebytakingriskierpositionsThisproblem
isdramaticallyillustratedbyperiodiccasesinwhichldquorogue
tradersrdquoincurlossesthatarebigenoughtodamageoreven
destroy large financial institutions In 1995 nick Leeson
broughtdownBaringsBankwitha$1billionlossandin
2008itwasrevealedthatJeacuterocircmeKervielhadseverelydamshy
agedSocieacuteteacuteGeacuteneacuteralewithalossofover$7billion
Conflictsofinterestorldquoagencyproblemsrdquoalsoexistat
manyotherlevelswithinthefinancialsystemShareholders
offinancialinstitutionshaveaconflictofinterestwiththe
bankrsquosseniorexecutivesespeciallywhenthoseexecutives
arerewardedforgoodperformancebutdonothavealarge
fractionoftheirwealthtiedupinthesharesofthebank
Manyfinancialinstitutionshavelargequantitiesofdebt
Copyrighted Material
18 bull CHapTer 1
which creates a conflict of interest between the bankrsquos
creditorsanditsshareholdersShareholdershaveanincenshy
tivetoauthorizeexcessivelyriskyinvestmentsforexample
especiallyafterabankhasincurredlossesthaterodethe
valueoftheshareholdersrsquoclaimThegainsontheserisky
investmentswillaccruelargelytoshareholderswhilethe
losseswillmostlybebornebycreditorsTheconflictwith
creditorsalsoreducestheincentivesfortheshareholders
of troubled institutions to raisenewcapitalbecause that
wouldstrengthen thepositionofcreditorswhilediluting
theshareholdersrsquopositionThisldquodebtoverhangrdquoproblem
waswidelycitedduringtheWorldFinancialCrisiswhen
many banks that were insolvent or close to insolvency
seemedreluctanteithertoraisenewcapitalortoreduce
theirrisksbysellingdistressedsecurities11
atthehighestlevelthereisaconflictofinterestbetween
societyasawholeandtheprivateownersoffinancialinshy
stitutions Because robust financial institutions promote
economicgrowthandemploymentduringfinancialcrises
governmentsoftenrescuetroubledfirmstheyperceiveto
be systemically importantThe result is privatized gains
andsocializedlossesIfthingsgowellthefirmsrsquoowners
andmanagersclaimtheprofitsbutifthingsgopoorlysoshy
cietysubsidizesthelosses
The candidates for government bailouts are popularly
describedasldquotoobigtofailrdquoMorepreciselytheargument
for government supportmdashwhich many economists chalshy
lengemdashisaboutfirmsthataretoosystemicallyimportantto
failInits200annualreporttheeuropeanCentralBank
describedsystemicriskasldquoTheriskthattheinabilityofone
Copyrighted Material
InTroDuCT Ion bull 19
institutiontomeetitsobligationswhenduewillcauseother
institutions to be unable tomeet their obligationswhen
dueSuchafailuremaycausesignificantliquidityorcredit
problemsandas a resultcould threaten the stabilityof
or confidence in marketsrdquo Systemically important firms
arethosewhosefailurecouldposealargethreattothestashy
bilityoforconfidenceinmarketsThesefirmsarelikelyto
belargebuttheyalsotendtohavecomplexinterconnecshy
tionswithotherfinancialinstitutions
Tooshybigshytoshyfailpoliciesoffersystemicallyimportantfirms
theexplicitorimplicitpromiseofabailoutwhenthingsgo
wrongThesepoliciesaredestructiveforseveralreasons
Firstbecause the possibility of a bailoutmeans a firmrsquos
stakeholders claim all the profits but only some of the
lossesfinancialfirmsthatmightreceivegovernmentsupshy
porthaveanincentivetotakeextrariskThefirmrsquosshareshy
holderscreditorsemployeesandmanagement all share
thetemptationTheresultisanincreaseintherisksborne
bysocietyasawhole
Secondthesepoliciesencouragesmallerfinancialinstishy
tutionstoexpandortobecomemorecloselyinterconnected
with other firms so they move under the tooshybigshytoshyfail
umbrellaFirmshaveanincentivetodowhateverittakes
tomakepolicymakersfeartheirfailurecreatingthevery
fragilitythegovernmentwishestoavoidBeliefthatagovshy
ernmentrescuewillprotectafinancial institutionrsquoscredishy
tors inacrisisalsogivesafirmacompetitiveadvantage
loweringitscostoffinancingandallowingittoofferbetter
prices to its customers than its fundamental productivity
warrants
Copyrighted Material
20 bull CHapTer 1
Thirdinefficientfirmsthatcannotcompeteontheirown
shouldfailotherwisefirmshavelessincentivetobecome
andstayefficientagovernmentpolicythatpropsupinshy
efficientfirmsiswastefulanddestructiveallowingthese
firmstofailfreesupresourcesandprovidesopportunities
formoreefficientandinnovativecompetitorstoflourish
Fourthandmostgenerallycapitalismisunderminedby
policiesthatprivatizegainsbutsocializelossesGovernment
guaranteedinstitutionscanbecomegovernmentruninstishy
tutionsallocatingcreditforexampletomaximizepolitical
gainratherthaneconomicwelfare
The conflictbetween society and theownersoffinanshy
cialfirmsbecomesmoreseriousduringseverecriseswhen
manyfinancialinstitutionsareclosetoinsolventIt isthe
primemotivationforourregulatoryproposalsbutseveral
ofthelowershylevelconflictswehavedescribedarerelevant
becausetheymagnifytheriskbornebysocietyasawhole
Theselfshyservingbehaviorthatmanyofourrecommenshy
dations targetmdashwhether by traders senior management
orthefirmrsquosownersmdashneednotbestrategicintentionally
maliciousorevenconsciousConsideratraderwhoinadshy
vertentlydevelopsaninvestmentstrategywithhighlyprobshy
ablegainsandimprobablebutlargelossesLikeafirmthat
hassoldearthquakeinsurancethestrategymayproducea
longstringofimpressivereturnsbeforeoneyearoflosses
wipesoutmanyyearsofprofits12 Ifsoduringthegood
yearsthetraderwillbecelebratedforhisorherbrilliance
rewarded with large bonuses and given more resources
to manageMany sophisticated traders and hedge funds
Copyrighted Material
InTroDuCT Ion bull 21
werenotawareoftheldquoearthquakerisksrdquoinherentinmany
of theirstrategiesSimilarlywhenfirmstakeactionsthat
increasethelikelihoodofagovernmentbailoutinthenext
financialcrisisthemarketrewardsthemwithalowercost
of capitalas firms become too big to fail for example
the implicit government guarantee reduces the riskiness
of their debt and lowers the interest rate demanded by
theircreditorsaCeoworkingtomaximizefirmvaluemay
notevenrealize the importanceof thegovernmentguarshy
anteebut a Darwinian process will encourage behavior
thatexploitsit
Bankruptcy and Resolution Procedures
Itisimpossibletowriteafinancialcontractthatspecifies
everypossiblecontingencyInsteadcontractsrelyonbankshy
ruptcytodetermineoutcomesincertainbadandunlikely
statesoftheworldInbankruptcycontrolofafirmistransshy
ferredfromtheshareholderswhonolongerhaveastake
inlossesbecausetheirsharesareworthlittletothedebtshy
holders It is in societyrsquos interest to develop bankruptcy
proceduresthatmaximizethepostshybankruptcyvalueofa
firmrsquosassetsInparticularsocietyshouldavoidthedestrucshy
tionofvaluethatoccurswithdisorderlyliquidation
Disorderlyliquidationoffinancialinstitutionsisparticushy
larly costlyFirstvaluableknowledge that the institution
hasaccumulatedaboutitscounterpartiesmdashborrowerstradshy
ingpartnersandsoonmdashcandisappearastheinstitution
losesemployeesandceasestooperatenormallyFinancial
Copyrighted Material
22 bull CHapTer 1
economistshavefoundthatthecollapseofabankhasamashy
terialadverseimpactonmanyofitsborrowers1 Second
the prospect of a disorderly liquidation makes it more
likelythatatroubledfinancialinstitutionwillsufferarun
by creditors who conclude they are better off claiming
whatmoney theycan todayrather thanwaiting through
protracted liquidation proceedings Third ldquofire salesrdquo of
specializedassets inadisorderly liquidationcandepress
prices and thereby spread problems to other holders of
theassetclassFourthdisorderlyliquidationincreasesthe
uncertaintyabouttheimpactofafinancialinstitutionrsquosfailshy
ureonitscounterpartiesandotherclaimholdersBecause
financialfirmsaretightlyinterconnectedthisuncertainty
canprecipitateorintensifyafinancialcrisis1
In theunitedStatesthestandardbankruptcycodealshy
lowsbothforliquidationofafirmandthesaleofitsassets
(Chapter7)andforcontinuedoperationofafirmunder
the supervision of a bankruptcy judgewho protects the
firmfromcreditorsrsquoclaimswhileareorganizationplanis
approved(Chapter11)Theseproceduresappeartowork
wellfornonfinancialcorporationsbutnotsowellforfinanshy
cialorganizationsTheChapter11approachofseparatinga
firmrsquosfinancialaffairsfromitsnonfinancialbusinessactivishy
tiesisinfeasiblewhenthebusinessofthefirmisfinancial
transactionsFurthermoremanyfinancialinstitutionsrely
heavily on shortshyterm debtpossibly as a valuable discishy
plineonbankexecutiveswhocanrapidlychangetherisks
theirfirmstakeThismakesfinancialfirmsvulnerabletoa
rapidwithdrawalofshortshytermcreditthatislikelytooccur
beforeanyeventthatwouldtriggerbankruptcy
Copyrighted Material
InTroDuCT Ion bull 2
Wearguebelowthatthereisaneedforaspecialresolushy
tionprocedurethatcanbeappliedtolargeinsolventfinanshy
cialinstitutionsWealsoadvocateregulatorychangesthat
would push financial firms towardmore resilient capital
structures
Bank Runs
Classicbank runs inwhichdepositors race towithdraw
their funds before a bank failswere one of the central
contributors to theGreatDepressionDeposit insurance
whichwasintroducedaftertheDepressiontocounterthis
destructiveprocessmadedemanddepositsoneofthemost
stableformsofbankfinancingduringtheWorldFinancial
CrisisManyfinancialinstitutionshoweversufferedamodshy
ernversionofbankruns
Banksespeciallythosewithinvestmentbankingactivishy
tiestypicallyfinanceasignificantfractionoftheirbusiness
withovernightcommercialpaperreposandothershortshy
terminstrumentsInnormaltimesbanksrolloverthisdebt
asitmaturestakingnewloanstopayofftheoldInacrishy
sishoweveruncertaintyaboutwhetheratroubledinstitushy
tionwouldbeabletopayoffitscreditorstomorrowcauses
lenderstostopextendingcredittodayThusshortshytermfishy
nancingcanleadtoarunthatissimilartoaclassicrunon
deposits
even some secured creditors participated in runs durshy
ingtheWorldFinancialCrisisBanksoftenuserepurchase
agreements to borrow money securing the loan by givshy
ingthelenderafinancialassetsuchasaTreasurybond
Copyrighted Material
2 bull CHapTer 1
ascollateralBecausetheyareovershycollateralizedwithasshy
setsworthperhaps$105guaranteeingevery$100inloans
lendersviewldquoreposrdquoasasafewaytoextendcreditWhen
credit markets froze during the Crisis however lenders
worried that retrieving collateral and selling itwouldbe
difficultandnotworththesmallinterestonanovernight
loanasaresultatvarioustimesduringtheCrisismany
investmentbankshaddifficultyrollingovereventheirseshy
cured loanseven relatively healthy financial institutions
werehamperedbythetroubleintherepomarketafteraushy
gust2007asthemarketbecamemoreandmoreuncertain
about the prices securities would fetch in a forced sale
these institutions found they could borrow less and less
withthesamecollateral15
prime brokerage accounts also saw a runshylike withshy
drawalbycustomersManylargebankshaveprimebrokershy
agegroupsthatassisthedgefundsandotherinstitutionalinshy
vestorsbyprovidingfinancingsecuritieslendingclearing
custodial servicesandoperational supportInexchange
thefundspayfeesandcriticallypostcollateraltosecure
theirloansWithsomerestrictionsthatweexplaininChapshy
ter10theprimebrokercanthenusethecollateralinits
ownbusinessinsomecasescomminglingitwiththefirmrsquos
ownassetsDuringtheCrisishedgefundsmonitoredthe
financial wellshybeing of their prime brokers and like deshy
positorsintheDepressionfledwiththeircollateralatthe
firstsignoftroubleBearStearnsforexamplehadalarge
prime brokerage business according to press accounts
oneofthelargesthedgefundsthatusedBearStearnsasa
Copyrighted Material
InTroDuCT Ion bull 25
primebrokerrenaissanceTechnologieswithdrew$5bilshy
lionofcashintheweekthefirmfailedWithsuchoutflows
it is not surprising that Bear Stearns ran out of money
eventhoughithadmorethan$18billionincashaweek
earlier
Likeclassicbankrunsmodernbankrunsarebothdeshy
structiveandselfshyfulfillingConcernthatabankmightbe
in trouble spurs its creditors and counterparties towithshy
draworwithholdtheircapitalasaresultevenrumorsofa
problemmaybeenoughtodestroyaviableinstitutionThe
importanceofmodernbankrunsduringtheWorldFinanshy
cialCrisisisarecurringthemethroughoutthebookand
wemakeseveralproposalsthatareintendedtoreducethe
frequencyofsuchevents
The Inadequacy of the Regulatory Structure
TheWorldFinancialCrisismadeitclearthatfinancialinnoshy
vationhadoverwhelmedexistingfinancialregulationsnoshy
tableexamplesincludeaIGrsquosdecisiontosellanextremely
large amount of credit default swaps on subprime debt
tobanksintheunitedStatesandabroadtheholdingof
Lehmanpaperbymoneymarketfundsparticularlythereshy
serveprimaryFundthecomplexityofthederivativebooks
atLehmanandotherinvestmentbanksandthedifficultyof
simultaneouslyapplyingseveralcountriesrsquobankruptcycodes
tothesubsidiariesofmultinationalfinancialinstitutions1
Thereisatradeshyoffbetweenfinancialinnovationandstashy
bilityInnovationcanimprovethefinancialsystemrsquosability
Copyrighted Material
2 bull CHapTer 1
toallocateresourcestotheirhighestvaluedusebutitcan
alsoreducethestabilityofthesystemThechallengeisto
developregulationsthatimprovestabilitywithoutstifling
innovation In addition regulation often leads to innoshy
vations designed to evade the regulationswhich makes
thefinancialsystemmorefragileForexamplemanyofthe
specialshypurposevehiclesthatimplodedintheCrisiswere
createdtogetaroundcapitalrequirements
In many countries the response of regulators to the
World Financial Crisis was hampered by the fragmented
nature of their regulatory systems Financial regulations
are typically designed to ensure thehealth of individual
institutionsratherthanthefinancialsystemasawholeIn
thisbookwearguethatsystemicregulationisanimporshy
tantfunctionthatrequiresaspecialmandateandthatthe
central bank is particularly well equipped to fulfill this
function
Finallyeffectivefinancialregulationrequiresthatpolitishy
ciansandultimatelythepublichaveanadequateundershy
standing of the financial system The political turmoil
surroundingtheCrisissuggeststheimportanceofdissemishy
natingexpertknowledgeaboutfinancetoabroaderaudishy
enceThisisoneofourmotivationsforwritingthisbook
What Were the orIgIns oF the World FInancIal crIsIs
LiketheoriginsoftheFirstWorldWarthecausesofthe
Crisiswillbedebatedbyscholarsformanyyears
Copyrighted Material
InTroDuCT Ion bull 27
Most observers agree that the strong runshyup and subshy
sequentsharpdeclineinthepricesofstockshousesand
otherfinancialassetsindevelopedcountrieswasanimporshy
tantcatalystfortheCrisisThereisdisagreementhowever
aboutwhetherthispatterninpricesistheresultofrational
investorbehaviororldquoirrationalbubblesrdquo
SomearguethattherunshyupbeforetheCrisiswasdriven
by investorswhoknowingly acceptedunusually low exshy
pectedreturnsandtheyofferseveralpossiblereasonswhy
Firsttherewasasurgeofsavingsinemergingcountries
drivenbyacombinationofrapideconomicgrowthanddeshy
mographicsperhapsbecauseofadesiretoaccumulateforshy
eignreservesintheaftermathoftheasiacrisisof1997ndash98
muchof thiswealthwas invested indevelopedmarkets
Secondfinancialmarketswereunusually tranquilduring
200to200Withlowvolatilityinvestorsmayhavesettled
for a low risk premiumThird influenced by fears of a
Japaneseshystyledeflation resulting from themarketdownshy
turnof2000ndash2001andbyabeliefthattheyshouldnottry
to usemonetary policy to counteract rising asset prices
central bankers in the united States maintained a loose
monetarypolicythroughouttheperiod17andfromthisrashy
tionalviewofinvestorstheplungeinassetpricesthatacshy
companiedtheCrisiswascausedbybadnewsaboutfuture
cashflowsunexpectedincreasesinthereturnsrequiredby
investorsorboth
otherssuggestamoredirectexplanationThehighprices
before theCrisisweredrivenby an irrational belief that
prices would continue to rise and the collapse of asset
priceswastheinevitableresultofthismistakeWhatever
Copyrighted Material
28 bull CHapTer 1
theexplanationthesharpdropinassetpricesbothconshy
tributedtoandwasasymptomoftheCrisis
other commentators argue that the financial system
becamevulnerablebecausemanymarketparticipantsasshy
sessedrisksinaccuratelyduringtheperiodleadingupto
theWorldFinancialCrisisConsumersbanksandinvestors
ingeneralunderestimatedtheriskofhousepricedeclines
increasingthepricestheywerewillingtopayforrealesshy
tatethecredittheywerewillingtoextendandthevaluashy
tionsofbanksthatextendedsuchcreditBanksputmuch
weight on the recent pastwhen they estimated value at
riskwhichledthemtoconcludethatthelevelofriskwas
lowandthattherewaslittledownsidetohavinghighleshy
verageothermarketparticipantsdidnotfullyappreciate
thathighliquiditywassuppressingvolatilityandthatthe
processmightreversewithliquiditydecreasingandvolatilshy
ityincreasing
More generally the high level of financial innovation
driveninpartbythedecliningcostofinformationtechnolshy
ogymadeithardforriskassessmenttokeeppacewiththe
evolvingfinancialsystem18Thebenignenvironmentofthe
creditboomexacerbatedthisproblembytemptingfinanshy
cialinstitutionstounderinvestinriskmanagement
uSpolicymakersalsocontributedtotheseverityofthe
CrisisbypushingFannieMaeandFreddieMactoincrease
theavailabilityofmortgagefundingtoborrowerswithquesshy
tionableabilitytorepaytheirmortgagesasaresultofthis
pressure both agencies relaxed their standards for the
mortgages they purchased and guaranteedThe demand
Copyrighted Material
InTroDuCT Ion bull 29
forhomesbyborrowerswhoqualifiedformortgagesbeshy
causeoftheselowerstandardspusheduppricesandthe
defaultbymanyofthemduringtherecessioncontributed
tothedropinhomeprices
Thepanicandruninthefallof2008remainthecentral
distinguishingfeaturesoftheWorldFinancialCrisisasset
priceshave risenand fallenbeforeand theworldeconshy
omyhasbornelargefinancial lossesmanytimeswithout
suchasevereeconomicoutcomeConverselylossesfrom
completelydifferentunderlyingsourcesmdashcommercialreal
estateorperhapssovereigndefaultsmdashcouldcauseasimilar
catastrophe if theyagainprovoke tooshybigshytoshyfailchaosor
runs
Thisbookdoesnotseektoprovideacompletediagnosis
oftheWorldFinancialCrisisnordoesittakeastandonthe
relativeimportanceofthecontributingfactorslistedabove
ratherwebelieveourrecommendationswillhelpprevent
ormitigatefuturecriseseventhoughwedonotfullyundershy
standallthecausesofthelastone
CarmenreinhartandKennethrogoff amongothershave
pointedoutthatfinancialcriseshaveoccurredthroughout
thehistoryofcapitalismandthatthesecrisessharemany
commonpatterns19 Thelessonwedrawfromthisisthat
noacceptablesetofregulationscanpreventmarketparticishy
pantsfrommakingmistakesthatcreateeconomicinstability
ourpurposeinthisbookisinsteadtosuggestregulatory
reformsthatwillmakethesystemmorestabledespitethe
mistakesthataresuretocome
Copyrighted Material
8 bull CHapTer 1
reservesinthebankingsystemhadgrownfrom$billion
before the Crisis to over $800 billionThese actions are
notafocusofouranalysisbuttheysurelyhelpedprevent
theCrisisfromturningintoanotherGreatDepressionat
aminimumtheyeliminatedmostbanksrsquoconcernsabout
sourcesofcash
Bankfailuresineuropeinthefallof2008ledtomore
directbailoutsThenetherlandsBelgiumandLuxembourg
spent$1billiontopropupFortisamajoreuropeanbank
with about $1 trillion in assets The netherlands spent
$1billiontobailoutInGabankingandinsurancegiant
Germanyprovideda$50billionrescuepackageforHypo
realestateHoldingsSwitzerlandrescueduBSoneofthe
tenlargestbanksintheworldwitha$5billionpackage
Iceland took over its three largest banks and its subseshy
quent difficulties highlight what happens when the cost
ofbailingoutacountryrsquosbanksexceedsthegovernmentrsquos
resources
Throughoutthefallof2008therewasaldquoflighttoqualityrdquo
inmarketsaroundtheworldWheninvestorsareworried
aboutdefaulttheydemandhigherinterestratesYieldson
securitieswithanyhintofdefaultriskrosesharplyespeshy
ciallyinthefinancialsector
Theflighttoqualityisapparentintheinterestrateson
commercialpaperinFigure1Commercialpaperisshortshy
termunsecureddebtissuedbybanksandotherlargecorshy
porationsandisanimportantpartoftheirfinancingThe
commercialpaperratesforfinancialinstitutionsandlowershy
creditqualityborrowers jumped inSeptemberandoctoshy
berbutafterasmallincreasetherateforlargecreditworshy
Copyrighted Material
InTroDuCT Ion bull 9
7
6
5
4
3
2
1
0
A2P2 Nonfinancial
AA Financial
AA Nonfinancial
Jul 2008 Aug 2008 Sep 2008 Oct 2008 Nov 2008 Dec 2008
Figure1annualizedpercentYieldson0shyDayHighshyQuality(aa)FinancialandnonfinancialCommercialpaperandMediumshyQuality(a2p2)nonfinancialCommercialpaperinpercentaugusttoDecember2008SourceFederalreserve
thynonfinancialcompaniesactuallydeclinedTherateon
uSTreasurybillswhichareviewedas themost secure
investmentalsofellthethreeshymonthTreasurybillrateacshy
tuallydroppedtozeroforbriefperiodsinnovemberand
December2008
the run on the shadoW BankIng system
Thepanicthatstruckfinancialmarketsinthefallof2008
hasbeencharacterizedasarunontheshadowbankingsysshy
temandwithgoodreasonBeforetheCrisismanybonds
mortgagebackedsecuritiesandother credit instruments
Copyrighted Material
10 bull CHapTer 1
wereheldbyleveragednonshybankintermediariesincluding
hedgefunds investmentbanksbrokeragefirmsandspecialshy
purposevehiclesManyoftheseintermediarieswereforced
toldquodeleverrdquoduringoctoberandnovembersellingassetsto
repaytheircreditors
Hedgefundsandotherleveragedintermediariesusethe
securitiesintheirportfoliosascollateralwhentheyborrow
moneyDuringtheWorldFinancialCrisismanywarylendshy
ersdecidedthecollateralborrowershadpostedbeforethe
Crisis was no longer sufficient to guarantee repayment
Whenthelendersdemandedeithermoreorbettercollatshy
eralmanyborrowerswereforcedtoselltheirleveredposishy
tionsandrepaytheirloansTheresultwasareductionin
thequantityofassetstheyheldandintheirleverageInadshy
ditionhedgefundsandotherintermediariessufferedlarge
withdrawalsbypanickycustomersagainforcingthemto
sellsecuritiesonthemarketTheassetsbeingsoldweregenshy
erallyacquiredbyindividualinvestorsthefederalgovernshy
mentorcommercialbankswhichasagroupfinancedmost
oftheirpurchasesbyborrowingfromthegovernment
The financing difficulties faced by arbitrageurs and lishy
quidity providers are apparent in a series of fascinating
market pathologies In financialmarkets there are often
manydifferentwaystoobtainthesameoutcomeaninvesshy
torcanusemanydifferentcombinationsofsecuritiesfor
exampletorisklesslyconvertdollarstodayintodollarsin
sixmonthsThe actionsof arbitrageursusuallykeep the
costsof thedifferent approaches closely alignedDuring
thefallof2008thecostsoftendivergedwiththeapproach
thatrequiredmorecapitaltypicallycostingless
Copyrighted Material
InTroDuCT Ion bull 11
Theprincipleofcoveredinterestparityforexamplesays
thataftereliminatingexchangerateriskriskshyfreeinvesting
shouldhavethesamereturnineverycurrencyaninvestor
whowantstoinvestdollarstodayandreceivedollarsinthe
futureusuallybuysauSbondHecouldaccomplishthe
samethingbyconvertinghisdollarsintoeurosinvesting
inarisklesseurobondandlockingintheconversionof
theeuropayoffbackintodollarswithaforwardcontract
Sincebothstrategiesconvertdollarstodayintodollarsin
thefuturetheyshouldhavethesamereturn5 Supposeinshy
steadthereturnontheuSbondislowerThenanarbitrashy
geurcouldborrowmoneyintheunitedStatesatthelower
rateinvestitintheeurotransactionatthehigherrateand
makeaprofit
During the Crisis covered interest parity violations as
largeas20basispoints(020percent)emergedThismay
seemtrivialbutinnormaltimestheseviolationsrarelyexshy
ceed 2 basis pointsMoreover traders can usuallyldquolever
uprdquotransactionslikethisandmakealargeprofitButthatrsquos
thecatchmdashhedgefundsbrokeragesandinvestmentbanks
werebeingforcedtodeleverduringtheCrisisand20basis
points is not enough to enticemany longshyonly investors
to replace theuSbond theyarecurrentlyholdingwith
aforeignbondandsomeseeminglycomplicatedcurrency
transactions
other recent research finds similar disruptions of the
normalpricing relations linking (1)Treasurybondscorshy
poratebondsandcreditshydefault swaps (aTreasurybond
shouldbethesameasacorporatebondplusacreditdefault
swapmdashexceptforliquidityfinancingandCDScounterparty
Copyrighted Material
12 bull CHapTer 1
risk)(2)fixedandfloatingrate investments (asequence
ofshortshyterminvestmentsplusacontractswappingafloatshy
ing interest rate forafixed interest rateshouldhave the
same payoff as a fixed rate investment) () convertible
bondsdebtandequity()newlyissuedldquoonshytheshyrunrdquoand
recently issuedldquooffshytheshyrunrdquoTreasury bondswhich have
essentially the same payoff but differ in liquidity and
(5)stockandoptionpriceswhicharelinkedbywhatfishy
nancialeconomistscalltheputshycallparityrelation7
Thebreakdownofthesenormalpricingrelationsdoes
littledirectharm to the restof theeconomya20shybasisshy
pointviolationofcoveredinterestparityhaslittleeffecton
auSexporterusingcurrencycontractstolockintherate
atwhichitcanconvertfutureJapaneserevenuebackinto
dollarsTheseviolationsshowhoweverthatmarketswere
notfunctioningnormallyInparticulartheysuggestthere
wasnotmuchcapitalavailabletoprovideliquiditytobuyshy
ersandsellersanyoneneedingtosellsecuritiesquicklyin
suchamarketmdashsuchasafinancialinstitutiontryingtoreshy
duceitsriskmdashwasnotlikelytogetagoodprice
lendIng BankIng and the recessIon
Duringthefallof2008outputandfinancingactivityconshy
tracted sharply Commercial paper corporate bond and
equityissuanceallfelldramaticallyasdidmortgageorigishy
nations
originations of most types of asset backed securities
alsoslowedtoatrickleManybanksintheunitedStates
Jan 20
04Ju
l 200
4Ja
n 2005
Jul 2
005
Jan 20
06Ju
l 200
6Ja
n 2007
Jul 2
007
Jan 20
08Ju
l 200
8Ja
n 2009
Jul 2
009
Copyrighted Material
InTroDuCT Ion bull 1
0
50
100
150
200
250
Figure2assetBackedSecuritiesIssuedintheunitedStatesJanushyary200toDecember2009BillionsofDollarsperMonthSourceFederalreserve
and other countries no longer hold much of the credit
theyissueTheyhavemovedinsteadtoanldquooriginateand
sellrdquomodel inwhich theybundle together similar loans
suchasjumbomortgagescommercialloansstudentloans
or credit card debt and sell them to investors as asset
backedsecuritiesnewissuesofthesesecuritiesessentially
stopped inoctoberandnovember2008Figure2shows
that the amount of asset backed securities issued in the
united States rose from$288 billion in January 2000 to
$85billioninJune2007andthenplungedto$102bilshy
lioninSeptember2007IssuanceintheunitedStatesconshy
tinued to decline over the next year eventually falling
to only $87 billion in october 2008 and $ billion in
Copyrighted Material
1 bull CHapTer 1
novembermdashjust2percentofthevolume18monthsearlier
onlymortgagespooledbyFannieMaeandFreddieMac
withanexplicitgovernmentguaranteeandsubjecttohuge
Federalreservepurchasescontinuedtoflowtothemarket
There isplentyof anecdotal and surveyevidence that
banklendingalsodriedupduringtheCrisisForexample
loanofficerssurveyedbytheFederalreservereportedthat
credit conditionsprogressively tightenedduring2008In
asurveyabouttheirperceptionsofcreditconditionsand
corporatedecisionsasoflatenovember2008morethan
halfofthechieffinancialofficersoflargeamericanfirms
whorespondedsaidthattheirfirmswereeitherldquosomewhat
orveryaffectedbythecostoravailabilityofcreditrdquo8
There is a lively and fundamentally important debate
about why the quantity of lending fell Some financial
economists argue that banks wanted to lend more but
wereunable todosobecausetheyfacedbindingcapital
constraintsInthisviewinformationcostsandotherfricshy
tionsintheloanoriginationprocesskeptcustomersfrom
movingtolessconstrainedbanks
othersarguethattheprimaryreasonbankswereunwillshy
ingtolendisthattheircustomershadbecomelesscreditshy
worthyTheseeconomistspointoutthatthehighlevelof
uncertainty about future economic conditionsduring the
Crisisratchetedupthedefaultriskofeventhemostrelishy
ableclientsThisinterpretationofthedeclineinbanklendshy
ingimpliesthatnoamountofcapitalwouldhaveinduced
banksasagrouptolendmorebecauseallthegoodloans
werebeingmade
Figure shows data on the quantity of bank lending
Jan 20
08
Mar
2008
M
ay 20
08Ju
l 200
8Se
p 2008
Nov 20
08Ja
n 2009
Jan 20
09
May
2009
Jul 2
009
Sep 20
09Nov
2009
Copyrighted Material
InTroDuCT Ion bull 15
1050
1100
1150
1200
1250
1300
FigureCommercialandIndustrialLoansbyuSCommercialBanks2008ndash9inBillionsofDollarsSourceFederalreserve
intheunitedStatesin2008and2009Startinginoctober
2008therewasaspikeinlendingfollowedbyaprotracted
declineVVChariLawrenceChristianoandpatrickKehoe
takethespikeatfacevalueinaggregatebankslentmore
ataminimumthebankingsystemasawholemdashasopposed
to individual banksmdashwas not deleveraging to overcome
loss of capital9 Victoria Ivashina and David Scharfstein
notethatmuchoftheincreaseinbanklendingwasinvolshy
untaryonthepartofthebankstheresultofdrawdowns
byborrowersonexistinglinesofcredit10 Theyalsoshow
thatbanks thatweremorevulnerable todrawdownsbeshy
causetheywereinmoresyndicateswithLehmanreduced
subsequent lending more and conclude that there was
indeed a genuine contraction in the effective supply of
bankcredit
Copyrighted Material
1 bull CHapTer 1
economistswillargueabouttheeventsoftheWorldFishy
nancialCrisisforyearstocomeInfactwestillargueabout
theGreatDepressionnoneoftheanalysisbehindourrecshy
ommendationshoweverdepends onhow these debates
aresettledForexamplenomatterhowcapitalshyconstrained
thebankingsystemreallywasinthefallof2008ourproshy
posalsforchangesthatmakesuchconstraintslessbinding
andgivepolicymakersbettertoolswhentheyfearcapital
constraintsremainvalid
What Was Wrong WIth the FInancIal system durIng the crIsIs
The Crisis revealed a number of serious problems with
ourfinancialsystemSomehadbeeninthebackgroundall
alongothersdidnotappearuntiltheCrisisInthisbook
weemphasizefourcategoriesofproblemsconflictsofinshy
terestknowntoeconomistsasagencyproblemsthediffishy
cultyofapplyingstandardbankruptcyprocedurestofinanshy
cialinstitutionstheemergenceofamodernformofbank
runsandtheinadequacyoftheregulatorystructurewhich
hadnotkeptupwithrecentfinancialinnovation(Infact
muchinnovationservedtoescaperegulations)
Conflicts of Interest Agency Problems
Conflictsofinterestthatcannotberesolvedeasilybyconshy
tractsormarketsoccurthroughouttheeconomybutthey
Copyrighted Material
InTroDuCT Ion bull 17
canbeparticularlyharmfulinthefinancialsystemThere
areseveralreasonsFirstmanyfinancialtransactionsand
contractsinvolveaprincipalsuchasaninvestororshareshy
holderaskingatradermanagerorotheragenttoacton
hisorherbehalfSecondmostfinancial transactions inshy
volvehighlyuncertainfuturepayoffsandinmanytransacshy
tionsonepartyisbetterinformedaboutthepayoffsthan
the otherThird the high volatility of the future payoffs
oftenmakesithardtoassesswhethertheoutcomeofafishy
nancialtransactionisduetotheagentrsquoseffortsorluckand
fourththesumsinvolvedcanbehuge
Someproprietarytradersforexampleearnalotwhen
their tradesdowellbuttheirpersonal lossesare limited
whentheirtradesdopoorlyBecauseoftheasymmetricnashy
tureoftheircompensationthesetraderscanincreasetheir
expectedincomebytakingriskierpositionsThisproblem
isdramaticallyillustratedbyperiodiccasesinwhichldquorogue
tradersrdquoincurlossesthatarebigenoughtodamageoreven
destroy large financial institutions In 1995 nick Leeson
broughtdownBaringsBankwitha$1billionlossandin
2008itwasrevealedthatJeacuterocircmeKervielhadseverelydamshy
agedSocieacuteteacuteGeacuteneacuteralewithalossofover$7billion
Conflictsofinterestorldquoagencyproblemsrdquoalsoexistat
manyotherlevelswithinthefinancialsystemShareholders
offinancialinstitutionshaveaconflictofinterestwiththe
bankrsquosseniorexecutivesespeciallywhenthoseexecutives
arerewardedforgoodperformancebutdonothavealarge
fractionoftheirwealthtiedupinthesharesofthebank
Manyfinancialinstitutionshavelargequantitiesofdebt
Copyrighted Material
18 bull CHapTer 1
which creates a conflict of interest between the bankrsquos
creditorsanditsshareholdersShareholdershaveanincenshy
tivetoauthorizeexcessivelyriskyinvestmentsforexample
especiallyafterabankhasincurredlossesthaterodethe
valueoftheshareholdersrsquoclaimThegainsontheserisky
investmentswillaccruelargelytoshareholderswhilethe
losseswillmostlybebornebycreditorsTheconflictwith
creditorsalsoreducestheincentivesfortheshareholders
of troubled institutions to raisenewcapitalbecause that
wouldstrengthen thepositionofcreditorswhilediluting
theshareholdersrsquopositionThisldquodebtoverhangrdquoproblem
waswidelycitedduringtheWorldFinancialCrisiswhen
many banks that were insolvent or close to insolvency
seemedreluctanteithertoraisenewcapitalortoreduce
theirrisksbysellingdistressedsecurities11
atthehighestlevelthereisaconflictofinterestbetween
societyasawholeandtheprivateownersoffinancialinshy
stitutions Because robust financial institutions promote
economicgrowthandemploymentduringfinancialcrises
governmentsoftenrescuetroubledfirmstheyperceiveto
be systemically importantThe result is privatized gains
andsocializedlossesIfthingsgowellthefirmsrsquoowners
andmanagersclaimtheprofitsbutifthingsgopoorlysoshy
cietysubsidizesthelosses
The candidates for government bailouts are popularly
describedasldquotoobigtofailrdquoMorepreciselytheargument
for government supportmdashwhich many economists chalshy
lengemdashisaboutfirmsthataretoosystemicallyimportantto
failInits200annualreporttheeuropeanCentralBank
describedsystemicriskasldquoTheriskthattheinabilityofone
Copyrighted Material
InTroDuCT Ion bull 19
institutiontomeetitsobligationswhenduewillcauseother
institutions to be unable tomeet their obligationswhen
dueSuchafailuremaycausesignificantliquidityorcredit
problemsandas a resultcould threaten the stabilityof
or confidence in marketsrdquo Systemically important firms
arethosewhosefailurecouldposealargethreattothestashy
bilityoforconfidenceinmarketsThesefirmsarelikelyto
belargebuttheyalsotendtohavecomplexinterconnecshy
tionswithotherfinancialinstitutions
Tooshybigshytoshyfailpoliciesoffersystemicallyimportantfirms
theexplicitorimplicitpromiseofabailoutwhenthingsgo
wrongThesepoliciesaredestructiveforseveralreasons
Firstbecause the possibility of a bailoutmeans a firmrsquos
stakeholders claim all the profits but only some of the
lossesfinancialfirmsthatmightreceivegovernmentsupshy
porthaveanincentivetotakeextrariskThefirmrsquosshareshy
holderscreditorsemployeesandmanagement all share
thetemptationTheresultisanincreaseintherisksborne
bysocietyasawhole
Secondthesepoliciesencouragesmallerfinancialinstishy
tutionstoexpandortobecomemorecloselyinterconnected
with other firms so they move under the tooshybigshytoshyfail
umbrellaFirmshaveanincentivetodowhateverittakes
tomakepolicymakersfeartheirfailurecreatingthevery
fragilitythegovernmentwishestoavoidBeliefthatagovshy
ernmentrescuewillprotectafinancial institutionrsquoscredishy
tors inacrisisalsogivesafirmacompetitiveadvantage
loweringitscostoffinancingandallowingittoofferbetter
prices to its customers than its fundamental productivity
warrants
Copyrighted Material
20 bull CHapTer 1
Thirdinefficientfirmsthatcannotcompeteontheirown
shouldfailotherwisefirmshavelessincentivetobecome
andstayefficientagovernmentpolicythatpropsupinshy
efficientfirmsiswastefulanddestructiveallowingthese
firmstofailfreesupresourcesandprovidesopportunities
formoreefficientandinnovativecompetitorstoflourish
Fourthandmostgenerallycapitalismisunderminedby
policiesthatprivatizegainsbutsocializelossesGovernment
guaranteedinstitutionscanbecomegovernmentruninstishy
tutionsallocatingcreditforexampletomaximizepolitical
gainratherthaneconomicwelfare
The conflictbetween society and theownersoffinanshy
cialfirmsbecomesmoreseriousduringseverecriseswhen
manyfinancialinstitutionsareclosetoinsolventIt isthe
primemotivationforourregulatoryproposalsbutseveral
ofthelowershylevelconflictswehavedescribedarerelevant
becausetheymagnifytheriskbornebysocietyasawhole
Theselfshyservingbehaviorthatmanyofourrecommenshy
dations targetmdashwhether by traders senior management
orthefirmrsquosownersmdashneednotbestrategicintentionally
maliciousorevenconsciousConsideratraderwhoinadshy
vertentlydevelopsaninvestmentstrategywithhighlyprobshy
ablegainsandimprobablebutlargelossesLikeafirmthat
hassoldearthquakeinsurancethestrategymayproducea
longstringofimpressivereturnsbeforeoneyearoflosses
wipesoutmanyyearsofprofits12 Ifsoduringthegood
yearsthetraderwillbecelebratedforhisorherbrilliance
rewarded with large bonuses and given more resources
to manageMany sophisticated traders and hedge funds
Copyrighted Material
InTroDuCT Ion bull 21
werenotawareoftheldquoearthquakerisksrdquoinherentinmany
of theirstrategiesSimilarlywhenfirmstakeactionsthat
increasethelikelihoodofagovernmentbailoutinthenext
financialcrisisthemarketrewardsthemwithalowercost
of capitalas firms become too big to fail for example
the implicit government guarantee reduces the riskiness
of their debt and lowers the interest rate demanded by
theircreditorsaCeoworkingtomaximizefirmvaluemay
notevenrealize the importanceof thegovernmentguarshy
anteebut a Darwinian process will encourage behavior
thatexploitsit
Bankruptcy and Resolution Procedures
Itisimpossibletowriteafinancialcontractthatspecifies
everypossiblecontingencyInsteadcontractsrelyonbankshy
ruptcytodetermineoutcomesincertainbadandunlikely
statesoftheworldInbankruptcycontrolofafirmistransshy
ferredfromtheshareholderswhonolongerhaveastake
inlossesbecausetheirsharesareworthlittletothedebtshy
holders It is in societyrsquos interest to develop bankruptcy
proceduresthatmaximizethepostshybankruptcyvalueofa
firmrsquosassetsInparticularsocietyshouldavoidthedestrucshy
tionofvaluethatoccurswithdisorderlyliquidation
Disorderlyliquidationoffinancialinstitutionsisparticushy
larly costlyFirstvaluableknowledge that the institution
hasaccumulatedaboutitscounterpartiesmdashborrowerstradshy
ingpartnersandsoonmdashcandisappearastheinstitution
losesemployeesandceasestooperatenormallyFinancial
Copyrighted Material
22 bull CHapTer 1
economistshavefoundthatthecollapseofabankhasamashy
terialadverseimpactonmanyofitsborrowers1 Second
the prospect of a disorderly liquidation makes it more
likelythatatroubledfinancialinstitutionwillsufferarun
by creditors who conclude they are better off claiming
whatmoney theycan todayrather thanwaiting through
protracted liquidation proceedings Third ldquofire salesrdquo of
specializedassets inadisorderly liquidationcandepress
prices and thereby spread problems to other holders of
theassetclassFourthdisorderlyliquidationincreasesthe
uncertaintyabouttheimpactofafinancialinstitutionrsquosfailshy
ureonitscounterpartiesandotherclaimholdersBecause
financialfirmsaretightlyinterconnectedthisuncertainty
canprecipitateorintensifyafinancialcrisis1
In theunitedStatesthestandardbankruptcycodealshy
lowsbothforliquidationofafirmandthesaleofitsassets
(Chapter7)andforcontinuedoperationofafirmunder
the supervision of a bankruptcy judgewho protects the
firmfromcreditorsrsquoclaimswhileareorganizationplanis
approved(Chapter11)Theseproceduresappeartowork
wellfornonfinancialcorporationsbutnotsowellforfinanshy
cialorganizationsTheChapter11approachofseparatinga
firmrsquosfinancialaffairsfromitsnonfinancialbusinessactivishy
tiesisinfeasiblewhenthebusinessofthefirmisfinancial
transactionsFurthermoremanyfinancialinstitutionsrely
heavily on shortshyterm debtpossibly as a valuable discishy
plineonbankexecutiveswhocanrapidlychangetherisks
theirfirmstakeThismakesfinancialfirmsvulnerabletoa
rapidwithdrawalofshortshytermcreditthatislikelytooccur
beforeanyeventthatwouldtriggerbankruptcy
Copyrighted Material
InTroDuCT Ion bull 2
Wearguebelowthatthereisaneedforaspecialresolushy
tionprocedurethatcanbeappliedtolargeinsolventfinanshy
cialinstitutionsWealsoadvocateregulatorychangesthat
would push financial firms towardmore resilient capital
structures
Bank Runs
Classicbank runs inwhichdepositors race towithdraw
their funds before a bank failswere one of the central
contributors to theGreatDepressionDeposit insurance
whichwasintroducedaftertheDepressiontocounterthis
destructiveprocessmadedemanddepositsoneofthemost
stableformsofbankfinancingduringtheWorldFinancial
CrisisManyfinancialinstitutionshoweversufferedamodshy
ernversionofbankruns
Banksespeciallythosewithinvestmentbankingactivishy
tiestypicallyfinanceasignificantfractionoftheirbusiness
withovernightcommercialpaperreposandothershortshy
terminstrumentsInnormaltimesbanksrolloverthisdebt
asitmaturestakingnewloanstopayofftheoldInacrishy
sishoweveruncertaintyaboutwhetheratroubledinstitushy
tionwouldbeabletopayoffitscreditorstomorrowcauses
lenderstostopextendingcredittodayThusshortshytermfishy
nancingcanleadtoarunthatissimilartoaclassicrunon
deposits
even some secured creditors participated in runs durshy
ingtheWorldFinancialCrisisBanksoftenuserepurchase
agreements to borrow money securing the loan by givshy
ingthelenderafinancialassetsuchasaTreasurybond
Copyrighted Material
2 bull CHapTer 1
ascollateralBecausetheyareovershycollateralizedwithasshy
setsworthperhaps$105guaranteeingevery$100inloans
lendersviewldquoreposrdquoasasafewaytoextendcreditWhen
credit markets froze during the Crisis however lenders
worried that retrieving collateral and selling itwouldbe
difficultandnotworththesmallinterestonanovernight
loanasaresultatvarioustimesduringtheCrisismany
investmentbankshaddifficultyrollingovereventheirseshy
cured loanseven relatively healthy financial institutions
werehamperedbythetroubleintherepomarketafteraushy
gust2007asthemarketbecamemoreandmoreuncertain
about the prices securities would fetch in a forced sale
these institutions found they could borrow less and less
withthesamecollateral15
prime brokerage accounts also saw a runshylike withshy
drawalbycustomersManylargebankshaveprimebrokershy
agegroupsthatassisthedgefundsandotherinstitutionalinshy
vestorsbyprovidingfinancingsecuritieslendingclearing
custodial servicesandoperational supportInexchange
thefundspayfeesandcriticallypostcollateraltosecure
theirloansWithsomerestrictionsthatweexplaininChapshy
ter10theprimebrokercanthenusethecollateralinits
ownbusinessinsomecasescomminglingitwiththefirmrsquos
ownassetsDuringtheCrisishedgefundsmonitoredthe
financial wellshybeing of their prime brokers and like deshy
positorsintheDepressionfledwiththeircollateralatthe
firstsignoftroubleBearStearnsforexamplehadalarge
prime brokerage business according to press accounts
oneofthelargesthedgefundsthatusedBearStearnsasa
Copyrighted Material
InTroDuCT Ion bull 25
primebrokerrenaissanceTechnologieswithdrew$5bilshy
lionofcashintheweekthefirmfailedWithsuchoutflows
it is not surprising that Bear Stearns ran out of money
eventhoughithadmorethan$18billionincashaweek
earlier
Likeclassicbankrunsmodernbankrunsarebothdeshy
structiveandselfshyfulfillingConcernthatabankmightbe
in trouble spurs its creditors and counterparties towithshy
draworwithholdtheircapitalasaresultevenrumorsofa
problemmaybeenoughtodestroyaviableinstitutionThe
importanceofmodernbankrunsduringtheWorldFinanshy
cialCrisisisarecurringthemethroughoutthebookand
wemakeseveralproposalsthatareintendedtoreducethe
frequencyofsuchevents
The Inadequacy of the Regulatory Structure
TheWorldFinancialCrisismadeitclearthatfinancialinnoshy
vationhadoverwhelmedexistingfinancialregulationsnoshy
tableexamplesincludeaIGrsquosdecisiontosellanextremely
large amount of credit default swaps on subprime debt
tobanksintheunitedStatesandabroadtheholdingof
Lehmanpaperbymoneymarketfundsparticularlythereshy
serveprimaryFundthecomplexityofthederivativebooks
atLehmanandotherinvestmentbanksandthedifficultyof
simultaneouslyapplyingseveralcountriesrsquobankruptcycodes
tothesubsidiariesofmultinationalfinancialinstitutions1
Thereisatradeshyoffbetweenfinancialinnovationandstashy
bilityInnovationcanimprovethefinancialsystemrsquosability
Copyrighted Material
2 bull CHapTer 1
toallocateresourcestotheirhighestvaluedusebutitcan
alsoreducethestabilityofthesystemThechallengeisto
developregulationsthatimprovestabilitywithoutstifling
innovation In addition regulation often leads to innoshy
vations designed to evade the regulationswhich makes
thefinancialsystemmorefragileForexamplemanyofthe
specialshypurposevehiclesthatimplodedintheCrisiswere
createdtogetaroundcapitalrequirements
In many countries the response of regulators to the
World Financial Crisis was hampered by the fragmented
nature of their regulatory systems Financial regulations
are typically designed to ensure thehealth of individual
institutionsratherthanthefinancialsystemasawholeIn
thisbookwearguethatsystemicregulationisanimporshy
tantfunctionthatrequiresaspecialmandateandthatthe
central bank is particularly well equipped to fulfill this
function
Finallyeffectivefinancialregulationrequiresthatpolitishy
ciansandultimatelythepublichaveanadequateundershy
standing of the financial system The political turmoil
surroundingtheCrisissuggeststheimportanceofdissemishy
natingexpertknowledgeaboutfinancetoabroaderaudishy
enceThisisoneofourmotivationsforwritingthisbook
What Were the orIgIns oF the World FInancIal crIsIs
LiketheoriginsoftheFirstWorldWarthecausesofthe
Crisiswillbedebatedbyscholarsformanyyears
Copyrighted Material
InTroDuCT Ion bull 27
Most observers agree that the strong runshyup and subshy
sequentsharpdeclineinthepricesofstockshousesand
otherfinancialassetsindevelopedcountrieswasanimporshy
tantcatalystfortheCrisisThereisdisagreementhowever
aboutwhetherthispatterninpricesistheresultofrational
investorbehaviororldquoirrationalbubblesrdquo
SomearguethattherunshyupbeforetheCrisiswasdriven
by investorswhoknowingly acceptedunusually low exshy
pectedreturnsandtheyofferseveralpossiblereasonswhy
Firsttherewasasurgeofsavingsinemergingcountries
drivenbyacombinationofrapideconomicgrowthanddeshy
mographicsperhapsbecauseofadesiretoaccumulateforshy
eignreservesintheaftermathoftheasiacrisisof1997ndash98
muchof thiswealthwas invested indevelopedmarkets
Secondfinancialmarketswereunusually tranquilduring
200to200Withlowvolatilityinvestorsmayhavesettled
for a low risk premiumThird influenced by fears of a
Japaneseshystyledeflation resulting from themarketdownshy
turnof2000ndash2001andbyabeliefthattheyshouldnottry
to usemonetary policy to counteract rising asset prices
central bankers in the united States maintained a loose
monetarypolicythroughouttheperiod17andfromthisrashy
tionalviewofinvestorstheplungeinassetpricesthatacshy
companiedtheCrisiswascausedbybadnewsaboutfuture
cashflowsunexpectedincreasesinthereturnsrequiredby
investorsorboth
otherssuggestamoredirectexplanationThehighprices
before theCrisisweredrivenby an irrational belief that
prices would continue to rise and the collapse of asset
priceswastheinevitableresultofthismistakeWhatever
Copyrighted Material
28 bull CHapTer 1
theexplanationthesharpdropinassetpricesbothconshy
tributedtoandwasasymptomoftheCrisis
other commentators argue that the financial system
becamevulnerablebecausemanymarketparticipantsasshy
sessedrisksinaccuratelyduringtheperiodleadingupto
theWorldFinancialCrisisConsumersbanksandinvestors
ingeneralunderestimatedtheriskofhousepricedeclines
increasingthepricestheywerewillingtopayforrealesshy
tatethecredittheywerewillingtoextendandthevaluashy
tionsofbanksthatextendedsuchcreditBanksputmuch
weight on the recent pastwhen they estimated value at
riskwhichledthemtoconcludethatthelevelofriskwas
lowandthattherewaslittledownsidetohavinghighleshy
verageothermarketparticipantsdidnotfullyappreciate
thathighliquiditywassuppressingvolatilityandthatthe
processmightreversewithliquiditydecreasingandvolatilshy
ityincreasing
More generally the high level of financial innovation
driveninpartbythedecliningcostofinformationtechnolshy
ogymadeithardforriskassessmenttokeeppacewiththe
evolvingfinancialsystem18Thebenignenvironmentofthe
creditboomexacerbatedthisproblembytemptingfinanshy
cialinstitutionstounderinvestinriskmanagement
uSpolicymakersalsocontributedtotheseverityofthe
CrisisbypushingFannieMaeandFreddieMactoincrease
theavailabilityofmortgagefundingtoborrowerswithquesshy
tionableabilitytorepaytheirmortgagesasaresultofthis
pressure both agencies relaxed their standards for the
mortgages they purchased and guaranteedThe demand
Copyrighted Material
InTroDuCT Ion bull 29
forhomesbyborrowerswhoqualifiedformortgagesbeshy
causeoftheselowerstandardspusheduppricesandthe
defaultbymanyofthemduringtherecessioncontributed
tothedropinhomeprices
Thepanicandruninthefallof2008remainthecentral
distinguishingfeaturesoftheWorldFinancialCrisisasset
priceshave risenand fallenbeforeand theworldeconshy
omyhasbornelargefinancial lossesmanytimeswithout
suchasevereeconomicoutcomeConverselylossesfrom
completelydifferentunderlyingsourcesmdashcommercialreal
estateorperhapssovereigndefaultsmdashcouldcauseasimilar
catastrophe if theyagainprovoke tooshybigshytoshyfailchaosor
runs
Thisbookdoesnotseektoprovideacompletediagnosis
oftheWorldFinancialCrisisnordoesittakeastandonthe
relativeimportanceofthecontributingfactorslistedabove
ratherwebelieveourrecommendationswillhelpprevent
ormitigatefuturecriseseventhoughwedonotfullyundershy
standallthecausesofthelastone
CarmenreinhartandKennethrogoff amongothershave
pointedoutthatfinancialcriseshaveoccurredthroughout
thehistoryofcapitalismandthatthesecrisessharemany
commonpatterns19 Thelessonwedrawfromthisisthat
noacceptablesetofregulationscanpreventmarketparticishy
pantsfrommakingmistakesthatcreateeconomicinstability
ourpurposeinthisbookisinsteadtosuggestregulatory
reformsthatwillmakethesystemmorestabledespitethe
mistakesthataresuretocome
Copyrighted Material
InTroDuCT Ion bull 9
7
6
5
4
3
2
1
0
A2P2 Nonfinancial
AA Financial
AA Nonfinancial
Jul 2008 Aug 2008 Sep 2008 Oct 2008 Nov 2008 Dec 2008
Figure1annualizedpercentYieldson0shyDayHighshyQuality(aa)FinancialandnonfinancialCommercialpaperandMediumshyQuality(a2p2)nonfinancialCommercialpaperinpercentaugusttoDecember2008SourceFederalreserve
thynonfinancialcompaniesactuallydeclinedTherateon
uSTreasurybillswhichareviewedas themost secure
investmentalsofellthethreeshymonthTreasurybillrateacshy
tuallydroppedtozeroforbriefperiodsinnovemberand
December2008
the run on the shadoW BankIng system
Thepanicthatstruckfinancialmarketsinthefallof2008
hasbeencharacterizedasarunontheshadowbankingsysshy
temandwithgoodreasonBeforetheCrisismanybonds
mortgagebackedsecuritiesandother credit instruments
Copyrighted Material
10 bull CHapTer 1
wereheldbyleveragednonshybankintermediariesincluding
hedgefunds investmentbanksbrokeragefirmsandspecialshy
purposevehiclesManyoftheseintermediarieswereforced
toldquodeleverrdquoduringoctoberandnovembersellingassetsto
repaytheircreditors
Hedgefundsandotherleveragedintermediariesusethe
securitiesintheirportfoliosascollateralwhentheyborrow
moneyDuringtheWorldFinancialCrisismanywarylendshy
ersdecidedthecollateralborrowershadpostedbeforethe
Crisis was no longer sufficient to guarantee repayment
Whenthelendersdemandedeithermoreorbettercollatshy
eralmanyborrowerswereforcedtoselltheirleveredposishy
tionsandrepaytheirloansTheresultwasareductionin
thequantityofassetstheyheldandintheirleverageInadshy
ditionhedgefundsandotherintermediariessufferedlarge
withdrawalsbypanickycustomersagainforcingthemto
sellsecuritiesonthemarketTheassetsbeingsoldweregenshy
erallyacquiredbyindividualinvestorsthefederalgovernshy
mentorcommercialbankswhichasagroupfinancedmost
oftheirpurchasesbyborrowingfromthegovernment
The financing difficulties faced by arbitrageurs and lishy
quidity providers are apparent in a series of fascinating
market pathologies In financialmarkets there are often
manydifferentwaystoobtainthesameoutcomeaninvesshy
torcanusemanydifferentcombinationsofsecuritiesfor
exampletorisklesslyconvertdollarstodayintodollarsin
sixmonthsThe actionsof arbitrageursusuallykeep the
costsof thedifferent approaches closely alignedDuring
thefallof2008thecostsoftendivergedwiththeapproach
thatrequiredmorecapitaltypicallycostingless
Copyrighted Material
InTroDuCT Ion bull 11
Theprincipleofcoveredinterestparityforexamplesays
thataftereliminatingexchangerateriskriskshyfreeinvesting
shouldhavethesamereturnineverycurrencyaninvestor
whowantstoinvestdollarstodayandreceivedollarsinthe
futureusuallybuysauSbondHecouldaccomplishthe
samethingbyconvertinghisdollarsintoeurosinvesting
inarisklesseurobondandlockingintheconversionof
theeuropayoffbackintodollarswithaforwardcontract
Sincebothstrategiesconvertdollarstodayintodollarsin
thefuturetheyshouldhavethesamereturn5 Supposeinshy
steadthereturnontheuSbondislowerThenanarbitrashy
geurcouldborrowmoneyintheunitedStatesatthelower
rateinvestitintheeurotransactionatthehigherrateand
makeaprofit
During the Crisis covered interest parity violations as
largeas20basispoints(020percent)emergedThismay
seemtrivialbutinnormaltimestheseviolationsrarelyexshy
ceed 2 basis pointsMoreover traders can usuallyldquolever
uprdquotransactionslikethisandmakealargeprofitButthatrsquos
thecatchmdashhedgefundsbrokeragesandinvestmentbanks
werebeingforcedtodeleverduringtheCrisisand20basis
points is not enough to enticemany longshyonly investors
to replace theuSbond theyarecurrentlyholdingwith
aforeignbondandsomeseeminglycomplicatedcurrency
transactions
other recent research finds similar disruptions of the
normalpricing relations linking (1)Treasurybondscorshy
poratebondsandcreditshydefault swaps (aTreasurybond
shouldbethesameasacorporatebondplusacreditdefault
swapmdashexceptforliquidityfinancingandCDScounterparty
Copyrighted Material
12 bull CHapTer 1
risk)(2)fixedandfloatingrate investments (asequence
ofshortshyterminvestmentsplusacontractswappingafloatshy
ing interest rate forafixed interest rateshouldhave the
same payoff as a fixed rate investment) () convertible
bondsdebtandequity()newlyissuedldquoonshytheshyrunrdquoand
recently issuedldquooffshytheshyrunrdquoTreasury bondswhich have
essentially the same payoff but differ in liquidity and
(5)stockandoptionpriceswhicharelinkedbywhatfishy
nancialeconomistscalltheputshycallparityrelation7
Thebreakdownofthesenormalpricingrelationsdoes
littledirectharm to the restof theeconomya20shybasisshy
pointviolationofcoveredinterestparityhaslittleeffecton
auSexporterusingcurrencycontractstolockintherate
atwhichitcanconvertfutureJapaneserevenuebackinto
dollarsTheseviolationsshowhoweverthatmarketswere
notfunctioningnormallyInparticulartheysuggestthere
wasnotmuchcapitalavailabletoprovideliquiditytobuyshy
ersandsellersanyoneneedingtosellsecuritiesquicklyin
suchamarketmdashsuchasafinancialinstitutiontryingtoreshy
duceitsriskmdashwasnotlikelytogetagoodprice
lendIng BankIng and the recessIon
Duringthefallof2008outputandfinancingactivityconshy
tracted sharply Commercial paper corporate bond and
equityissuanceallfelldramaticallyasdidmortgageorigishy
nations
originations of most types of asset backed securities
alsoslowedtoatrickleManybanksintheunitedStates
Jan 20
04Ju
l 200
4Ja
n 2005
Jul 2
005
Jan 20
06Ju
l 200
6Ja
n 2007
Jul 2
007
Jan 20
08Ju
l 200
8Ja
n 2009
Jul 2
009
Copyrighted Material
InTroDuCT Ion bull 1
0
50
100
150
200
250
Figure2assetBackedSecuritiesIssuedintheunitedStatesJanushyary200toDecember2009BillionsofDollarsperMonthSourceFederalreserve
and other countries no longer hold much of the credit
theyissueTheyhavemovedinsteadtoanldquooriginateand
sellrdquomodel inwhich theybundle together similar loans
suchasjumbomortgagescommercialloansstudentloans
or credit card debt and sell them to investors as asset
backedsecuritiesnewissuesofthesesecuritiesessentially
stopped inoctoberandnovember2008Figure2shows
that the amount of asset backed securities issued in the
united States rose from$288 billion in January 2000 to
$85billioninJune2007andthenplungedto$102bilshy
lioninSeptember2007IssuanceintheunitedStatesconshy
tinued to decline over the next year eventually falling
to only $87 billion in october 2008 and $ billion in
Copyrighted Material
1 bull CHapTer 1
novembermdashjust2percentofthevolume18monthsearlier
onlymortgagespooledbyFannieMaeandFreddieMac
withanexplicitgovernmentguaranteeandsubjecttohuge
Federalreservepurchasescontinuedtoflowtothemarket
There isplentyof anecdotal and surveyevidence that
banklendingalsodriedupduringtheCrisisForexample
loanofficerssurveyedbytheFederalreservereportedthat
credit conditionsprogressively tightenedduring2008In
asurveyabouttheirperceptionsofcreditconditionsand
corporatedecisionsasoflatenovember2008morethan
halfofthechieffinancialofficersoflargeamericanfirms
whorespondedsaidthattheirfirmswereeitherldquosomewhat
orveryaffectedbythecostoravailabilityofcreditrdquo8
There is a lively and fundamentally important debate
about why the quantity of lending fell Some financial
economists argue that banks wanted to lend more but
wereunable todosobecausetheyfacedbindingcapital
constraintsInthisviewinformationcostsandotherfricshy
tionsintheloanoriginationprocesskeptcustomersfrom
movingtolessconstrainedbanks
othersarguethattheprimaryreasonbankswereunwillshy
ingtolendisthattheircustomershadbecomelesscreditshy
worthyTheseeconomistspointoutthatthehighlevelof
uncertainty about future economic conditionsduring the
Crisisratchetedupthedefaultriskofeventhemostrelishy
ableclientsThisinterpretationofthedeclineinbanklendshy
ingimpliesthatnoamountofcapitalwouldhaveinduced
banksasagrouptolendmorebecauseallthegoodloans
werebeingmade
Figure shows data on the quantity of bank lending
Jan 20
08
Mar
2008
M
ay 20
08Ju
l 200
8Se
p 2008
Nov 20
08Ja
n 2009
Jan 20
09
May
2009
Jul 2
009
Sep 20
09Nov
2009
Copyrighted Material
InTroDuCT Ion bull 15
1050
1100
1150
1200
1250
1300
FigureCommercialandIndustrialLoansbyuSCommercialBanks2008ndash9inBillionsofDollarsSourceFederalreserve
intheunitedStatesin2008and2009Startinginoctober
2008therewasaspikeinlendingfollowedbyaprotracted
declineVVChariLawrenceChristianoandpatrickKehoe
takethespikeatfacevalueinaggregatebankslentmore
ataminimumthebankingsystemasawholemdashasopposed
to individual banksmdashwas not deleveraging to overcome
loss of capital9 Victoria Ivashina and David Scharfstein
notethatmuchoftheincreaseinbanklendingwasinvolshy
untaryonthepartofthebankstheresultofdrawdowns
byborrowersonexistinglinesofcredit10 Theyalsoshow
thatbanks thatweremorevulnerable todrawdownsbeshy
causetheywereinmoresyndicateswithLehmanreduced
subsequent lending more and conclude that there was
indeed a genuine contraction in the effective supply of
bankcredit
Copyrighted Material
1 bull CHapTer 1
economistswillargueabouttheeventsoftheWorldFishy
nancialCrisisforyearstocomeInfactwestillargueabout
theGreatDepressionnoneoftheanalysisbehindourrecshy
ommendationshoweverdepends onhow these debates
aresettledForexamplenomatterhowcapitalshyconstrained
thebankingsystemreallywasinthefallof2008ourproshy
posalsforchangesthatmakesuchconstraintslessbinding
andgivepolicymakersbettertoolswhentheyfearcapital
constraintsremainvalid
What Was Wrong WIth the FInancIal system durIng the crIsIs
The Crisis revealed a number of serious problems with
ourfinancialsystemSomehadbeeninthebackgroundall
alongothersdidnotappearuntiltheCrisisInthisbook
weemphasizefourcategoriesofproblemsconflictsofinshy
terestknowntoeconomistsasagencyproblemsthediffishy
cultyofapplyingstandardbankruptcyprocedurestofinanshy
cialinstitutionstheemergenceofamodernformofbank
runsandtheinadequacyoftheregulatorystructurewhich
hadnotkeptupwithrecentfinancialinnovation(Infact
muchinnovationservedtoescaperegulations)
Conflicts of Interest Agency Problems
Conflictsofinterestthatcannotberesolvedeasilybyconshy
tractsormarketsoccurthroughouttheeconomybutthey
Copyrighted Material
InTroDuCT Ion bull 17
canbeparticularlyharmfulinthefinancialsystemThere
areseveralreasonsFirstmanyfinancialtransactionsand
contractsinvolveaprincipalsuchasaninvestororshareshy
holderaskingatradermanagerorotheragenttoacton
hisorherbehalfSecondmostfinancial transactions inshy
volvehighlyuncertainfuturepayoffsandinmanytransacshy
tionsonepartyisbetterinformedaboutthepayoffsthan
the otherThird the high volatility of the future payoffs
oftenmakesithardtoassesswhethertheoutcomeofafishy
nancialtransactionisduetotheagentrsquoseffortsorluckand
fourththesumsinvolvedcanbehuge
Someproprietarytradersforexampleearnalotwhen
their tradesdowellbuttheirpersonal lossesare limited
whentheirtradesdopoorlyBecauseoftheasymmetricnashy
tureoftheircompensationthesetraderscanincreasetheir
expectedincomebytakingriskierpositionsThisproblem
isdramaticallyillustratedbyperiodiccasesinwhichldquorogue
tradersrdquoincurlossesthatarebigenoughtodamageoreven
destroy large financial institutions In 1995 nick Leeson
broughtdownBaringsBankwitha$1billionlossandin
2008itwasrevealedthatJeacuterocircmeKervielhadseverelydamshy
agedSocieacuteteacuteGeacuteneacuteralewithalossofover$7billion
Conflictsofinterestorldquoagencyproblemsrdquoalsoexistat
manyotherlevelswithinthefinancialsystemShareholders
offinancialinstitutionshaveaconflictofinterestwiththe
bankrsquosseniorexecutivesespeciallywhenthoseexecutives
arerewardedforgoodperformancebutdonothavealarge
fractionoftheirwealthtiedupinthesharesofthebank
Manyfinancialinstitutionshavelargequantitiesofdebt
Copyrighted Material
18 bull CHapTer 1
which creates a conflict of interest between the bankrsquos
creditorsanditsshareholdersShareholdershaveanincenshy
tivetoauthorizeexcessivelyriskyinvestmentsforexample
especiallyafterabankhasincurredlossesthaterodethe
valueoftheshareholdersrsquoclaimThegainsontheserisky
investmentswillaccruelargelytoshareholderswhilethe
losseswillmostlybebornebycreditorsTheconflictwith
creditorsalsoreducestheincentivesfortheshareholders
of troubled institutions to raisenewcapitalbecause that
wouldstrengthen thepositionofcreditorswhilediluting
theshareholdersrsquopositionThisldquodebtoverhangrdquoproblem
waswidelycitedduringtheWorldFinancialCrisiswhen
many banks that were insolvent or close to insolvency
seemedreluctanteithertoraisenewcapitalortoreduce
theirrisksbysellingdistressedsecurities11
atthehighestlevelthereisaconflictofinterestbetween
societyasawholeandtheprivateownersoffinancialinshy
stitutions Because robust financial institutions promote
economicgrowthandemploymentduringfinancialcrises
governmentsoftenrescuetroubledfirmstheyperceiveto
be systemically importantThe result is privatized gains
andsocializedlossesIfthingsgowellthefirmsrsquoowners
andmanagersclaimtheprofitsbutifthingsgopoorlysoshy
cietysubsidizesthelosses
The candidates for government bailouts are popularly
describedasldquotoobigtofailrdquoMorepreciselytheargument
for government supportmdashwhich many economists chalshy
lengemdashisaboutfirmsthataretoosystemicallyimportantto
failInits200annualreporttheeuropeanCentralBank
describedsystemicriskasldquoTheriskthattheinabilityofone
Copyrighted Material
InTroDuCT Ion bull 19
institutiontomeetitsobligationswhenduewillcauseother
institutions to be unable tomeet their obligationswhen
dueSuchafailuremaycausesignificantliquidityorcredit
problemsandas a resultcould threaten the stabilityof
or confidence in marketsrdquo Systemically important firms
arethosewhosefailurecouldposealargethreattothestashy
bilityoforconfidenceinmarketsThesefirmsarelikelyto
belargebuttheyalsotendtohavecomplexinterconnecshy
tionswithotherfinancialinstitutions
Tooshybigshytoshyfailpoliciesoffersystemicallyimportantfirms
theexplicitorimplicitpromiseofabailoutwhenthingsgo
wrongThesepoliciesaredestructiveforseveralreasons
Firstbecause the possibility of a bailoutmeans a firmrsquos
stakeholders claim all the profits but only some of the
lossesfinancialfirmsthatmightreceivegovernmentsupshy
porthaveanincentivetotakeextrariskThefirmrsquosshareshy
holderscreditorsemployeesandmanagement all share
thetemptationTheresultisanincreaseintherisksborne
bysocietyasawhole
Secondthesepoliciesencouragesmallerfinancialinstishy
tutionstoexpandortobecomemorecloselyinterconnected
with other firms so they move under the tooshybigshytoshyfail
umbrellaFirmshaveanincentivetodowhateverittakes
tomakepolicymakersfeartheirfailurecreatingthevery
fragilitythegovernmentwishestoavoidBeliefthatagovshy
ernmentrescuewillprotectafinancial institutionrsquoscredishy
tors inacrisisalsogivesafirmacompetitiveadvantage
loweringitscostoffinancingandallowingittoofferbetter
prices to its customers than its fundamental productivity
warrants
Copyrighted Material
20 bull CHapTer 1
Thirdinefficientfirmsthatcannotcompeteontheirown
shouldfailotherwisefirmshavelessincentivetobecome
andstayefficientagovernmentpolicythatpropsupinshy
efficientfirmsiswastefulanddestructiveallowingthese
firmstofailfreesupresourcesandprovidesopportunities
formoreefficientandinnovativecompetitorstoflourish
Fourthandmostgenerallycapitalismisunderminedby
policiesthatprivatizegainsbutsocializelossesGovernment
guaranteedinstitutionscanbecomegovernmentruninstishy
tutionsallocatingcreditforexampletomaximizepolitical
gainratherthaneconomicwelfare
The conflictbetween society and theownersoffinanshy
cialfirmsbecomesmoreseriousduringseverecriseswhen
manyfinancialinstitutionsareclosetoinsolventIt isthe
primemotivationforourregulatoryproposalsbutseveral
ofthelowershylevelconflictswehavedescribedarerelevant
becausetheymagnifytheriskbornebysocietyasawhole
Theselfshyservingbehaviorthatmanyofourrecommenshy
dations targetmdashwhether by traders senior management
orthefirmrsquosownersmdashneednotbestrategicintentionally
maliciousorevenconsciousConsideratraderwhoinadshy
vertentlydevelopsaninvestmentstrategywithhighlyprobshy
ablegainsandimprobablebutlargelossesLikeafirmthat
hassoldearthquakeinsurancethestrategymayproducea
longstringofimpressivereturnsbeforeoneyearoflosses
wipesoutmanyyearsofprofits12 Ifsoduringthegood
yearsthetraderwillbecelebratedforhisorherbrilliance
rewarded with large bonuses and given more resources
to manageMany sophisticated traders and hedge funds
Copyrighted Material
InTroDuCT Ion bull 21
werenotawareoftheldquoearthquakerisksrdquoinherentinmany
of theirstrategiesSimilarlywhenfirmstakeactionsthat
increasethelikelihoodofagovernmentbailoutinthenext
financialcrisisthemarketrewardsthemwithalowercost
of capitalas firms become too big to fail for example
the implicit government guarantee reduces the riskiness
of their debt and lowers the interest rate demanded by
theircreditorsaCeoworkingtomaximizefirmvaluemay
notevenrealize the importanceof thegovernmentguarshy
anteebut a Darwinian process will encourage behavior
thatexploitsit
Bankruptcy and Resolution Procedures
Itisimpossibletowriteafinancialcontractthatspecifies
everypossiblecontingencyInsteadcontractsrelyonbankshy
ruptcytodetermineoutcomesincertainbadandunlikely
statesoftheworldInbankruptcycontrolofafirmistransshy
ferredfromtheshareholderswhonolongerhaveastake
inlossesbecausetheirsharesareworthlittletothedebtshy
holders It is in societyrsquos interest to develop bankruptcy
proceduresthatmaximizethepostshybankruptcyvalueofa
firmrsquosassetsInparticularsocietyshouldavoidthedestrucshy
tionofvaluethatoccurswithdisorderlyliquidation
Disorderlyliquidationoffinancialinstitutionsisparticushy
larly costlyFirstvaluableknowledge that the institution
hasaccumulatedaboutitscounterpartiesmdashborrowerstradshy
ingpartnersandsoonmdashcandisappearastheinstitution
losesemployeesandceasestooperatenormallyFinancial
Copyrighted Material
22 bull CHapTer 1
economistshavefoundthatthecollapseofabankhasamashy
terialadverseimpactonmanyofitsborrowers1 Second
the prospect of a disorderly liquidation makes it more
likelythatatroubledfinancialinstitutionwillsufferarun
by creditors who conclude they are better off claiming
whatmoney theycan todayrather thanwaiting through
protracted liquidation proceedings Third ldquofire salesrdquo of
specializedassets inadisorderly liquidationcandepress
prices and thereby spread problems to other holders of
theassetclassFourthdisorderlyliquidationincreasesthe
uncertaintyabouttheimpactofafinancialinstitutionrsquosfailshy
ureonitscounterpartiesandotherclaimholdersBecause
financialfirmsaretightlyinterconnectedthisuncertainty
canprecipitateorintensifyafinancialcrisis1
In theunitedStatesthestandardbankruptcycodealshy
lowsbothforliquidationofafirmandthesaleofitsassets
(Chapter7)andforcontinuedoperationofafirmunder
the supervision of a bankruptcy judgewho protects the
firmfromcreditorsrsquoclaimswhileareorganizationplanis
approved(Chapter11)Theseproceduresappeartowork
wellfornonfinancialcorporationsbutnotsowellforfinanshy
cialorganizationsTheChapter11approachofseparatinga
firmrsquosfinancialaffairsfromitsnonfinancialbusinessactivishy
tiesisinfeasiblewhenthebusinessofthefirmisfinancial
transactionsFurthermoremanyfinancialinstitutionsrely
heavily on shortshyterm debtpossibly as a valuable discishy
plineonbankexecutiveswhocanrapidlychangetherisks
theirfirmstakeThismakesfinancialfirmsvulnerabletoa
rapidwithdrawalofshortshytermcreditthatislikelytooccur
beforeanyeventthatwouldtriggerbankruptcy
Copyrighted Material
InTroDuCT Ion bull 2
Wearguebelowthatthereisaneedforaspecialresolushy
tionprocedurethatcanbeappliedtolargeinsolventfinanshy
cialinstitutionsWealsoadvocateregulatorychangesthat
would push financial firms towardmore resilient capital
structures
Bank Runs
Classicbank runs inwhichdepositors race towithdraw
their funds before a bank failswere one of the central
contributors to theGreatDepressionDeposit insurance
whichwasintroducedaftertheDepressiontocounterthis
destructiveprocessmadedemanddepositsoneofthemost
stableformsofbankfinancingduringtheWorldFinancial
CrisisManyfinancialinstitutionshoweversufferedamodshy
ernversionofbankruns
Banksespeciallythosewithinvestmentbankingactivishy
tiestypicallyfinanceasignificantfractionoftheirbusiness
withovernightcommercialpaperreposandothershortshy
terminstrumentsInnormaltimesbanksrolloverthisdebt
asitmaturestakingnewloanstopayofftheoldInacrishy
sishoweveruncertaintyaboutwhetheratroubledinstitushy
tionwouldbeabletopayoffitscreditorstomorrowcauses
lenderstostopextendingcredittodayThusshortshytermfishy
nancingcanleadtoarunthatissimilartoaclassicrunon
deposits
even some secured creditors participated in runs durshy
ingtheWorldFinancialCrisisBanksoftenuserepurchase
agreements to borrow money securing the loan by givshy
ingthelenderafinancialassetsuchasaTreasurybond
Copyrighted Material
2 bull CHapTer 1
ascollateralBecausetheyareovershycollateralizedwithasshy
setsworthperhaps$105guaranteeingevery$100inloans
lendersviewldquoreposrdquoasasafewaytoextendcreditWhen
credit markets froze during the Crisis however lenders
worried that retrieving collateral and selling itwouldbe
difficultandnotworththesmallinterestonanovernight
loanasaresultatvarioustimesduringtheCrisismany
investmentbankshaddifficultyrollingovereventheirseshy
cured loanseven relatively healthy financial institutions
werehamperedbythetroubleintherepomarketafteraushy
gust2007asthemarketbecamemoreandmoreuncertain
about the prices securities would fetch in a forced sale
these institutions found they could borrow less and less
withthesamecollateral15
prime brokerage accounts also saw a runshylike withshy
drawalbycustomersManylargebankshaveprimebrokershy
agegroupsthatassisthedgefundsandotherinstitutionalinshy
vestorsbyprovidingfinancingsecuritieslendingclearing
custodial servicesandoperational supportInexchange
thefundspayfeesandcriticallypostcollateraltosecure
theirloansWithsomerestrictionsthatweexplaininChapshy
ter10theprimebrokercanthenusethecollateralinits
ownbusinessinsomecasescomminglingitwiththefirmrsquos
ownassetsDuringtheCrisishedgefundsmonitoredthe
financial wellshybeing of their prime brokers and like deshy
positorsintheDepressionfledwiththeircollateralatthe
firstsignoftroubleBearStearnsforexamplehadalarge
prime brokerage business according to press accounts
oneofthelargesthedgefundsthatusedBearStearnsasa
Copyrighted Material
InTroDuCT Ion bull 25
primebrokerrenaissanceTechnologieswithdrew$5bilshy
lionofcashintheweekthefirmfailedWithsuchoutflows
it is not surprising that Bear Stearns ran out of money
eventhoughithadmorethan$18billionincashaweek
earlier
Likeclassicbankrunsmodernbankrunsarebothdeshy
structiveandselfshyfulfillingConcernthatabankmightbe
in trouble spurs its creditors and counterparties towithshy
draworwithholdtheircapitalasaresultevenrumorsofa
problemmaybeenoughtodestroyaviableinstitutionThe
importanceofmodernbankrunsduringtheWorldFinanshy
cialCrisisisarecurringthemethroughoutthebookand
wemakeseveralproposalsthatareintendedtoreducethe
frequencyofsuchevents
The Inadequacy of the Regulatory Structure
TheWorldFinancialCrisismadeitclearthatfinancialinnoshy
vationhadoverwhelmedexistingfinancialregulationsnoshy
tableexamplesincludeaIGrsquosdecisiontosellanextremely
large amount of credit default swaps on subprime debt
tobanksintheunitedStatesandabroadtheholdingof
Lehmanpaperbymoneymarketfundsparticularlythereshy
serveprimaryFundthecomplexityofthederivativebooks
atLehmanandotherinvestmentbanksandthedifficultyof
simultaneouslyapplyingseveralcountriesrsquobankruptcycodes
tothesubsidiariesofmultinationalfinancialinstitutions1
Thereisatradeshyoffbetweenfinancialinnovationandstashy
bilityInnovationcanimprovethefinancialsystemrsquosability
Copyrighted Material
2 bull CHapTer 1
toallocateresourcestotheirhighestvaluedusebutitcan
alsoreducethestabilityofthesystemThechallengeisto
developregulationsthatimprovestabilitywithoutstifling
innovation In addition regulation often leads to innoshy
vations designed to evade the regulationswhich makes
thefinancialsystemmorefragileForexamplemanyofthe
specialshypurposevehiclesthatimplodedintheCrisiswere
createdtogetaroundcapitalrequirements
In many countries the response of regulators to the
World Financial Crisis was hampered by the fragmented
nature of their regulatory systems Financial regulations
are typically designed to ensure thehealth of individual
institutionsratherthanthefinancialsystemasawholeIn
thisbookwearguethatsystemicregulationisanimporshy
tantfunctionthatrequiresaspecialmandateandthatthe
central bank is particularly well equipped to fulfill this
function
Finallyeffectivefinancialregulationrequiresthatpolitishy
ciansandultimatelythepublichaveanadequateundershy
standing of the financial system The political turmoil
surroundingtheCrisissuggeststheimportanceofdissemishy
natingexpertknowledgeaboutfinancetoabroaderaudishy
enceThisisoneofourmotivationsforwritingthisbook
What Were the orIgIns oF the World FInancIal crIsIs
LiketheoriginsoftheFirstWorldWarthecausesofthe
Crisiswillbedebatedbyscholarsformanyyears
Copyrighted Material
InTroDuCT Ion bull 27
Most observers agree that the strong runshyup and subshy
sequentsharpdeclineinthepricesofstockshousesand
otherfinancialassetsindevelopedcountrieswasanimporshy
tantcatalystfortheCrisisThereisdisagreementhowever
aboutwhetherthispatterninpricesistheresultofrational
investorbehaviororldquoirrationalbubblesrdquo
SomearguethattherunshyupbeforetheCrisiswasdriven
by investorswhoknowingly acceptedunusually low exshy
pectedreturnsandtheyofferseveralpossiblereasonswhy
Firsttherewasasurgeofsavingsinemergingcountries
drivenbyacombinationofrapideconomicgrowthanddeshy
mographicsperhapsbecauseofadesiretoaccumulateforshy
eignreservesintheaftermathoftheasiacrisisof1997ndash98
muchof thiswealthwas invested indevelopedmarkets
Secondfinancialmarketswereunusually tranquilduring
200to200Withlowvolatilityinvestorsmayhavesettled
for a low risk premiumThird influenced by fears of a
Japaneseshystyledeflation resulting from themarketdownshy
turnof2000ndash2001andbyabeliefthattheyshouldnottry
to usemonetary policy to counteract rising asset prices
central bankers in the united States maintained a loose
monetarypolicythroughouttheperiod17andfromthisrashy
tionalviewofinvestorstheplungeinassetpricesthatacshy
companiedtheCrisiswascausedbybadnewsaboutfuture
cashflowsunexpectedincreasesinthereturnsrequiredby
investorsorboth
otherssuggestamoredirectexplanationThehighprices
before theCrisisweredrivenby an irrational belief that
prices would continue to rise and the collapse of asset
priceswastheinevitableresultofthismistakeWhatever
Copyrighted Material
28 bull CHapTer 1
theexplanationthesharpdropinassetpricesbothconshy
tributedtoandwasasymptomoftheCrisis
other commentators argue that the financial system
becamevulnerablebecausemanymarketparticipantsasshy
sessedrisksinaccuratelyduringtheperiodleadingupto
theWorldFinancialCrisisConsumersbanksandinvestors
ingeneralunderestimatedtheriskofhousepricedeclines
increasingthepricestheywerewillingtopayforrealesshy
tatethecredittheywerewillingtoextendandthevaluashy
tionsofbanksthatextendedsuchcreditBanksputmuch
weight on the recent pastwhen they estimated value at
riskwhichledthemtoconcludethatthelevelofriskwas
lowandthattherewaslittledownsidetohavinghighleshy
verageothermarketparticipantsdidnotfullyappreciate
thathighliquiditywassuppressingvolatilityandthatthe
processmightreversewithliquiditydecreasingandvolatilshy
ityincreasing
More generally the high level of financial innovation
driveninpartbythedecliningcostofinformationtechnolshy
ogymadeithardforriskassessmenttokeeppacewiththe
evolvingfinancialsystem18Thebenignenvironmentofthe
creditboomexacerbatedthisproblembytemptingfinanshy
cialinstitutionstounderinvestinriskmanagement
uSpolicymakersalsocontributedtotheseverityofthe
CrisisbypushingFannieMaeandFreddieMactoincrease
theavailabilityofmortgagefundingtoborrowerswithquesshy
tionableabilitytorepaytheirmortgagesasaresultofthis
pressure both agencies relaxed their standards for the
mortgages they purchased and guaranteedThe demand
Copyrighted Material
InTroDuCT Ion bull 29
forhomesbyborrowerswhoqualifiedformortgagesbeshy
causeoftheselowerstandardspusheduppricesandthe
defaultbymanyofthemduringtherecessioncontributed
tothedropinhomeprices
Thepanicandruninthefallof2008remainthecentral
distinguishingfeaturesoftheWorldFinancialCrisisasset
priceshave risenand fallenbeforeand theworldeconshy
omyhasbornelargefinancial lossesmanytimeswithout
suchasevereeconomicoutcomeConverselylossesfrom
completelydifferentunderlyingsourcesmdashcommercialreal
estateorperhapssovereigndefaultsmdashcouldcauseasimilar
catastrophe if theyagainprovoke tooshybigshytoshyfailchaosor
runs
Thisbookdoesnotseektoprovideacompletediagnosis
oftheWorldFinancialCrisisnordoesittakeastandonthe
relativeimportanceofthecontributingfactorslistedabove
ratherwebelieveourrecommendationswillhelpprevent
ormitigatefuturecriseseventhoughwedonotfullyundershy
standallthecausesofthelastone
CarmenreinhartandKennethrogoff amongothershave
pointedoutthatfinancialcriseshaveoccurredthroughout
thehistoryofcapitalismandthatthesecrisessharemany
commonpatterns19 Thelessonwedrawfromthisisthat
noacceptablesetofregulationscanpreventmarketparticishy
pantsfrommakingmistakesthatcreateeconomicinstability
ourpurposeinthisbookisinsteadtosuggestregulatory
reformsthatwillmakethesystemmorestabledespitethe
mistakesthataresuretocome
Copyrighted Material
10 bull CHapTer 1
wereheldbyleveragednonshybankintermediariesincluding
hedgefunds investmentbanksbrokeragefirmsandspecialshy
purposevehiclesManyoftheseintermediarieswereforced
toldquodeleverrdquoduringoctoberandnovembersellingassetsto
repaytheircreditors
Hedgefundsandotherleveragedintermediariesusethe
securitiesintheirportfoliosascollateralwhentheyborrow
moneyDuringtheWorldFinancialCrisismanywarylendshy
ersdecidedthecollateralborrowershadpostedbeforethe
Crisis was no longer sufficient to guarantee repayment
Whenthelendersdemandedeithermoreorbettercollatshy
eralmanyborrowerswereforcedtoselltheirleveredposishy
tionsandrepaytheirloansTheresultwasareductionin
thequantityofassetstheyheldandintheirleverageInadshy
ditionhedgefundsandotherintermediariessufferedlarge
withdrawalsbypanickycustomersagainforcingthemto
sellsecuritiesonthemarketTheassetsbeingsoldweregenshy
erallyacquiredbyindividualinvestorsthefederalgovernshy
mentorcommercialbankswhichasagroupfinancedmost
oftheirpurchasesbyborrowingfromthegovernment
The financing difficulties faced by arbitrageurs and lishy
quidity providers are apparent in a series of fascinating
market pathologies In financialmarkets there are often
manydifferentwaystoobtainthesameoutcomeaninvesshy
torcanusemanydifferentcombinationsofsecuritiesfor
exampletorisklesslyconvertdollarstodayintodollarsin
sixmonthsThe actionsof arbitrageursusuallykeep the
costsof thedifferent approaches closely alignedDuring
thefallof2008thecostsoftendivergedwiththeapproach
thatrequiredmorecapitaltypicallycostingless
Copyrighted Material
InTroDuCT Ion bull 11
Theprincipleofcoveredinterestparityforexamplesays
thataftereliminatingexchangerateriskriskshyfreeinvesting
shouldhavethesamereturnineverycurrencyaninvestor
whowantstoinvestdollarstodayandreceivedollarsinthe
futureusuallybuysauSbondHecouldaccomplishthe
samethingbyconvertinghisdollarsintoeurosinvesting
inarisklesseurobondandlockingintheconversionof
theeuropayoffbackintodollarswithaforwardcontract
Sincebothstrategiesconvertdollarstodayintodollarsin
thefuturetheyshouldhavethesamereturn5 Supposeinshy
steadthereturnontheuSbondislowerThenanarbitrashy
geurcouldborrowmoneyintheunitedStatesatthelower
rateinvestitintheeurotransactionatthehigherrateand
makeaprofit
During the Crisis covered interest parity violations as
largeas20basispoints(020percent)emergedThismay
seemtrivialbutinnormaltimestheseviolationsrarelyexshy
ceed 2 basis pointsMoreover traders can usuallyldquolever
uprdquotransactionslikethisandmakealargeprofitButthatrsquos
thecatchmdashhedgefundsbrokeragesandinvestmentbanks
werebeingforcedtodeleverduringtheCrisisand20basis
points is not enough to enticemany longshyonly investors
to replace theuSbond theyarecurrentlyholdingwith
aforeignbondandsomeseeminglycomplicatedcurrency
transactions
other recent research finds similar disruptions of the
normalpricing relations linking (1)Treasurybondscorshy
poratebondsandcreditshydefault swaps (aTreasurybond
shouldbethesameasacorporatebondplusacreditdefault
swapmdashexceptforliquidityfinancingandCDScounterparty
Copyrighted Material
12 bull CHapTer 1
risk)(2)fixedandfloatingrate investments (asequence
ofshortshyterminvestmentsplusacontractswappingafloatshy
ing interest rate forafixed interest rateshouldhave the
same payoff as a fixed rate investment) () convertible
bondsdebtandequity()newlyissuedldquoonshytheshyrunrdquoand
recently issuedldquooffshytheshyrunrdquoTreasury bondswhich have
essentially the same payoff but differ in liquidity and
(5)stockandoptionpriceswhicharelinkedbywhatfishy
nancialeconomistscalltheputshycallparityrelation7
Thebreakdownofthesenormalpricingrelationsdoes
littledirectharm to the restof theeconomya20shybasisshy
pointviolationofcoveredinterestparityhaslittleeffecton
auSexporterusingcurrencycontractstolockintherate
atwhichitcanconvertfutureJapaneserevenuebackinto
dollarsTheseviolationsshowhoweverthatmarketswere
notfunctioningnormallyInparticulartheysuggestthere
wasnotmuchcapitalavailabletoprovideliquiditytobuyshy
ersandsellersanyoneneedingtosellsecuritiesquicklyin
suchamarketmdashsuchasafinancialinstitutiontryingtoreshy
duceitsriskmdashwasnotlikelytogetagoodprice
lendIng BankIng and the recessIon
Duringthefallof2008outputandfinancingactivityconshy
tracted sharply Commercial paper corporate bond and
equityissuanceallfelldramaticallyasdidmortgageorigishy
nations
originations of most types of asset backed securities
alsoslowedtoatrickleManybanksintheunitedStates
Jan 20
04Ju
l 200
4Ja
n 2005
Jul 2
005
Jan 20
06Ju
l 200
6Ja
n 2007
Jul 2
007
Jan 20
08Ju
l 200
8Ja
n 2009
Jul 2
009
Copyrighted Material
InTroDuCT Ion bull 1
0
50
100
150
200
250
Figure2assetBackedSecuritiesIssuedintheunitedStatesJanushyary200toDecember2009BillionsofDollarsperMonthSourceFederalreserve
and other countries no longer hold much of the credit
theyissueTheyhavemovedinsteadtoanldquooriginateand
sellrdquomodel inwhich theybundle together similar loans
suchasjumbomortgagescommercialloansstudentloans
or credit card debt and sell them to investors as asset
backedsecuritiesnewissuesofthesesecuritiesessentially
stopped inoctoberandnovember2008Figure2shows
that the amount of asset backed securities issued in the
united States rose from$288 billion in January 2000 to
$85billioninJune2007andthenplungedto$102bilshy
lioninSeptember2007IssuanceintheunitedStatesconshy
tinued to decline over the next year eventually falling
to only $87 billion in october 2008 and $ billion in
Copyrighted Material
1 bull CHapTer 1
novembermdashjust2percentofthevolume18monthsearlier
onlymortgagespooledbyFannieMaeandFreddieMac
withanexplicitgovernmentguaranteeandsubjecttohuge
Federalreservepurchasescontinuedtoflowtothemarket
There isplentyof anecdotal and surveyevidence that
banklendingalsodriedupduringtheCrisisForexample
loanofficerssurveyedbytheFederalreservereportedthat
credit conditionsprogressively tightenedduring2008In
asurveyabouttheirperceptionsofcreditconditionsand
corporatedecisionsasoflatenovember2008morethan
halfofthechieffinancialofficersoflargeamericanfirms
whorespondedsaidthattheirfirmswereeitherldquosomewhat
orveryaffectedbythecostoravailabilityofcreditrdquo8
There is a lively and fundamentally important debate
about why the quantity of lending fell Some financial
economists argue that banks wanted to lend more but
wereunable todosobecausetheyfacedbindingcapital
constraintsInthisviewinformationcostsandotherfricshy
tionsintheloanoriginationprocesskeptcustomersfrom
movingtolessconstrainedbanks
othersarguethattheprimaryreasonbankswereunwillshy
ingtolendisthattheircustomershadbecomelesscreditshy
worthyTheseeconomistspointoutthatthehighlevelof
uncertainty about future economic conditionsduring the
Crisisratchetedupthedefaultriskofeventhemostrelishy
ableclientsThisinterpretationofthedeclineinbanklendshy
ingimpliesthatnoamountofcapitalwouldhaveinduced
banksasagrouptolendmorebecauseallthegoodloans
werebeingmade
Figure shows data on the quantity of bank lending
Jan 20
08
Mar
2008
M
ay 20
08Ju
l 200
8Se
p 2008
Nov 20
08Ja
n 2009
Jan 20
09
May
2009
Jul 2
009
Sep 20
09Nov
2009
Copyrighted Material
InTroDuCT Ion bull 15
1050
1100
1150
1200
1250
1300
FigureCommercialandIndustrialLoansbyuSCommercialBanks2008ndash9inBillionsofDollarsSourceFederalreserve
intheunitedStatesin2008and2009Startinginoctober
2008therewasaspikeinlendingfollowedbyaprotracted
declineVVChariLawrenceChristianoandpatrickKehoe
takethespikeatfacevalueinaggregatebankslentmore
ataminimumthebankingsystemasawholemdashasopposed
to individual banksmdashwas not deleveraging to overcome
loss of capital9 Victoria Ivashina and David Scharfstein
notethatmuchoftheincreaseinbanklendingwasinvolshy
untaryonthepartofthebankstheresultofdrawdowns
byborrowersonexistinglinesofcredit10 Theyalsoshow
thatbanks thatweremorevulnerable todrawdownsbeshy
causetheywereinmoresyndicateswithLehmanreduced
subsequent lending more and conclude that there was
indeed a genuine contraction in the effective supply of
bankcredit
Copyrighted Material
1 bull CHapTer 1
economistswillargueabouttheeventsoftheWorldFishy
nancialCrisisforyearstocomeInfactwestillargueabout
theGreatDepressionnoneoftheanalysisbehindourrecshy
ommendationshoweverdepends onhow these debates
aresettledForexamplenomatterhowcapitalshyconstrained
thebankingsystemreallywasinthefallof2008ourproshy
posalsforchangesthatmakesuchconstraintslessbinding
andgivepolicymakersbettertoolswhentheyfearcapital
constraintsremainvalid
What Was Wrong WIth the FInancIal system durIng the crIsIs
The Crisis revealed a number of serious problems with
ourfinancialsystemSomehadbeeninthebackgroundall
alongothersdidnotappearuntiltheCrisisInthisbook
weemphasizefourcategoriesofproblemsconflictsofinshy
terestknowntoeconomistsasagencyproblemsthediffishy
cultyofapplyingstandardbankruptcyprocedurestofinanshy
cialinstitutionstheemergenceofamodernformofbank
runsandtheinadequacyoftheregulatorystructurewhich
hadnotkeptupwithrecentfinancialinnovation(Infact
muchinnovationservedtoescaperegulations)
Conflicts of Interest Agency Problems
Conflictsofinterestthatcannotberesolvedeasilybyconshy
tractsormarketsoccurthroughouttheeconomybutthey
Copyrighted Material
InTroDuCT Ion bull 17
canbeparticularlyharmfulinthefinancialsystemThere
areseveralreasonsFirstmanyfinancialtransactionsand
contractsinvolveaprincipalsuchasaninvestororshareshy
holderaskingatradermanagerorotheragenttoacton
hisorherbehalfSecondmostfinancial transactions inshy
volvehighlyuncertainfuturepayoffsandinmanytransacshy
tionsonepartyisbetterinformedaboutthepayoffsthan
the otherThird the high volatility of the future payoffs
oftenmakesithardtoassesswhethertheoutcomeofafishy
nancialtransactionisduetotheagentrsquoseffortsorluckand
fourththesumsinvolvedcanbehuge
Someproprietarytradersforexampleearnalotwhen
their tradesdowellbuttheirpersonal lossesare limited
whentheirtradesdopoorlyBecauseoftheasymmetricnashy
tureoftheircompensationthesetraderscanincreasetheir
expectedincomebytakingriskierpositionsThisproblem
isdramaticallyillustratedbyperiodiccasesinwhichldquorogue
tradersrdquoincurlossesthatarebigenoughtodamageoreven
destroy large financial institutions In 1995 nick Leeson
broughtdownBaringsBankwitha$1billionlossandin
2008itwasrevealedthatJeacuterocircmeKervielhadseverelydamshy
agedSocieacuteteacuteGeacuteneacuteralewithalossofover$7billion
Conflictsofinterestorldquoagencyproblemsrdquoalsoexistat
manyotherlevelswithinthefinancialsystemShareholders
offinancialinstitutionshaveaconflictofinterestwiththe
bankrsquosseniorexecutivesespeciallywhenthoseexecutives
arerewardedforgoodperformancebutdonothavealarge
fractionoftheirwealthtiedupinthesharesofthebank
Manyfinancialinstitutionshavelargequantitiesofdebt
Copyrighted Material
18 bull CHapTer 1
which creates a conflict of interest between the bankrsquos
creditorsanditsshareholdersShareholdershaveanincenshy
tivetoauthorizeexcessivelyriskyinvestmentsforexample
especiallyafterabankhasincurredlossesthaterodethe
valueoftheshareholdersrsquoclaimThegainsontheserisky
investmentswillaccruelargelytoshareholderswhilethe
losseswillmostlybebornebycreditorsTheconflictwith
creditorsalsoreducestheincentivesfortheshareholders
of troubled institutions to raisenewcapitalbecause that
wouldstrengthen thepositionofcreditorswhilediluting
theshareholdersrsquopositionThisldquodebtoverhangrdquoproblem
waswidelycitedduringtheWorldFinancialCrisiswhen
many banks that were insolvent or close to insolvency
seemedreluctanteithertoraisenewcapitalortoreduce
theirrisksbysellingdistressedsecurities11
atthehighestlevelthereisaconflictofinterestbetween
societyasawholeandtheprivateownersoffinancialinshy
stitutions Because robust financial institutions promote
economicgrowthandemploymentduringfinancialcrises
governmentsoftenrescuetroubledfirmstheyperceiveto
be systemically importantThe result is privatized gains
andsocializedlossesIfthingsgowellthefirmsrsquoowners
andmanagersclaimtheprofitsbutifthingsgopoorlysoshy
cietysubsidizesthelosses
The candidates for government bailouts are popularly
describedasldquotoobigtofailrdquoMorepreciselytheargument
for government supportmdashwhich many economists chalshy
lengemdashisaboutfirmsthataretoosystemicallyimportantto
failInits200annualreporttheeuropeanCentralBank
describedsystemicriskasldquoTheriskthattheinabilityofone
Copyrighted Material
InTroDuCT Ion bull 19
institutiontomeetitsobligationswhenduewillcauseother
institutions to be unable tomeet their obligationswhen
dueSuchafailuremaycausesignificantliquidityorcredit
problemsandas a resultcould threaten the stabilityof
or confidence in marketsrdquo Systemically important firms
arethosewhosefailurecouldposealargethreattothestashy
bilityoforconfidenceinmarketsThesefirmsarelikelyto
belargebuttheyalsotendtohavecomplexinterconnecshy
tionswithotherfinancialinstitutions
Tooshybigshytoshyfailpoliciesoffersystemicallyimportantfirms
theexplicitorimplicitpromiseofabailoutwhenthingsgo
wrongThesepoliciesaredestructiveforseveralreasons
Firstbecause the possibility of a bailoutmeans a firmrsquos
stakeholders claim all the profits but only some of the
lossesfinancialfirmsthatmightreceivegovernmentsupshy
porthaveanincentivetotakeextrariskThefirmrsquosshareshy
holderscreditorsemployeesandmanagement all share
thetemptationTheresultisanincreaseintherisksborne
bysocietyasawhole
Secondthesepoliciesencouragesmallerfinancialinstishy
tutionstoexpandortobecomemorecloselyinterconnected
with other firms so they move under the tooshybigshytoshyfail
umbrellaFirmshaveanincentivetodowhateverittakes
tomakepolicymakersfeartheirfailurecreatingthevery
fragilitythegovernmentwishestoavoidBeliefthatagovshy
ernmentrescuewillprotectafinancial institutionrsquoscredishy
tors inacrisisalsogivesafirmacompetitiveadvantage
loweringitscostoffinancingandallowingittoofferbetter
prices to its customers than its fundamental productivity
warrants
Copyrighted Material
20 bull CHapTer 1
Thirdinefficientfirmsthatcannotcompeteontheirown
shouldfailotherwisefirmshavelessincentivetobecome
andstayefficientagovernmentpolicythatpropsupinshy
efficientfirmsiswastefulanddestructiveallowingthese
firmstofailfreesupresourcesandprovidesopportunities
formoreefficientandinnovativecompetitorstoflourish
Fourthandmostgenerallycapitalismisunderminedby
policiesthatprivatizegainsbutsocializelossesGovernment
guaranteedinstitutionscanbecomegovernmentruninstishy
tutionsallocatingcreditforexampletomaximizepolitical
gainratherthaneconomicwelfare
The conflictbetween society and theownersoffinanshy
cialfirmsbecomesmoreseriousduringseverecriseswhen
manyfinancialinstitutionsareclosetoinsolventIt isthe
primemotivationforourregulatoryproposalsbutseveral
ofthelowershylevelconflictswehavedescribedarerelevant
becausetheymagnifytheriskbornebysocietyasawhole
Theselfshyservingbehaviorthatmanyofourrecommenshy
dations targetmdashwhether by traders senior management
orthefirmrsquosownersmdashneednotbestrategicintentionally
maliciousorevenconsciousConsideratraderwhoinadshy
vertentlydevelopsaninvestmentstrategywithhighlyprobshy
ablegainsandimprobablebutlargelossesLikeafirmthat
hassoldearthquakeinsurancethestrategymayproducea
longstringofimpressivereturnsbeforeoneyearoflosses
wipesoutmanyyearsofprofits12 Ifsoduringthegood
yearsthetraderwillbecelebratedforhisorherbrilliance
rewarded with large bonuses and given more resources
to manageMany sophisticated traders and hedge funds
Copyrighted Material
InTroDuCT Ion bull 21
werenotawareoftheldquoearthquakerisksrdquoinherentinmany
of theirstrategiesSimilarlywhenfirmstakeactionsthat
increasethelikelihoodofagovernmentbailoutinthenext
financialcrisisthemarketrewardsthemwithalowercost
of capitalas firms become too big to fail for example
the implicit government guarantee reduces the riskiness
of their debt and lowers the interest rate demanded by
theircreditorsaCeoworkingtomaximizefirmvaluemay
notevenrealize the importanceof thegovernmentguarshy
anteebut a Darwinian process will encourage behavior
thatexploitsit
Bankruptcy and Resolution Procedures
Itisimpossibletowriteafinancialcontractthatspecifies
everypossiblecontingencyInsteadcontractsrelyonbankshy
ruptcytodetermineoutcomesincertainbadandunlikely
statesoftheworldInbankruptcycontrolofafirmistransshy
ferredfromtheshareholderswhonolongerhaveastake
inlossesbecausetheirsharesareworthlittletothedebtshy
holders It is in societyrsquos interest to develop bankruptcy
proceduresthatmaximizethepostshybankruptcyvalueofa
firmrsquosassetsInparticularsocietyshouldavoidthedestrucshy
tionofvaluethatoccurswithdisorderlyliquidation
Disorderlyliquidationoffinancialinstitutionsisparticushy
larly costlyFirstvaluableknowledge that the institution
hasaccumulatedaboutitscounterpartiesmdashborrowerstradshy
ingpartnersandsoonmdashcandisappearastheinstitution
losesemployeesandceasestooperatenormallyFinancial
Copyrighted Material
22 bull CHapTer 1
economistshavefoundthatthecollapseofabankhasamashy
terialadverseimpactonmanyofitsborrowers1 Second
the prospect of a disorderly liquidation makes it more
likelythatatroubledfinancialinstitutionwillsufferarun
by creditors who conclude they are better off claiming
whatmoney theycan todayrather thanwaiting through
protracted liquidation proceedings Third ldquofire salesrdquo of
specializedassets inadisorderly liquidationcandepress
prices and thereby spread problems to other holders of
theassetclassFourthdisorderlyliquidationincreasesthe
uncertaintyabouttheimpactofafinancialinstitutionrsquosfailshy
ureonitscounterpartiesandotherclaimholdersBecause
financialfirmsaretightlyinterconnectedthisuncertainty
canprecipitateorintensifyafinancialcrisis1
In theunitedStatesthestandardbankruptcycodealshy
lowsbothforliquidationofafirmandthesaleofitsassets
(Chapter7)andforcontinuedoperationofafirmunder
the supervision of a bankruptcy judgewho protects the
firmfromcreditorsrsquoclaimswhileareorganizationplanis
approved(Chapter11)Theseproceduresappeartowork
wellfornonfinancialcorporationsbutnotsowellforfinanshy
cialorganizationsTheChapter11approachofseparatinga
firmrsquosfinancialaffairsfromitsnonfinancialbusinessactivishy
tiesisinfeasiblewhenthebusinessofthefirmisfinancial
transactionsFurthermoremanyfinancialinstitutionsrely
heavily on shortshyterm debtpossibly as a valuable discishy
plineonbankexecutiveswhocanrapidlychangetherisks
theirfirmstakeThismakesfinancialfirmsvulnerabletoa
rapidwithdrawalofshortshytermcreditthatislikelytooccur
beforeanyeventthatwouldtriggerbankruptcy
Copyrighted Material
InTroDuCT Ion bull 2
Wearguebelowthatthereisaneedforaspecialresolushy
tionprocedurethatcanbeappliedtolargeinsolventfinanshy
cialinstitutionsWealsoadvocateregulatorychangesthat
would push financial firms towardmore resilient capital
structures
Bank Runs
Classicbank runs inwhichdepositors race towithdraw
their funds before a bank failswere one of the central
contributors to theGreatDepressionDeposit insurance
whichwasintroducedaftertheDepressiontocounterthis
destructiveprocessmadedemanddepositsoneofthemost
stableformsofbankfinancingduringtheWorldFinancial
CrisisManyfinancialinstitutionshoweversufferedamodshy
ernversionofbankruns
Banksespeciallythosewithinvestmentbankingactivishy
tiestypicallyfinanceasignificantfractionoftheirbusiness
withovernightcommercialpaperreposandothershortshy
terminstrumentsInnormaltimesbanksrolloverthisdebt
asitmaturestakingnewloanstopayofftheoldInacrishy
sishoweveruncertaintyaboutwhetheratroubledinstitushy
tionwouldbeabletopayoffitscreditorstomorrowcauses
lenderstostopextendingcredittodayThusshortshytermfishy
nancingcanleadtoarunthatissimilartoaclassicrunon
deposits
even some secured creditors participated in runs durshy
ingtheWorldFinancialCrisisBanksoftenuserepurchase
agreements to borrow money securing the loan by givshy
ingthelenderafinancialassetsuchasaTreasurybond
Copyrighted Material
2 bull CHapTer 1
ascollateralBecausetheyareovershycollateralizedwithasshy
setsworthperhaps$105guaranteeingevery$100inloans
lendersviewldquoreposrdquoasasafewaytoextendcreditWhen
credit markets froze during the Crisis however lenders
worried that retrieving collateral and selling itwouldbe
difficultandnotworththesmallinterestonanovernight
loanasaresultatvarioustimesduringtheCrisismany
investmentbankshaddifficultyrollingovereventheirseshy
cured loanseven relatively healthy financial institutions
werehamperedbythetroubleintherepomarketafteraushy
gust2007asthemarketbecamemoreandmoreuncertain
about the prices securities would fetch in a forced sale
these institutions found they could borrow less and less
withthesamecollateral15
prime brokerage accounts also saw a runshylike withshy
drawalbycustomersManylargebankshaveprimebrokershy
agegroupsthatassisthedgefundsandotherinstitutionalinshy
vestorsbyprovidingfinancingsecuritieslendingclearing
custodial servicesandoperational supportInexchange
thefundspayfeesandcriticallypostcollateraltosecure
theirloansWithsomerestrictionsthatweexplaininChapshy
ter10theprimebrokercanthenusethecollateralinits
ownbusinessinsomecasescomminglingitwiththefirmrsquos
ownassetsDuringtheCrisishedgefundsmonitoredthe
financial wellshybeing of their prime brokers and like deshy
positorsintheDepressionfledwiththeircollateralatthe
firstsignoftroubleBearStearnsforexamplehadalarge
prime brokerage business according to press accounts
oneofthelargesthedgefundsthatusedBearStearnsasa
Copyrighted Material
InTroDuCT Ion bull 25
primebrokerrenaissanceTechnologieswithdrew$5bilshy
lionofcashintheweekthefirmfailedWithsuchoutflows
it is not surprising that Bear Stearns ran out of money
eventhoughithadmorethan$18billionincashaweek
earlier
Likeclassicbankrunsmodernbankrunsarebothdeshy
structiveandselfshyfulfillingConcernthatabankmightbe
in trouble spurs its creditors and counterparties towithshy
draworwithholdtheircapitalasaresultevenrumorsofa
problemmaybeenoughtodestroyaviableinstitutionThe
importanceofmodernbankrunsduringtheWorldFinanshy
cialCrisisisarecurringthemethroughoutthebookand
wemakeseveralproposalsthatareintendedtoreducethe
frequencyofsuchevents
The Inadequacy of the Regulatory Structure
TheWorldFinancialCrisismadeitclearthatfinancialinnoshy
vationhadoverwhelmedexistingfinancialregulationsnoshy
tableexamplesincludeaIGrsquosdecisiontosellanextremely
large amount of credit default swaps on subprime debt
tobanksintheunitedStatesandabroadtheholdingof
Lehmanpaperbymoneymarketfundsparticularlythereshy
serveprimaryFundthecomplexityofthederivativebooks
atLehmanandotherinvestmentbanksandthedifficultyof
simultaneouslyapplyingseveralcountriesrsquobankruptcycodes
tothesubsidiariesofmultinationalfinancialinstitutions1
Thereisatradeshyoffbetweenfinancialinnovationandstashy
bilityInnovationcanimprovethefinancialsystemrsquosability
Copyrighted Material
2 bull CHapTer 1
toallocateresourcestotheirhighestvaluedusebutitcan
alsoreducethestabilityofthesystemThechallengeisto
developregulationsthatimprovestabilitywithoutstifling
innovation In addition regulation often leads to innoshy
vations designed to evade the regulationswhich makes
thefinancialsystemmorefragileForexamplemanyofthe
specialshypurposevehiclesthatimplodedintheCrisiswere
createdtogetaroundcapitalrequirements
In many countries the response of regulators to the
World Financial Crisis was hampered by the fragmented
nature of their regulatory systems Financial regulations
are typically designed to ensure thehealth of individual
institutionsratherthanthefinancialsystemasawholeIn
thisbookwearguethatsystemicregulationisanimporshy
tantfunctionthatrequiresaspecialmandateandthatthe
central bank is particularly well equipped to fulfill this
function
Finallyeffectivefinancialregulationrequiresthatpolitishy
ciansandultimatelythepublichaveanadequateundershy
standing of the financial system The political turmoil
surroundingtheCrisissuggeststheimportanceofdissemishy
natingexpertknowledgeaboutfinancetoabroaderaudishy
enceThisisoneofourmotivationsforwritingthisbook
What Were the orIgIns oF the World FInancIal crIsIs
LiketheoriginsoftheFirstWorldWarthecausesofthe
Crisiswillbedebatedbyscholarsformanyyears
Copyrighted Material
InTroDuCT Ion bull 27
Most observers agree that the strong runshyup and subshy
sequentsharpdeclineinthepricesofstockshousesand
otherfinancialassetsindevelopedcountrieswasanimporshy
tantcatalystfortheCrisisThereisdisagreementhowever
aboutwhetherthispatterninpricesistheresultofrational
investorbehaviororldquoirrationalbubblesrdquo
SomearguethattherunshyupbeforetheCrisiswasdriven
by investorswhoknowingly acceptedunusually low exshy
pectedreturnsandtheyofferseveralpossiblereasonswhy
Firsttherewasasurgeofsavingsinemergingcountries
drivenbyacombinationofrapideconomicgrowthanddeshy
mographicsperhapsbecauseofadesiretoaccumulateforshy
eignreservesintheaftermathoftheasiacrisisof1997ndash98
muchof thiswealthwas invested indevelopedmarkets
Secondfinancialmarketswereunusually tranquilduring
200to200Withlowvolatilityinvestorsmayhavesettled
for a low risk premiumThird influenced by fears of a
Japaneseshystyledeflation resulting from themarketdownshy
turnof2000ndash2001andbyabeliefthattheyshouldnottry
to usemonetary policy to counteract rising asset prices
central bankers in the united States maintained a loose
monetarypolicythroughouttheperiod17andfromthisrashy
tionalviewofinvestorstheplungeinassetpricesthatacshy
companiedtheCrisiswascausedbybadnewsaboutfuture
cashflowsunexpectedincreasesinthereturnsrequiredby
investorsorboth
otherssuggestamoredirectexplanationThehighprices
before theCrisisweredrivenby an irrational belief that
prices would continue to rise and the collapse of asset
priceswastheinevitableresultofthismistakeWhatever
Copyrighted Material
28 bull CHapTer 1
theexplanationthesharpdropinassetpricesbothconshy
tributedtoandwasasymptomoftheCrisis
other commentators argue that the financial system
becamevulnerablebecausemanymarketparticipantsasshy
sessedrisksinaccuratelyduringtheperiodleadingupto
theWorldFinancialCrisisConsumersbanksandinvestors
ingeneralunderestimatedtheriskofhousepricedeclines
increasingthepricestheywerewillingtopayforrealesshy
tatethecredittheywerewillingtoextendandthevaluashy
tionsofbanksthatextendedsuchcreditBanksputmuch
weight on the recent pastwhen they estimated value at
riskwhichledthemtoconcludethatthelevelofriskwas
lowandthattherewaslittledownsidetohavinghighleshy
verageothermarketparticipantsdidnotfullyappreciate
thathighliquiditywassuppressingvolatilityandthatthe
processmightreversewithliquiditydecreasingandvolatilshy
ityincreasing
More generally the high level of financial innovation
driveninpartbythedecliningcostofinformationtechnolshy
ogymadeithardforriskassessmenttokeeppacewiththe
evolvingfinancialsystem18Thebenignenvironmentofthe
creditboomexacerbatedthisproblembytemptingfinanshy
cialinstitutionstounderinvestinriskmanagement
uSpolicymakersalsocontributedtotheseverityofthe
CrisisbypushingFannieMaeandFreddieMactoincrease
theavailabilityofmortgagefundingtoborrowerswithquesshy
tionableabilitytorepaytheirmortgagesasaresultofthis
pressure both agencies relaxed their standards for the
mortgages they purchased and guaranteedThe demand
Copyrighted Material
InTroDuCT Ion bull 29
forhomesbyborrowerswhoqualifiedformortgagesbeshy
causeoftheselowerstandardspusheduppricesandthe
defaultbymanyofthemduringtherecessioncontributed
tothedropinhomeprices
Thepanicandruninthefallof2008remainthecentral
distinguishingfeaturesoftheWorldFinancialCrisisasset
priceshave risenand fallenbeforeand theworldeconshy
omyhasbornelargefinancial lossesmanytimeswithout
suchasevereeconomicoutcomeConverselylossesfrom
completelydifferentunderlyingsourcesmdashcommercialreal
estateorperhapssovereigndefaultsmdashcouldcauseasimilar
catastrophe if theyagainprovoke tooshybigshytoshyfailchaosor
runs
Thisbookdoesnotseektoprovideacompletediagnosis
oftheWorldFinancialCrisisnordoesittakeastandonthe
relativeimportanceofthecontributingfactorslistedabove
ratherwebelieveourrecommendationswillhelpprevent
ormitigatefuturecriseseventhoughwedonotfullyundershy
standallthecausesofthelastone
CarmenreinhartandKennethrogoff amongothershave
pointedoutthatfinancialcriseshaveoccurredthroughout
thehistoryofcapitalismandthatthesecrisessharemany
commonpatterns19 Thelessonwedrawfromthisisthat
noacceptablesetofregulationscanpreventmarketparticishy
pantsfrommakingmistakesthatcreateeconomicinstability
ourpurposeinthisbookisinsteadtosuggestregulatory
reformsthatwillmakethesystemmorestabledespitethe
mistakesthataresuretocome
Copyrighted Material
InTroDuCT Ion bull 11
Theprincipleofcoveredinterestparityforexamplesays
thataftereliminatingexchangerateriskriskshyfreeinvesting
shouldhavethesamereturnineverycurrencyaninvestor
whowantstoinvestdollarstodayandreceivedollarsinthe
futureusuallybuysauSbondHecouldaccomplishthe
samethingbyconvertinghisdollarsintoeurosinvesting
inarisklesseurobondandlockingintheconversionof
theeuropayoffbackintodollarswithaforwardcontract
Sincebothstrategiesconvertdollarstodayintodollarsin
thefuturetheyshouldhavethesamereturn5 Supposeinshy
steadthereturnontheuSbondislowerThenanarbitrashy
geurcouldborrowmoneyintheunitedStatesatthelower
rateinvestitintheeurotransactionatthehigherrateand
makeaprofit
During the Crisis covered interest parity violations as
largeas20basispoints(020percent)emergedThismay
seemtrivialbutinnormaltimestheseviolationsrarelyexshy
ceed 2 basis pointsMoreover traders can usuallyldquolever
uprdquotransactionslikethisandmakealargeprofitButthatrsquos
thecatchmdashhedgefundsbrokeragesandinvestmentbanks
werebeingforcedtodeleverduringtheCrisisand20basis
points is not enough to enticemany longshyonly investors
to replace theuSbond theyarecurrentlyholdingwith
aforeignbondandsomeseeminglycomplicatedcurrency
transactions
other recent research finds similar disruptions of the
normalpricing relations linking (1)Treasurybondscorshy
poratebondsandcreditshydefault swaps (aTreasurybond
shouldbethesameasacorporatebondplusacreditdefault
swapmdashexceptforliquidityfinancingandCDScounterparty
Copyrighted Material
12 bull CHapTer 1
risk)(2)fixedandfloatingrate investments (asequence
ofshortshyterminvestmentsplusacontractswappingafloatshy
ing interest rate forafixed interest rateshouldhave the
same payoff as a fixed rate investment) () convertible
bondsdebtandequity()newlyissuedldquoonshytheshyrunrdquoand
recently issuedldquooffshytheshyrunrdquoTreasury bondswhich have
essentially the same payoff but differ in liquidity and
(5)stockandoptionpriceswhicharelinkedbywhatfishy
nancialeconomistscalltheputshycallparityrelation7
Thebreakdownofthesenormalpricingrelationsdoes
littledirectharm to the restof theeconomya20shybasisshy
pointviolationofcoveredinterestparityhaslittleeffecton
auSexporterusingcurrencycontractstolockintherate
atwhichitcanconvertfutureJapaneserevenuebackinto
dollarsTheseviolationsshowhoweverthatmarketswere
notfunctioningnormallyInparticulartheysuggestthere
wasnotmuchcapitalavailabletoprovideliquiditytobuyshy
ersandsellersanyoneneedingtosellsecuritiesquicklyin
suchamarketmdashsuchasafinancialinstitutiontryingtoreshy
duceitsriskmdashwasnotlikelytogetagoodprice
lendIng BankIng and the recessIon
Duringthefallof2008outputandfinancingactivityconshy
tracted sharply Commercial paper corporate bond and
equityissuanceallfelldramaticallyasdidmortgageorigishy
nations
originations of most types of asset backed securities
alsoslowedtoatrickleManybanksintheunitedStates
Jan 20
04Ju
l 200
4Ja
n 2005
Jul 2
005
Jan 20
06Ju
l 200
6Ja
n 2007
Jul 2
007
Jan 20
08Ju
l 200
8Ja
n 2009
Jul 2
009
Copyrighted Material
InTroDuCT Ion bull 1
0
50
100
150
200
250
Figure2assetBackedSecuritiesIssuedintheunitedStatesJanushyary200toDecember2009BillionsofDollarsperMonthSourceFederalreserve
and other countries no longer hold much of the credit
theyissueTheyhavemovedinsteadtoanldquooriginateand
sellrdquomodel inwhich theybundle together similar loans
suchasjumbomortgagescommercialloansstudentloans
or credit card debt and sell them to investors as asset
backedsecuritiesnewissuesofthesesecuritiesessentially
stopped inoctoberandnovember2008Figure2shows
that the amount of asset backed securities issued in the
united States rose from$288 billion in January 2000 to
$85billioninJune2007andthenplungedto$102bilshy
lioninSeptember2007IssuanceintheunitedStatesconshy
tinued to decline over the next year eventually falling
to only $87 billion in october 2008 and $ billion in
Copyrighted Material
1 bull CHapTer 1
novembermdashjust2percentofthevolume18monthsearlier
onlymortgagespooledbyFannieMaeandFreddieMac
withanexplicitgovernmentguaranteeandsubjecttohuge
Federalreservepurchasescontinuedtoflowtothemarket
There isplentyof anecdotal and surveyevidence that
banklendingalsodriedupduringtheCrisisForexample
loanofficerssurveyedbytheFederalreservereportedthat
credit conditionsprogressively tightenedduring2008In
asurveyabouttheirperceptionsofcreditconditionsand
corporatedecisionsasoflatenovember2008morethan
halfofthechieffinancialofficersoflargeamericanfirms
whorespondedsaidthattheirfirmswereeitherldquosomewhat
orveryaffectedbythecostoravailabilityofcreditrdquo8
There is a lively and fundamentally important debate
about why the quantity of lending fell Some financial
economists argue that banks wanted to lend more but
wereunable todosobecausetheyfacedbindingcapital
constraintsInthisviewinformationcostsandotherfricshy
tionsintheloanoriginationprocesskeptcustomersfrom
movingtolessconstrainedbanks
othersarguethattheprimaryreasonbankswereunwillshy
ingtolendisthattheircustomershadbecomelesscreditshy
worthyTheseeconomistspointoutthatthehighlevelof
uncertainty about future economic conditionsduring the
Crisisratchetedupthedefaultriskofeventhemostrelishy
ableclientsThisinterpretationofthedeclineinbanklendshy
ingimpliesthatnoamountofcapitalwouldhaveinduced
banksasagrouptolendmorebecauseallthegoodloans
werebeingmade
Figure shows data on the quantity of bank lending
Jan 20
08
Mar
2008
M
ay 20
08Ju
l 200
8Se
p 2008
Nov 20
08Ja
n 2009
Jan 20
09
May
2009
Jul 2
009
Sep 20
09Nov
2009
Copyrighted Material
InTroDuCT Ion bull 15
1050
1100
1150
1200
1250
1300
FigureCommercialandIndustrialLoansbyuSCommercialBanks2008ndash9inBillionsofDollarsSourceFederalreserve
intheunitedStatesin2008and2009Startinginoctober
2008therewasaspikeinlendingfollowedbyaprotracted
declineVVChariLawrenceChristianoandpatrickKehoe
takethespikeatfacevalueinaggregatebankslentmore
ataminimumthebankingsystemasawholemdashasopposed
to individual banksmdashwas not deleveraging to overcome
loss of capital9 Victoria Ivashina and David Scharfstein
notethatmuchoftheincreaseinbanklendingwasinvolshy
untaryonthepartofthebankstheresultofdrawdowns
byborrowersonexistinglinesofcredit10 Theyalsoshow
thatbanks thatweremorevulnerable todrawdownsbeshy
causetheywereinmoresyndicateswithLehmanreduced
subsequent lending more and conclude that there was
indeed a genuine contraction in the effective supply of
bankcredit
Copyrighted Material
1 bull CHapTer 1
economistswillargueabouttheeventsoftheWorldFishy
nancialCrisisforyearstocomeInfactwestillargueabout
theGreatDepressionnoneoftheanalysisbehindourrecshy
ommendationshoweverdepends onhow these debates
aresettledForexamplenomatterhowcapitalshyconstrained
thebankingsystemreallywasinthefallof2008ourproshy
posalsforchangesthatmakesuchconstraintslessbinding
andgivepolicymakersbettertoolswhentheyfearcapital
constraintsremainvalid
What Was Wrong WIth the FInancIal system durIng the crIsIs
The Crisis revealed a number of serious problems with
ourfinancialsystemSomehadbeeninthebackgroundall
alongothersdidnotappearuntiltheCrisisInthisbook
weemphasizefourcategoriesofproblemsconflictsofinshy
terestknowntoeconomistsasagencyproblemsthediffishy
cultyofapplyingstandardbankruptcyprocedurestofinanshy
cialinstitutionstheemergenceofamodernformofbank
runsandtheinadequacyoftheregulatorystructurewhich
hadnotkeptupwithrecentfinancialinnovation(Infact
muchinnovationservedtoescaperegulations)
Conflicts of Interest Agency Problems
Conflictsofinterestthatcannotberesolvedeasilybyconshy
tractsormarketsoccurthroughouttheeconomybutthey
Copyrighted Material
InTroDuCT Ion bull 17
canbeparticularlyharmfulinthefinancialsystemThere
areseveralreasonsFirstmanyfinancialtransactionsand
contractsinvolveaprincipalsuchasaninvestororshareshy
holderaskingatradermanagerorotheragenttoacton
hisorherbehalfSecondmostfinancial transactions inshy
volvehighlyuncertainfuturepayoffsandinmanytransacshy
tionsonepartyisbetterinformedaboutthepayoffsthan
the otherThird the high volatility of the future payoffs
oftenmakesithardtoassesswhethertheoutcomeofafishy
nancialtransactionisduetotheagentrsquoseffortsorluckand
fourththesumsinvolvedcanbehuge
Someproprietarytradersforexampleearnalotwhen
their tradesdowellbuttheirpersonal lossesare limited
whentheirtradesdopoorlyBecauseoftheasymmetricnashy
tureoftheircompensationthesetraderscanincreasetheir
expectedincomebytakingriskierpositionsThisproblem
isdramaticallyillustratedbyperiodiccasesinwhichldquorogue
tradersrdquoincurlossesthatarebigenoughtodamageoreven
destroy large financial institutions In 1995 nick Leeson
broughtdownBaringsBankwitha$1billionlossandin
2008itwasrevealedthatJeacuterocircmeKervielhadseverelydamshy
agedSocieacuteteacuteGeacuteneacuteralewithalossofover$7billion
Conflictsofinterestorldquoagencyproblemsrdquoalsoexistat
manyotherlevelswithinthefinancialsystemShareholders
offinancialinstitutionshaveaconflictofinterestwiththe
bankrsquosseniorexecutivesespeciallywhenthoseexecutives
arerewardedforgoodperformancebutdonothavealarge
fractionoftheirwealthtiedupinthesharesofthebank
Manyfinancialinstitutionshavelargequantitiesofdebt
Copyrighted Material
18 bull CHapTer 1
which creates a conflict of interest between the bankrsquos
creditorsanditsshareholdersShareholdershaveanincenshy
tivetoauthorizeexcessivelyriskyinvestmentsforexample
especiallyafterabankhasincurredlossesthaterodethe
valueoftheshareholdersrsquoclaimThegainsontheserisky
investmentswillaccruelargelytoshareholderswhilethe
losseswillmostlybebornebycreditorsTheconflictwith
creditorsalsoreducestheincentivesfortheshareholders
of troubled institutions to raisenewcapitalbecause that
wouldstrengthen thepositionofcreditorswhilediluting
theshareholdersrsquopositionThisldquodebtoverhangrdquoproblem
waswidelycitedduringtheWorldFinancialCrisiswhen
many banks that were insolvent or close to insolvency
seemedreluctanteithertoraisenewcapitalortoreduce
theirrisksbysellingdistressedsecurities11
atthehighestlevelthereisaconflictofinterestbetween
societyasawholeandtheprivateownersoffinancialinshy
stitutions Because robust financial institutions promote
economicgrowthandemploymentduringfinancialcrises
governmentsoftenrescuetroubledfirmstheyperceiveto
be systemically importantThe result is privatized gains
andsocializedlossesIfthingsgowellthefirmsrsquoowners
andmanagersclaimtheprofitsbutifthingsgopoorlysoshy
cietysubsidizesthelosses
The candidates for government bailouts are popularly
describedasldquotoobigtofailrdquoMorepreciselytheargument
for government supportmdashwhich many economists chalshy
lengemdashisaboutfirmsthataretoosystemicallyimportantto
failInits200annualreporttheeuropeanCentralBank
describedsystemicriskasldquoTheriskthattheinabilityofone
Copyrighted Material
InTroDuCT Ion bull 19
institutiontomeetitsobligationswhenduewillcauseother
institutions to be unable tomeet their obligationswhen
dueSuchafailuremaycausesignificantliquidityorcredit
problemsandas a resultcould threaten the stabilityof
or confidence in marketsrdquo Systemically important firms
arethosewhosefailurecouldposealargethreattothestashy
bilityoforconfidenceinmarketsThesefirmsarelikelyto
belargebuttheyalsotendtohavecomplexinterconnecshy
tionswithotherfinancialinstitutions
Tooshybigshytoshyfailpoliciesoffersystemicallyimportantfirms
theexplicitorimplicitpromiseofabailoutwhenthingsgo
wrongThesepoliciesaredestructiveforseveralreasons
Firstbecause the possibility of a bailoutmeans a firmrsquos
stakeholders claim all the profits but only some of the
lossesfinancialfirmsthatmightreceivegovernmentsupshy
porthaveanincentivetotakeextrariskThefirmrsquosshareshy
holderscreditorsemployeesandmanagement all share
thetemptationTheresultisanincreaseintherisksborne
bysocietyasawhole
Secondthesepoliciesencouragesmallerfinancialinstishy
tutionstoexpandortobecomemorecloselyinterconnected
with other firms so they move under the tooshybigshytoshyfail
umbrellaFirmshaveanincentivetodowhateverittakes
tomakepolicymakersfeartheirfailurecreatingthevery
fragilitythegovernmentwishestoavoidBeliefthatagovshy
ernmentrescuewillprotectafinancial institutionrsquoscredishy
tors inacrisisalsogivesafirmacompetitiveadvantage
loweringitscostoffinancingandallowingittoofferbetter
prices to its customers than its fundamental productivity
warrants
Copyrighted Material
20 bull CHapTer 1
Thirdinefficientfirmsthatcannotcompeteontheirown
shouldfailotherwisefirmshavelessincentivetobecome
andstayefficientagovernmentpolicythatpropsupinshy
efficientfirmsiswastefulanddestructiveallowingthese
firmstofailfreesupresourcesandprovidesopportunities
formoreefficientandinnovativecompetitorstoflourish
Fourthandmostgenerallycapitalismisunderminedby
policiesthatprivatizegainsbutsocializelossesGovernment
guaranteedinstitutionscanbecomegovernmentruninstishy
tutionsallocatingcreditforexampletomaximizepolitical
gainratherthaneconomicwelfare
The conflictbetween society and theownersoffinanshy
cialfirmsbecomesmoreseriousduringseverecriseswhen
manyfinancialinstitutionsareclosetoinsolventIt isthe
primemotivationforourregulatoryproposalsbutseveral
ofthelowershylevelconflictswehavedescribedarerelevant
becausetheymagnifytheriskbornebysocietyasawhole
Theselfshyservingbehaviorthatmanyofourrecommenshy
dations targetmdashwhether by traders senior management
orthefirmrsquosownersmdashneednotbestrategicintentionally
maliciousorevenconsciousConsideratraderwhoinadshy
vertentlydevelopsaninvestmentstrategywithhighlyprobshy
ablegainsandimprobablebutlargelossesLikeafirmthat
hassoldearthquakeinsurancethestrategymayproducea
longstringofimpressivereturnsbeforeoneyearoflosses
wipesoutmanyyearsofprofits12 Ifsoduringthegood
yearsthetraderwillbecelebratedforhisorherbrilliance
rewarded with large bonuses and given more resources
to manageMany sophisticated traders and hedge funds
Copyrighted Material
InTroDuCT Ion bull 21
werenotawareoftheldquoearthquakerisksrdquoinherentinmany
of theirstrategiesSimilarlywhenfirmstakeactionsthat
increasethelikelihoodofagovernmentbailoutinthenext
financialcrisisthemarketrewardsthemwithalowercost
of capitalas firms become too big to fail for example
the implicit government guarantee reduces the riskiness
of their debt and lowers the interest rate demanded by
theircreditorsaCeoworkingtomaximizefirmvaluemay
notevenrealize the importanceof thegovernmentguarshy
anteebut a Darwinian process will encourage behavior
thatexploitsit
Bankruptcy and Resolution Procedures
Itisimpossibletowriteafinancialcontractthatspecifies
everypossiblecontingencyInsteadcontractsrelyonbankshy
ruptcytodetermineoutcomesincertainbadandunlikely
statesoftheworldInbankruptcycontrolofafirmistransshy
ferredfromtheshareholderswhonolongerhaveastake
inlossesbecausetheirsharesareworthlittletothedebtshy
holders It is in societyrsquos interest to develop bankruptcy
proceduresthatmaximizethepostshybankruptcyvalueofa
firmrsquosassetsInparticularsocietyshouldavoidthedestrucshy
tionofvaluethatoccurswithdisorderlyliquidation
Disorderlyliquidationoffinancialinstitutionsisparticushy
larly costlyFirstvaluableknowledge that the institution
hasaccumulatedaboutitscounterpartiesmdashborrowerstradshy
ingpartnersandsoonmdashcandisappearastheinstitution
losesemployeesandceasestooperatenormallyFinancial
Copyrighted Material
22 bull CHapTer 1
economistshavefoundthatthecollapseofabankhasamashy
terialadverseimpactonmanyofitsborrowers1 Second
the prospect of a disorderly liquidation makes it more
likelythatatroubledfinancialinstitutionwillsufferarun
by creditors who conclude they are better off claiming
whatmoney theycan todayrather thanwaiting through
protracted liquidation proceedings Third ldquofire salesrdquo of
specializedassets inadisorderly liquidationcandepress
prices and thereby spread problems to other holders of
theassetclassFourthdisorderlyliquidationincreasesthe
uncertaintyabouttheimpactofafinancialinstitutionrsquosfailshy
ureonitscounterpartiesandotherclaimholdersBecause
financialfirmsaretightlyinterconnectedthisuncertainty
canprecipitateorintensifyafinancialcrisis1
In theunitedStatesthestandardbankruptcycodealshy
lowsbothforliquidationofafirmandthesaleofitsassets
(Chapter7)andforcontinuedoperationofafirmunder
the supervision of a bankruptcy judgewho protects the
firmfromcreditorsrsquoclaimswhileareorganizationplanis
approved(Chapter11)Theseproceduresappeartowork
wellfornonfinancialcorporationsbutnotsowellforfinanshy
cialorganizationsTheChapter11approachofseparatinga
firmrsquosfinancialaffairsfromitsnonfinancialbusinessactivishy
tiesisinfeasiblewhenthebusinessofthefirmisfinancial
transactionsFurthermoremanyfinancialinstitutionsrely
heavily on shortshyterm debtpossibly as a valuable discishy
plineonbankexecutiveswhocanrapidlychangetherisks
theirfirmstakeThismakesfinancialfirmsvulnerabletoa
rapidwithdrawalofshortshytermcreditthatislikelytooccur
beforeanyeventthatwouldtriggerbankruptcy
Copyrighted Material
InTroDuCT Ion bull 2
Wearguebelowthatthereisaneedforaspecialresolushy
tionprocedurethatcanbeappliedtolargeinsolventfinanshy
cialinstitutionsWealsoadvocateregulatorychangesthat
would push financial firms towardmore resilient capital
structures
Bank Runs
Classicbank runs inwhichdepositors race towithdraw
their funds before a bank failswere one of the central
contributors to theGreatDepressionDeposit insurance
whichwasintroducedaftertheDepressiontocounterthis
destructiveprocessmadedemanddepositsoneofthemost
stableformsofbankfinancingduringtheWorldFinancial
CrisisManyfinancialinstitutionshoweversufferedamodshy
ernversionofbankruns
Banksespeciallythosewithinvestmentbankingactivishy
tiestypicallyfinanceasignificantfractionoftheirbusiness
withovernightcommercialpaperreposandothershortshy
terminstrumentsInnormaltimesbanksrolloverthisdebt
asitmaturestakingnewloanstopayofftheoldInacrishy
sishoweveruncertaintyaboutwhetheratroubledinstitushy
tionwouldbeabletopayoffitscreditorstomorrowcauses
lenderstostopextendingcredittodayThusshortshytermfishy
nancingcanleadtoarunthatissimilartoaclassicrunon
deposits
even some secured creditors participated in runs durshy
ingtheWorldFinancialCrisisBanksoftenuserepurchase
agreements to borrow money securing the loan by givshy
ingthelenderafinancialassetsuchasaTreasurybond
Copyrighted Material
2 bull CHapTer 1
ascollateralBecausetheyareovershycollateralizedwithasshy
setsworthperhaps$105guaranteeingevery$100inloans
lendersviewldquoreposrdquoasasafewaytoextendcreditWhen
credit markets froze during the Crisis however lenders
worried that retrieving collateral and selling itwouldbe
difficultandnotworththesmallinterestonanovernight
loanasaresultatvarioustimesduringtheCrisismany
investmentbankshaddifficultyrollingovereventheirseshy
cured loanseven relatively healthy financial institutions
werehamperedbythetroubleintherepomarketafteraushy
gust2007asthemarketbecamemoreandmoreuncertain
about the prices securities would fetch in a forced sale
these institutions found they could borrow less and less
withthesamecollateral15
prime brokerage accounts also saw a runshylike withshy
drawalbycustomersManylargebankshaveprimebrokershy
agegroupsthatassisthedgefundsandotherinstitutionalinshy
vestorsbyprovidingfinancingsecuritieslendingclearing
custodial servicesandoperational supportInexchange
thefundspayfeesandcriticallypostcollateraltosecure
theirloansWithsomerestrictionsthatweexplaininChapshy
ter10theprimebrokercanthenusethecollateralinits
ownbusinessinsomecasescomminglingitwiththefirmrsquos
ownassetsDuringtheCrisishedgefundsmonitoredthe
financial wellshybeing of their prime brokers and like deshy
positorsintheDepressionfledwiththeircollateralatthe
firstsignoftroubleBearStearnsforexamplehadalarge
prime brokerage business according to press accounts
oneofthelargesthedgefundsthatusedBearStearnsasa
Copyrighted Material
InTroDuCT Ion bull 25
primebrokerrenaissanceTechnologieswithdrew$5bilshy
lionofcashintheweekthefirmfailedWithsuchoutflows
it is not surprising that Bear Stearns ran out of money
eventhoughithadmorethan$18billionincashaweek
earlier
Likeclassicbankrunsmodernbankrunsarebothdeshy
structiveandselfshyfulfillingConcernthatabankmightbe
in trouble spurs its creditors and counterparties towithshy
draworwithholdtheircapitalasaresultevenrumorsofa
problemmaybeenoughtodestroyaviableinstitutionThe
importanceofmodernbankrunsduringtheWorldFinanshy
cialCrisisisarecurringthemethroughoutthebookand
wemakeseveralproposalsthatareintendedtoreducethe
frequencyofsuchevents
The Inadequacy of the Regulatory Structure
TheWorldFinancialCrisismadeitclearthatfinancialinnoshy
vationhadoverwhelmedexistingfinancialregulationsnoshy
tableexamplesincludeaIGrsquosdecisiontosellanextremely
large amount of credit default swaps on subprime debt
tobanksintheunitedStatesandabroadtheholdingof
Lehmanpaperbymoneymarketfundsparticularlythereshy
serveprimaryFundthecomplexityofthederivativebooks
atLehmanandotherinvestmentbanksandthedifficultyof
simultaneouslyapplyingseveralcountriesrsquobankruptcycodes
tothesubsidiariesofmultinationalfinancialinstitutions1
Thereisatradeshyoffbetweenfinancialinnovationandstashy
bilityInnovationcanimprovethefinancialsystemrsquosability
Copyrighted Material
2 bull CHapTer 1
toallocateresourcestotheirhighestvaluedusebutitcan
alsoreducethestabilityofthesystemThechallengeisto
developregulationsthatimprovestabilitywithoutstifling
innovation In addition regulation often leads to innoshy
vations designed to evade the regulationswhich makes
thefinancialsystemmorefragileForexamplemanyofthe
specialshypurposevehiclesthatimplodedintheCrisiswere
createdtogetaroundcapitalrequirements
In many countries the response of regulators to the
World Financial Crisis was hampered by the fragmented
nature of their regulatory systems Financial regulations
are typically designed to ensure thehealth of individual
institutionsratherthanthefinancialsystemasawholeIn
thisbookwearguethatsystemicregulationisanimporshy
tantfunctionthatrequiresaspecialmandateandthatthe
central bank is particularly well equipped to fulfill this
function
Finallyeffectivefinancialregulationrequiresthatpolitishy
ciansandultimatelythepublichaveanadequateundershy
standing of the financial system The political turmoil
surroundingtheCrisissuggeststheimportanceofdissemishy
natingexpertknowledgeaboutfinancetoabroaderaudishy
enceThisisoneofourmotivationsforwritingthisbook
What Were the orIgIns oF the World FInancIal crIsIs
LiketheoriginsoftheFirstWorldWarthecausesofthe
Crisiswillbedebatedbyscholarsformanyyears
Copyrighted Material
InTroDuCT Ion bull 27
Most observers agree that the strong runshyup and subshy
sequentsharpdeclineinthepricesofstockshousesand
otherfinancialassetsindevelopedcountrieswasanimporshy
tantcatalystfortheCrisisThereisdisagreementhowever
aboutwhetherthispatterninpricesistheresultofrational
investorbehaviororldquoirrationalbubblesrdquo
SomearguethattherunshyupbeforetheCrisiswasdriven
by investorswhoknowingly acceptedunusually low exshy
pectedreturnsandtheyofferseveralpossiblereasonswhy
Firsttherewasasurgeofsavingsinemergingcountries
drivenbyacombinationofrapideconomicgrowthanddeshy
mographicsperhapsbecauseofadesiretoaccumulateforshy
eignreservesintheaftermathoftheasiacrisisof1997ndash98
muchof thiswealthwas invested indevelopedmarkets
Secondfinancialmarketswereunusually tranquilduring
200to200Withlowvolatilityinvestorsmayhavesettled
for a low risk premiumThird influenced by fears of a
Japaneseshystyledeflation resulting from themarketdownshy
turnof2000ndash2001andbyabeliefthattheyshouldnottry
to usemonetary policy to counteract rising asset prices
central bankers in the united States maintained a loose
monetarypolicythroughouttheperiod17andfromthisrashy
tionalviewofinvestorstheplungeinassetpricesthatacshy
companiedtheCrisiswascausedbybadnewsaboutfuture
cashflowsunexpectedincreasesinthereturnsrequiredby
investorsorboth
otherssuggestamoredirectexplanationThehighprices
before theCrisisweredrivenby an irrational belief that
prices would continue to rise and the collapse of asset
priceswastheinevitableresultofthismistakeWhatever
Copyrighted Material
28 bull CHapTer 1
theexplanationthesharpdropinassetpricesbothconshy
tributedtoandwasasymptomoftheCrisis
other commentators argue that the financial system
becamevulnerablebecausemanymarketparticipantsasshy
sessedrisksinaccuratelyduringtheperiodleadingupto
theWorldFinancialCrisisConsumersbanksandinvestors
ingeneralunderestimatedtheriskofhousepricedeclines
increasingthepricestheywerewillingtopayforrealesshy
tatethecredittheywerewillingtoextendandthevaluashy
tionsofbanksthatextendedsuchcreditBanksputmuch
weight on the recent pastwhen they estimated value at
riskwhichledthemtoconcludethatthelevelofriskwas
lowandthattherewaslittledownsidetohavinghighleshy
verageothermarketparticipantsdidnotfullyappreciate
thathighliquiditywassuppressingvolatilityandthatthe
processmightreversewithliquiditydecreasingandvolatilshy
ityincreasing
More generally the high level of financial innovation
driveninpartbythedecliningcostofinformationtechnolshy
ogymadeithardforriskassessmenttokeeppacewiththe
evolvingfinancialsystem18Thebenignenvironmentofthe
creditboomexacerbatedthisproblembytemptingfinanshy
cialinstitutionstounderinvestinriskmanagement
uSpolicymakersalsocontributedtotheseverityofthe
CrisisbypushingFannieMaeandFreddieMactoincrease
theavailabilityofmortgagefundingtoborrowerswithquesshy
tionableabilitytorepaytheirmortgagesasaresultofthis
pressure both agencies relaxed their standards for the
mortgages they purchased and guaranteedThe demand
Copyrighted Material
InTroDuCT Ion bull 29
forhomesbyborrowerswhoqualifiedformortgagesbeshy
causeoftheselowerstandardspusheduppricesandthe
defaultbymanyofthemduringtherecessioncontributed
tothedropinhomeprices
Thepanicandruninthefallof2008remainthecentral
distinguishingfeaturesoftheWorldFinancialCrisisasset
priceshave risenand fallenbeforeand theworldeconshy
omyhasbornelargefinancial lossesmanytimeswithout
suchasevereeconomicoutcomeConverselylossesfrom
completelydifferentunderlyingsourcesmdashcommercialreal
estateorperhapssovereigndefaultsmdashcouldcauseasimilar
catastrophe if theyagainprovoke tooshybigshytoshyfailchaosor
runs
Thisbookdoesnotseektoprovideacompletediagnosis
oftheWorldFinancialCrisisnordoesittakeastandonthe
relativeimportanceofthecontributingfactorslistedabove
ratherwebelieveourrecommendationswillhelpprevent
ormitigatefuturecriseseventhoughwedonotfullyundershy
standallthecausesofthelastone
CarmenreinhartandKennethrogoff amongothershave
pointedoutthatfinancialcriseshaveoccurredthroughout
thehistoryofcapitalismandthatthesecrisessharemany
commonpatterns19 Thelessonwedrawfromthisisthat
noacceptablesetofregulationscanpreventmarketparticishy
pantsfrommakingmistakesthatcreateeconomicinstability
ourpurposeinthisbookisinsteadtosuggestregulatory
reformsthatwillmakethesystemmorestabledespitethe
mistakesthataresuretocome
Copyrighted Material
12 bull CHapTer 1
risk)(2)fixedandfloatingrate investments (asequence
ofshortshyterminvestmentsplusacontractswappingafloatshy
ing interest rate forafixed interest rateshouldhave the
same payoff as a fixed rate investment) () convertible
bondsdebtandequity()newlyissuedldquoonshytheshyrunrdquoand
recently issuedldquooffshytheshyrunrdquoTreasury bondswhich have
essentially the same payoff but differ in liquidity and
(5)stockandoptionpriceswhicharelinkedbywhatfishy
nancialeconomistscalltheputshycallparityrelation7
Thebreakdownofthesenormalpricingrelationsdoes
littledirectharm to the restof theeconomya20shybasisshy
pointviolationofcoveredinterestparityhaslittleeffecton
auSexporterusingcurrencycontractstolockintherate
atwhichitcanconvertfutureJapaneserevenuebackinto
dollarsTheseviolationsshowhoweverthatmarketswere
notfunctioningnormallyInparticulartheysuggestthere
wasnotmuchcapitalavailabletoprovideliquiditytobuyshy
ersandsellersanyoneneedingtosellsecuritiesquicklyin
suchamarketmdashsuchasafinancialinstitutiontryingtoreshy
duceitsriskmdashwasnotlikelytogetagoodprice
lendIng BankIng and the recessIon
Duringthefallof2008outputandfinancingactivityconshy
tracted sharply Commercial paper corporate bond and
equityissuanceallfelldramaticallyasdidmortgageorigishy
nations
originations of most types of asset backed securities
alsoslowedtoatrickleManybanksintheunitedStates
Jan 20
04Ju
l 200
4Ja
n 2005
Jul 2
005
Jan 20
06Ju
l 200
6Ja
n 2007
Jul 2
007
Jan 20
08Ju
l 200
8Ja
n 2009
Jul 2
009
Copyrighted Material
InTroDuCT Ion bull 1
0
50
100
150
200
250
Figure2assetBackedSecuritiesIssuedintheunitedStatesJanushyary200toDecember2009BillionsofDollarsperMonthSourceFederalreserve
and other countries no longer hold much of the credit
theyissueTheyhavemovedinsteadtoanldquooriginateand
sellrdquomodel inwhich theybundle together similar loans
suchasjumbomortgagescommercialloansstudentloans
or credit card debt and sell them to investors as asset
backedsecuritiesnewissuesofthesesecuritiesessentially
stopped inoctoberandnovember2008Figure2shows
that the amount of asset backed securities issued in the
united States rose from$288 billion in January 2000 to
$85billioninJune2007andthenplungedto$102bilshy
lioninSeptember2007IssuanceintheunitedStatesconshy
tinued to decline over the next year eventually falling
to only $87 billion in october 2008 and $ billion in
Copyrighted Material
1 bull CHapTer 1
novembermdashjust2percentofthevolume18monthsearlier
onlymortgagespooledbyFannieMaeandFreddieMac
withanexplicitgovernmentguaranteeandsubjecttohuge
Federalreservepurchasescontinuedtoflowtothemarket
There isplentyof anecdotal and surveyevidence that
banklendingalsodriedupduringtheCrisisForexample
loanofficerssurveyedbytheFederalreservereportedthat
credit conditionsprogressively tightenedduring2008In
asurveyabouttheirperceptionsofcreditconditionsand
corporatedecisionsasoflatenovember2008morethan
halfofthechieffinancialofficersoflargeamericanfirms
whorespondedsaidthattheirfirmswereeitherldquosomewhat
orveryaffectedbythecostoravailabilityofcreditrdquo8
There is a lively and fundamentally important debate
about why the quantity of lending fell Some financial
economists argue that banks wanted to lend more but
wereunable todosobecausetheyfacedbindingcapital
constraintsInthisviewinformationcostsandotherfricshy
tionsintheloanoriginationprocesskeptcustomersfrom
movingtolessconstrainedbanks
othersarguethattheprimaryreasonbankswereunwillshy
ingtolendisthattheircustomershadbecomelesscreditshy
worthyTheseeconomistspointoutthatthehighlevelof
uncertainty about future economic conditionsduring the
Crisisratchetedupthedefaultriskofeventhemostrelishy
ableclientsThisinterpretationofthedeclineinbanklendshy
ingimpliesthatnoamountofcapitalwouldhaveinduced
banksasagrouptolendmorebecauseallthegoodloans
werebeingmade
Figure shows data on the quantity of bank lending
Jan 20
08
Mar
2008
M
ay 20
08Ju
l 200
8Se
p 2008
Nov 20
08Ja
n 2009
Jan 20
09
May
2009
Jul 2
009
Sep 20
09Nov
2009
Copyrighted Material
InTroDuCT Ion bull 15
1050
1100
1150
1200
1250
1300
FigureCommercialandIndustrialLoansbyuSCommercialBanks2008ndash9inBillionsofDollarsSourceFederalreserve
intheunitedStatesin2008and2009Startinginoctober
2008therewasaspikeinlendingfollowedbyaprotracted
declineVVChariLawrenceChristianoandpatrickKehoe
takethespikeatfacevalueinaggregatebankslentmore
ataminimumthebankingsystemasawholemdashasopposed
to individual banksmdashwas not deleveraging to overcome
loss of capital9 Victoria Ivashina and David Scharfstein
notethatmuchoftheincreaseinbanklendingwasinvolshy
untaryonthepartofthebankstheresultofdrawdowns
byborrowersonexistinglinesofcredit10 Theyalsoshow
thatbanks thatweremorevulnerable todrawdownsbeshy
causetheywereinmoresyndicateswithLehmanreduced
subsequent lending more and conclude that there was
indeed a genuine contraction in the effective supply of
bankcredit
Copyrighted Material
1 bull CHapTer 1
economistswillargueabouttheeventsoftheWorldFishy
nancialCrisisforyearstocomeInfactwestillargueabout
theGreatDepressionnoneoftheanalysisbehindourrecshy
ommendationshoweverdepends onhow these debates
aresettledForexamplenomatterhowcapitalshyconstrained
thebankingsystemreallywasinthefallof2008ourproshy
posalsforchangesthatmakesuchconstraintslessbinding
andgivepolicymakersbettertoolswhentheyfearcapital
constraintsremainvalid
What Was Wrong WIth the FInancIal system durIng the crIsIs
The Crisis revealed a number of serious problems with
ourfinancialsystemSomehadbeeninthebackgroundall
alongothersdidnotappearuntiltheCrisisInthisbook
weemphasizefourcategoriesofproblemsconflictsofinshy
terestknowntoeconomistsasagencyproblemsthediffishy
cultyofapplyingstandardbankruptcyprocedurestofinanshy
cialinstitutionstheemergenceofamodernformofbank
runsandtheinadequacyoftheregulatorystructurewhich
hadnotkeptupwithrecentfinancialinnovation(Infact
muchinnovationservedtoescaperegulations)
Conflicts of Interest Agency Problems
Conflictsofinterestthatcannotberesolvedeasilybyconshy
tractsormarketsoccurthroughouttheeconomybutthey
Copyrighted Material
InTroDuCT Ion bull 17
canbeparticularlyharmfulinthefinancialsystemThere
areseveralreasonsFirstmanyfinancialtransactionsand
contractsinvolveaprincipalsuchasaninvestororshareshy
holderaskingatradermanagerorotheragenttoacton
hisorherbehalfSecondmostfinancial transactions inshy
volvehighlyuncertainfuturepayoffsandinmanytransacshy
tionsonepartyisbetterinformedaboutthepayoffsthan
the otherThird the high volatility of the future payoffs
oftenmakesithardtoassesswhethertheoutcomeofafishy
nancialtransactionisduetotheagentrsquoseffortsorluckand
fourththesumsinvolvedcanbehuge
Someproprietarytradersforexampleearnalotwhen
their tradesdowellbuttheirpersonal lossesare limited
whentheirtradesdopoorlyBecauseoftheasymmetricnashy
tureoftheircompensationthesetraderscanincreasetheir
expectedincomebytakingriskierpositionsThisproblem
isdramaticallyillustratedbyperiodiccasesinwhichldquorogue
tradersrdquoincurlossesthatarebigenoughtodamageoreven
destroy large financial institutions In 1995 nick Leeson
broughtdownBaringsBankwitha$1billionlossandin
2008itwasrevealedthatJeacuterocircmeKervielhadseverelydamshy
agedSocieacuteteacuteGeacuteneacuteralewithalossofover$7billion
Conflictsofinterestorldquoagencyproblemsrdquoalsoexistat
manyotherlevelswithinthefinancialsystemShareholders
offinancialinstitutionshaveaconflictofinterestwiththe
bankrsquosseniorexecutivesespeciallywhenthoseexecutives
arerewardedforgoodperformancebutdonothavealarge
fractionoftheirwealthtiedupinthesharesofthebank
Manyfinancialinstitutionshavelargequantitiesofdebt
Copyrighted Material
18 bull CHapTer 1
which creates a conflict of interest between the bankrsquos
creditorsanditsshareholdersShareholdershaveanincenshy
tivetoauthorizeexcessivelyriskyinvestmentsforexample
especiallyafterabankhasincurredlossesthaterodethe
valueoftheshareholdersrsquoclaimThegainsontheserisky
investmentswillaccruelargelytoshareholderswhilethe
losseswillmostlybebornebycreditorsTheconflictwith
creditorsalsoreducestheincentivesfortheshareholders
of troubled institutions to raisenewcapitalbecause that
wouldstrengthen thepositionofcreditorswhilediluting
theshareholdersrsquopositionThisldquodebtoverhangrdquoproblem
waswidelycitedduringtheWorldFinancialCrisiswhen
many banks that were insolvent or close to insolvency
seemedreluctanteithertoraisenewcapitalortoreduce
theirrisksbysellingdistressedsecurities11
atthehighestlevelthereisaconflictofinterestbetween
societyasawholeandtheprivateownersoffinancialinshy
stitutions Because robust financial institutions promote
economicgrowthandemploymentduringfinancialcrises
governmentsoftenrescuetroubledfirmstheyperceiveto
be systemically importantThe result is privatized gains
andsocializedlossesIfthingsgowellthefirmsrsquoowners
andmanagersclaimtheprofitsbutifthingsgopoorlysoshy
cietysubsidizesthelosses
The candidates for government bailouts are popularly
describedasldquotoobigtofailrdquoMorepreciselytheargument
for government supportmdashwhich many economists chalshy
lengemdashisaboutfirmsthataretoosystemicallyimportantto
failInits200annualreporttheeuropeanCentralBank
describedsystemicriskasldquoTheriskthattheinabilityofone
Copyrighted Material
InTroDuCT Ion bull 19
institutiontomeetitsobligationswhenduewillcauseother
institutions to be unable tomeet their obligationswhen
dueSuchafailuremaycausesignificantliquidityorcredit
problemsandas a resultcould threaten the stabilityof
or confidence in marketsrdquo Systemically important firms
arethosewhosefailurecouldposealargethreattothestashy
bilityoforconfidenceinmarketsThesefirmsarelikelyto
belargebuttheyalsotendtohavecomplexinterconnecshy
tionswithotherfinancialinstitutions
Tooshybigshytoshyfailpoliciesoffersystemicallyimportantfirms
theexplicitorimplicitpromiseofabailoutwhenthingsgo
wrongThesepoliciesaredestructiveforseveralreasons
Firstbecause the possibility of a bailoutmeans a firmrsquos
stakeholders claim all the profits but only some of the
lossesfinancialfirmsthatmightreceivegovernmentsupshy
porthaveanincentivetotakeextrariskThefirmrsquosshareshy
holderscreditorsemployeesandmanagement all share
thetemptationTheresultisanincreaseintherisksborne
bysocietyasawhole
Secondthesepoliciesencouragesmallerfinancialinstishy
tutionstoexpandortobecomemorecloselyinterconnected
with other firms so they move under the tooshybigshytoshyfail
umbrellaFirmshaveanincentivetodowhateverittakes
tomakepolicymakersfeartheirfailurecreatingthevery
fragilitythegovernmentwishestoavoidBeliefthatagovshy
ernmentrescuewillprotectafinancial institutionrsquoscredishy
tors inacrisisalsogivesafirmacompetitiveadvantage
loweringitscostoffinancingandallowingittoofferbetter
prices to its customers than its fundamental productivity
warrants
Copyrighted Material
20 bull CHapTer 1
Thirdinefficientfirmsthatcannotcompeteontheirown
shouldfailotherwisefirmshavelessincentivetobecome
andstayefficientagovernmentpolicythatpropsupinshy
efficientfirmsiswastefulanddestructiveallowingthese
firmstofailfreesupresourcesandprovidesopportunities
formoreefficientandinnovativecompetitorstoflourish
Fourthandmostgenerallycapitalismisunderminedby
policiesthatprivatizegainsbutsocializelossesGovernment
guaranteedinstitutionscanbecomegovernmentruninstishy
tutionsallocatingcreditforexampletomaximizepolitical
gainratherthaneconomicwelfare
The conflictbetween society and theownersoffinanshy
cialfirmsbecomesmoreseriousduringseverecriseswhen
manyfinancialinstitutionsareclosetoinsolventIt isthe
primemotivationforourregulatoryproposalsbutseveral
ofthelowershylevelconflictswehavedescribedarerelevant
becausetheymagnifytheriskbornebysocietyasawhole
Theselfshyservingbehaviorthatmanyofourrecommenshy
dations targetmdashwhether by traders senior management
orthefirmrsquosownersmdashneednotbestrategicintentionally
maliciousorevenconsciousConsideratraderwhoinadshy
vertentlydevelopsaninvestmentstrategywithhighlyprobshy
ablegainsandimprobablebutlargelossesLikeafirmthat
hassoldearthquakeinsurancethestrategymayproducea
longstringofimpressivereturnsbeforeoneyearoflosses
wipesoutmanyyearsofprofits12 Ifsoduringthegood
yearsthetraderwillbecelebratedforhisorherbrilliance
rewarded with large bonuses and given more resources
to manageMany sophisticated traders and hedge funds
Copyrighted Material
InTroDuCT Ion bull 21
werenotawareoftheldquoearthquakerisksrdquoinherentinmany
of theirstrategiesSimilarlywhenfirmstakeactionsthat
increasethelikelihoodofagovernmentbailoutinthenext
financialcrisisthemarketrewardsthemwithalowercost
of capitalas firms become too big to fail for example
the implicit government guarantee reduces the riskiness
of their debt and lowers the interest rate demanded by
theircreditorsaCeoworkingtomaximizefirmvaluemay
notevenrealize the importanceof thegovernmentguarshy
anteebut a Darwinian process will encourage behavior
thatexploitsit
Bankruptcy and Resolution Procedures
Itisimpossibletowriteafinancialcontractthatspecifies
everypossiblecontingencyInsteadcontractsrelyonbankshy
ruptcytodetermineoutcomesincertainbadandunlikely
statesoftheworldInbankruptcycontrolofafirmistransshy
ferredfromtheshareholderswhonolongerhaveastake
inlossesbecausetheirsharesareworthlittletothedebtshy
holders It is in societyrsquos interest to develop bankruptcy
proceduresthatmaximizethepostshybankruptcyvalueofa
firmrsquosassetsInparticularsocietyshouldavoidthedestrucshy
tionofvaluethatoccurswithdisorderlyliquidation
Disorderlyliquidationoffinancialinstitutionsisparticushy
larly costlyFirstvaluableknowledge that the institution
hasaccumulatedaboutitscounterpartiesmdashborrowerstradshy
ingpartnersandsoonmdashcandisappearastheinstitution
losesemployeesandceasestooperatenormallyFinancial
Copyrighted Material
22 bull CHapTer 1
economistshavefoundthatthecollapseofabankhasamashy
terialadverseimpactonmanyofitsborrowers1 Second
the prospect of a disorderly liquidation makes it more
likelythatatroubledfinancialinstitutionwillsufferarun
by creditors who conclude they are better off claiming
whatmoney theycan todayrather thanwaiting through
protracted liquidation proceedings Third ldquofire salesrdquo of
specializedassets inadisorderly liquidationcandepress
prices and thereby spread problems to other holders of
theassetclassFourthdisorderlyliquidationincreasesthe
uncertaintyabouttheimpactofafinancialinstitutionrsquosfailshy
ureonitscounterpartiesandotherclaimholdersBecause
financialfirmsaretightlyinterconnectedthisuncertainty
canprecipitateorintensifyafinancialcrisis1
In theunitedStatesthestandardbankruptcycodealshy
lowsbothforliquidationofafirmandthesaleofitsassets
(Chapter7)andforcontinuedoperationofafirmunder
the supervision of a bankruptcy judgewho protects the
firmfromcreditorsrsquoclaimswhileareorganizationplanis
approved(Chapter11)Theseproceduresappeartowork
wellfornonfinancialcorporationsbutnotsowellforfinanshy
cialorganizationsTheChapter11approachofseparatinga
firmrsquosfinancialaffairsfromitsnonfinancialbusinessactivishy
tiesisinfeasiblewhenthebusinessofthefirmisfinancial
transactionsFurthermoremanyfinancialinstitutionsrely
heavily on shortshyterm debtpossibly as a valuable discishy
plineonbankexecutiveswhocanrapidlychangetherisks
theirfirmstakeThismakesfinancialfirmsvulnerabletoa
rapidwithdrawalofshortshytermcreditthatislikelytooccur
beforeanyeventthatwouldtriggerbankruptcy
Copyrighted Material
InTroDuCT Ion bull 2
Wearguebelowthatthereisaneedforaspecialresolushy
tionprocedurethatcanbeappliedtolargeinsolventfinanshy
cialinstitutionsWealsoadvocateregulatorychangesthat
would push financial firms towardmore resilient capital
structures
Bank Runs
Classicbank runs inwhichdepositors race towithdraw
their funds before a bank failswere one of the central
contributors to theGreatDepressionDeposit insurance
whichwasintroducedaftertheDepressiontocounterthis
destructiveprocessmadedemanddepositsoneofthemost
stableformsofbankfinancingduringtheWorldFinancial
CrisisManyfinancialinstitutionshoweversufferedamodshy
ernversionofbankruns
Banksespeciallythosewithinvestmentbankingactivishy
tiestypicallyfinanceasignificantfractionoftheirbusiness
withovernightcommercialpaperreposandothershortshy
terminstrumentsInnormaltimesbanksrolloverthisdebt
asitmaturestakingnewloanstopayofftheoldInacrishy
sishoweveruncertaintyaboutwhetheratroubledinstitushy
tionwouldbeabletopayoffitscreditorstomorrowcauses
lenderstostopextendingcredittodayThusshortshytermfishy
nancingcanleadtoarunthatissimilartoaclassicrunon
deposits
even some secured creditors participated in runs durshy
ingtheWorldFinancialCrisisBanksoftenuserepurchase
agreements to borrow money securing the loan by givshy
ingthelenderafinancialassetsuchasaTreasurybond
Copyrighted Material
2 bull CHapTer 1
ascollateralBecausetheyareovershycollateralizedwithasshy
setsworthperhaps$105guaranteeingevery$100inloans
lendersviewldquoreposrdquoasasafewaytoextendcreditWhen
credit markets froze during the Crisis however lenders
worried that retrieving collateral and selling itwouldbe
difficultandnotworththesmallinterestonanovernight
loanasaresultatvarioustimesduringtheCrisismany
investmentbankshaddifficultyrollingovereventheirseshy
cured loanseven relatively healthy financial institutions
werehamperedbythetroubleintherepomarketafteraushy
gust2007asthemarketbecamemoreandmoreuncertain
about the prices securities would fetch in a forced sale
these institutions found they could borrow less and less
withthesamecollateral15
prime brokerage accounts also saw a runshylike withshy
drawalbycustomersManylargebankshaveprimebrokershy
agegroupsthatassisthedgefundsandotherinstitutionalinshy
vestorsbyprovidingfinancingsecuritieslendingclearing
custodial servicesandoperational supportInexchange
thefundspayfeesandcriticallypostcollateraltosecure
theirloansWithsomerestrictionsthatweexplaininChapshy
ter10theprimebrokercanthenusethecollateralinits
ownbusinessinsomecasescomminglingitwiththefirmrsquos
ownassetsDuringtheCrisishedgefundsmonitoredthe
financial wellshybeing of their prime brokers and like deshy
positorsintheDepressionfledwiththeircollateralatthe
firstsignoftroubleBearStearnsforexamplehadalarge
prime brokerage business according to press accounts
oneofthelargesthedgefundsthatusedBearStearnsasa
Copyrighted Material
InTroDuCT Ion bull 25
primebrokerrenaissanceTechnologieswithdrew$5bilshy
lionofcashintheweekthefirmfailedWithsuchoutflows
it is not surprising that Bear Stearns ran out of money
eventhoughithadmorethan$18billionincashaweek
earlier
Likeclassicbankrunsmodernbankrunsarebothdeshy
structiveandselfshyfulfillingConcernthatabankmightbe
in trouble spurs its creditors and counterparties towithshy
draworwithholdtheircapitalasaresultevenrumorsofa
problemmaybeenoughtodestroyaviableinstitutionThe
importanceofmodernbankrunsduringtheWorldFinanshy
cialCrisisisarecurringthemethroughoutthebookand
wemakeseveralproposalsthatareintendedtoreducethe
frequencyofsuchevents
The Inadequacy of the Regulatory Structure
TheWorldFinancialCrisismadeitclearthatfinancialinnoshy
vationhadoverwhelmedexistingfinancialregulationsnoshy
tableexamplesincludeaIGrsquosdecisiontosellanextremely
large amount of credit default swaps on subprime debt
tobanksintheunitedStatesandabroadtheholdingof
Lehmanpaperbymoneymarketfundsparticularlythereshy
serveprimaryFundthecomplexityofthederivativebooks
atLehmanandotherinvestmentbanksandthedifficultyof
simultaneouslyapplyingseveralcountriesrsquobankruptcycodes
tothesubsidiariesofmultinationalfinancialinstitutions1
Thereisatradeshyoffbetweenfinancialinnovationandstashy
bilityInnovationcanimprovethefinancialsystemrsquosability
Copyrighted Material
2 bull CHapTer 1
toallocateresourcestotheirhighestvaluedusebutitcan
alsoreducethestabilityofthesystemThechallengeisto
developregulationsthatimprovestabilitywithoutstifling
innovation In addition regulation often leads to innoshy
vations designed to evade the regulationswhich makes
thefinancialsystemmorefragileForexamplemanyofthe
specialshypurposevehiclesthatimplodedintheCrisiswere
createdtogetaroundcapitalrequirements
In many countries the response of regulators to the
World Financial Crisis was hampered by the fragmented
nature of their regulatory systems Financial regulations
are typically designed to ensure thehealth of individual
institutionsratherthanthefinancialsystemasawholeIn
thisbookwearguethatsystemicregulationisanimporshy
tantfunctionthatrequiresaspecialmandateandthatthe
central bank is particularly well equipped to fulfill this
function
Finallyeffectivefinancialregulationrequiresthatpolitishy
ciansandultimatelythepublichaveanadequateundershy
standing of the financial system The political turmoil
surroundingtheCrisissuggeststheimportanceofdissemishy
natingexpertknowledgeaboutfinancetoabroaderaudishy
enceThisisoneofourmotivationsforwritingthisbook
What Were the orIgIns oF the World FInancIal crIsIs
LiketheoriginsoftheFirstWorldWarthecausesofthe
Crisiswillbedebatedbyscholarsformanyyears
Copyrighted Material
InTroDuCT Ion bull 27
Most observers agree that the strong runshyup and subshy
sequentsharpdeclineinthepricesofstockshousesand
otherfinancialassetsindevelopedcountrieswasanimporshy
tantcatalystfortheCrisisThereisdisagreementhowever
aboutwhetherthispatterninpricesistheresultofrational
investorbehaviororldquoirrationalbubblesrdquo
SomearguethattherunshyupbeforetheCrisiswasdriven
by investorswhoknowingly acceptedunusually low exshy
pectedreturnsandtheyofferseveralpossiblereasonswhy
Firsttherewasasurgeofsavingsinemergingcountries
drivenbyacombinationofrapideconomicgrowthanddeshy
mographicsperhapsbecauseofadesiretoaccumulateforshy
eignreservesintheaftermathoftheasiacrisisof1997ndash98
muchof thiswealthwas invested indevelopedmarkets
Secondfinancialmarketswereunusually tranquilduring
200to200Withlowvolatilityinvestorsmayhavesettled
for a low risk premiumThird influenced by fears of a
Japaneseshystyledeflation resulting from themarketdownshy
turnof2000ndash2001andbyabeliefthattheyshouldnottry
to usemonetary policy to counteract rising asset prices
central bankers in the united States maintained a loose
monetarypolicythroughouttheperiod17andfromthisrashy
tionalviewofinvestorstheplungeinassetpricesthatacshy
companiedtheCrisiswascausedbybadnewsaboutfuture
cashflowsunexpectedincreasesinthereturnsrequiredby
investorsorboth
otherssuggestamoredirectexplanationThehighprices
before theCrisisweredrivenby an irrational belief that
prices would continue to rise and the collapse of asset
priceswastheinevitableresultofthismistakeWhatever
Copyrighted Material
28 bull CHapTer 1
theexplanationthesharpdropinassetpricesbothconshy
tributedtoandwasasymptomoftheCrisis
other commentators argue that the financial system
becamevulnerablebecausemanymarketparticipantsasshy
sessedrisksinaccuratelyduringtheperiodleadingupto
theWorldFinancialCrisisConsumersbanksandinvestors
ingeneralunderestimatedtheriskofhousepricedeclines
increasingthepricestheywerewillingtopayforrealesshy
tatethecredittheywerewillingtoextendandthevaluashy
tionsofbanksthatextendedsuchcreditBanksputmuch
weight on the recent pastwhen they estimated value at
riskwhichledthemtoconcludethatthelevelofriskwas
lowandthattherewaslittledownsidetohavinghighleshy
verageothermarketparticipantsdidnotfullyappreciate
thathighliquiditywassuppressingvolatilityandthatthe
processmightreversewithliquiditydecreasingandvolatilshy
ityincreasing
More generally the high level of financial innovation
driveninpartbythedecliningcostofinformationtechnolshy
ogymadeithardforriskassessmenttokeeppacewiththe
evolvingfinancialsystem18Thebenignenvironmentofthe
creditboomexacerbatedthisproblembytemptingfinanshy
cialinstitutionstounderinvestinriskmanagement
uSpolicymakersalsocontributedtotheseverityofthe
CrisisbypushingFannieMaeandFreddieMactoincrease
theavailabilityofmortgagefundingtoborrowerswithquesshy
tionableabilitytorepaytheirmortgagesasaresultofthis
pressure both agencies relaxed their standards for the
mortgages they purchased and guaranteedThe demand
Copyrighted Material
InTroDuCT Ion bull 29
forhomesbyborrowerswhoqualifiedformortgagesbeshy
causeoftheselowerstandardspusheduppricesandthe
defaultbymanyofthemduringtherecessioncontributed
tothedropinhomeprices
Thepanicandruninthefallof2008remainthecentral
distinguishingfeaturesoftheWorldFinancialCrisisasset
priceshave risenand fallenbeforeand theworldeconshy
omyhasbornelargefinancial lossesmanytimeswithout
suchasevereeconomicoutcomeConverselylossesfrom
completelydifferentunderlyingsourcesmdashcommercialreal
estateorperhapssovereigndefaultsmdashcouldcauseasimilar
catastrophe if theyagainprovoke tooshybigshytoshyfailchaosor
runs
Thisbookdoesnotseektoprovideacompletediagnosis
oftheWorldFinancialCrisisnordoesittakeastandonthe
relativeimportanceofthecontributingfactorslistedabove
ratherwebelieveourrecommendationswillhelpprevent
ormitigatefuturecriseseventhoughwedonotfullyundershy
standallthecausesofthelastone
CarmenreinhartandKennethrogoff amongothershave
pointedoutthatfinancialcriseshaveoccurredthroughout
thehistoryofcapitalismandthatthesecrisessharemany
commonpatterns19 Thelessonwedrawfromthisisthat
noacceptablesetofregulationscanpreventmarketparticishy
pantsfrommakingmistakesthatcreateeconomicinstability
ourpurposeinthisbookisinsteadtosuggestregulatory
reformsthatwillmakethesystemmorestabledespitethe
mistakesthataresuretocome
Jan 20
04Ju
l 200
4Ja
n 2005
Jul 2
005
Jan 20
06Ju
l 200
6Ja
n 2007
Jul 2
007
Jan 20
08Ju
l 200
8Ja
n 2009
Jul 2
009
Copyrighted Material
InTroDuCT Ion bull 1
0
50
100
150
200
250
Figure2assetBackedSecuritiesIssuedintheunitedStatesJanushyary200toDecember2009BillionsofDollarsperMonthSourceFederalreserve
and other countries no longer hold much of the credit
theyissueTheyhavemovedinsteadtoanldquooriginateand
sellrdquomodel inwhich theybundle together similar loans
suchasjumbomortgagescommercialloansstudentloans
or credit card debt and sell them to investors as asset
backedsecuritiesnewissuesofthesesecuritiesessentially
stopped inoctoberandnovember2008Figure2shows
that the amount of asset backed securities issued in the
united States rose from$288 billion in January 2000 to
$85billioninJune2007andthenplungedto$102bilshy
lioninSeptember2007IssuanceintheunitedStatesconshy
tinued to decline over the next year eventually falling
to only $87 billion in october 2008 and $ billion in
Copyrighted Material
1 bull CHapTer 1
novembermdashjust2percentofthevolume18monthsearlier
onlymortgagespooledbyFannieMaeandFreddieMac
withanexplicitgovernmentguaranteeandsubjecttohuge
Federalreservepurchasescontinuedtoflowtothemarket
There isplentyof anecdotal and surveyevidence that
banklendingalsodriedupduringtheCrisisForexample
loanofficerssurveyedbytheFederalreservereportedthat
credit conditionsprogressively tightenedduring2008In
asurveyabouttheirperceptionsofcreditconditionsand
corporatedecisionsasoflatenovember2008morethan
halfofthechieffinancialofficersoflargeamericanfirms
whorespondedsaidthattheirfirmswereeitherldquosomewhat
orveryaffectedbythecostoravailabilityofcreditrdquo8
There is a lively and fundamentally important debate
about why the quantity of lending fell Some financial
economists argue that banks wanted to lend more but
wereunable todosobecausetheyfacedbindingcapital
constraintsInthisviewinformationcostsandotherfricshy
tionsintheloanoriginationprocesskeptcustomersfrom
movingtolessconstrainedbanks
othersarguethattheprimaryreasonbankswereunwillshy
ingtolendisthattheircustomershadbecomelesscreditshy
worthyTheseeconomistspointoutthatthehighlevelof
uncertainty about future economic conditionsduring the
Crisisratchetedupthedefaultriskofeventhemostrelishy
ableclientsThisinterpretationofthedeclineinbanklendshy
ingimpliesthatnoamountofcapitalwouldhaveinduced
banksasagrouptolendmorebecauseallthegoodloans
werebeingmade
Figure shows data on the quantity of bank lending
Jan 20
08
Mar
2008
M
ay 20
08Ju
l 200
8Se
p 2008
Nov 20
08Ja
n 2009
Jan 20
09
May
2009
Jul 2
009
Sep 20
09Nov
2009
Copyrighted Material
InTroDuCT Ion bull 15
1050
1100
1150
1200
1250
1300
FigureCommercialandIndustrialLoansbyuSCommercialBanks2008ndash9inBillionsofDollarsSourceFederalreserve
intheunitedStatesin2008and2009Startinginoctober
2008therewasaspikeinlendingfollowedbyaprotracted
declineVVChariLawrenceChristianoandpatrickKehoe
takethespikeatfacevalueinaggregatebankslentmore
ataminimumthebankingsystemasawholemdashasopposed
to individual banksmdashwas not deleveraging to overcome
loss of capital9 Victoria Ivashina and David Scharfstein
notethatmuchoftheincreaseinbanklendingwasinvolshy
untaryonthepartofthebankstheresultofdrawdowns
byborrowersonexistinglinesofcredit10 Theyalsoshow
thatbanks thatweremorevulnerable todrawdownsbeshy
causetheywereinmoresyndicateswithLehmanreduced
subsequent lending more and conclude that there was
indeed a genuine contraction in the effective supply of
bankcredit
Copyrighted Material
1 bull CHapTer 1
economistswillargueabouttheeventsoftheWorldFishy
nancialCrisisforyearstocomeInfactwestillargueabout
theGreatDepressionnoneoftheanalysisbehindourrecshy
ommendationshoweverdepends onhow these debates
aresettledForexamplenomatterhowcapitalshyconstrained
thebankingsystemreallywasinthefallof2008ourproshy
posalsforchangesthatmakesuchconstraintslessbinding
andgivepolicymakersbettertoolswhentheyfearcapital
constraintsremainvalid
What Was Wrong WIth the FInancIal system durIng the crIsIs
The Crisis revealed a number of serious problems with
ourfinancialsystemSomehadbeeninthebackgroundall
alongothersdidnotappearuntiltheCrisisInthisbook
weemphasizefourcategoriesofproblemsconflictsofinshy
terestknowntoeconomistsasagencyproblemsthediffishy
cultyofapplyingstandardbankruptcyprocedurestofinanshy
cialinstitutionstheemergenceofamodernformofbank
runsandtheinadequacyoftheregulatorystructurewhich
hadnotkeptupwithrecentfinancialinnovation(Infact
muchinnovationservedtoescaperegulations)
Conflicts of Interest Agency Problems
Conflictsofinterestthatcannotberesolvedeasilybyconshy
tractsormarketsoccurthroughouttheeconomybutthey
Copyrighted Material
InTroDuCT Ion bull 17
canbeparticularlyharmfulinthefinancialsystemThere
areseveralreasonsFirstmanyfinancialtransactionsand
contractsinvolveaprincipalsuchasaninvestororshareshy
holderaskingatradermanagerorotheragenttoacton
hisorherbehalfSecondmostfinancial transactions inshy
volvehighlyuncertainfuturepayoffsandinmanytransacshy
tionsonepartyisbetterinformedaboutthepayoffsthan
the otherThird the high volatility of the future payoffs
oftenmakesithardtoassesswhethertheoutcomeofafishy
nancialtransactionisduetotheagentrsquoseffortsorluckand
fourththesumsinvolvedcanbehuge
Someproprietarytradersforexampleearnalotwhen
their tradesdowellbuttheirpersonal lossesare limited
whentheirtradesdopoorlyBecauseoftheasymmetricnashy
tureoftheircompensationthesetraderscanincreasetheir
expectedincomebytakingriskierpositionsThisproblem
isdramaticallyillustratedbyperiodiccasesinwhichldquorogue
tradersrdquoincurlossesthatarebigenoughtodamageoreven
destroy large financial institutions In 1995 nick Leeson
broughtdownBaringsBankwitha$1billionlossandin
2008itwasrevealedthatJeacuterocircmeKervielhadseverelydamshy
agedSocieacuteteacuteGeacuteneacuteralewithalossofover$7billion
Conflictsofinterestorldquoagencyproblemsrdquoalsoexistat
manyotherlevelswithinthefinancialsystemShareholders
offinancialinstitutionshaveaconflictofinterestwiththe
bankrsquosseniorexecutivesespeciallywhenthoseexecutives
arerewardedforgoodperformancebutdonothavealarge
fractionoftheirwealthtiedupinthesharesofthebank
Manyfinancialinstitutionshavelargequantitiesofdebt
Copyrighted Material
18 bull CHapTer 1
which creates a conflict of interest between the bankrsquos
creditorsanditsshareholdersShareholdershaveanincenshy
tivetoauthorizeexcessivelyriskyinvestmentsforexample
especiallyafterabankhasincurredlossesthaterodethe
valueoftheshareholdersrsquoclaimThegainsontheserisky
investmentswillaccruelargelytoshareholderswhilethe
losseswillmostlybebornebycreditorsTheconflictwith
creditorsalsoreducestheincentivesfortheshareholders
of troubled institutions to raisenewcapitalbecause that
wouldstrengthen thepositionofcreditorswhilediluting
theshareholdersrsquopositionThisldquodebtoverhangrdquoproblem
waswidelycitedduringtheWorldFinancialCrisiswhen
many banks that were insolvent or close to insolvency
seemedreluctanteithertoraisenewcapitalortoreduce
theirrisksbysellingdistressedsecurities11
atthehighestlevelthereisaconflictofinterestbetween
societyasawholeandtheprivateownersoffinancialinshy
stitutions Because robust financial institutions promote
economicgrowthandemploymentduringfinancialcrises
governmentsoftenrescuetroubledfirmstheyperceiveto
be systemically importantThe result is privatized gains
andsocializedlossesIfthingsgowellthefirmsrsquoowners
andmanagersclaimtheprofitsbutifthingsgopoorlysoshy
cietysubsidizesthelosses
The candidates for government bailouts are popularly
describedasldquotoobigtofailrdquoMorepreciselytheargument
for government supportmdashwhich many economists chalshy
lengemdashisaboutfirmsthataretoosystemicallyimportantto
failInits200annualreporttheeuropeanCentralBank
describedsystemicriskasldquoTheriskthattheinabilityofone
Copyrighted Material
InTroDuCT Ion bull 19
institutiontomeetitsobligationswhenduewillcauseother
institutions to be unable tomeet their obligationswhen
dueSuchafailuremaycausesignificantliquidityorcredit
problemsandas a resultcould threaten the stabilityof
or confidence in marketsrdquo Systemically important firms
arethosewhosefailurecouldposealargethreattothestashy
bilityoforconfidenceinmarketsThesefirmsarelikelyto
belargebuttheyalsotendtohavecomplexinterconnecshy
tionswithotherfinancialinstitutions
Tooshybigshytoshyfailpoliciesoffersystemicallyimportantfirms
theexplicitorimplicitpromiseofabailoutwhenthingsgo
wrongThesepoliciesaredestructiveforseveralreasons
Firstbecause the possibility of a bailoutmeans a firmrsquos
stakeholders claim all the profits but only some of the
lossesfinancialfirmsthatmightreceivegovernmentsupshy
porthaveanincentivetotakeextrariskThefirmrsquosshareshy
holderscreditorsemployeesandmanagement all share
thetemptationTheresultisanincreaseintherisksborne
bysocietyasawhole
Secondthesepoliciesencouragesmallerfinancialinstishy
tutionstoexpandortobecomemorecloselyinterconnected
with other firms so they move under the tooshybigshytoshyfail
umbrellaFirmshaveanincentivetodowhateverittakes
tomakepolicymakersfeartheirfailurecreatingthevery
fragilitythegovernmentwishestoavoidBeliefthatagovshy
ernmentrescuewillprotectafinancial institutionrsquoscredishy
tors inacrisisalsogivesafirmacompetitiveadvantage
loweringitscostoffinancingandallowingittoofferbetter
prices to its customers than its fundamental productivity
warrants
Copyrighted Material
20 bull CHapTer 1
Thirdinefficientfirmsthatcannotcompeteontheirown
shouldfailotherwisefirmshavelessincentivetobecome
andstayefficientagovernmentpolicythatpropsupinshy
efficientfirmsiswastefulanddestructiveallowingthese
firmstofailfreesupresourcesandprovidesopportunities
formoreefficientandinnovativecompetitorstoflourish
Fourthandmostgenerallycapitalismisunderminedby
policiesthatprivatizegainsbutsocializelossesGovernment
guaranteedinstitutionscanbecomegovernmentruninstishy
tutionsallocatingcreditforexampletomaximizepolitical
gainratherthaneconomicwelfare
The conflictbetween society and theownersoffinanshy
cialfirmsbecomesmoreseriousduringseverecriseswhen
manyfinancialinstitutionsareclosetoinsolventIt isthe
primemotivationforourregulatoryproposalsbutseveral
ofthelowershylevelconflictswehavedescribedarerelevant
becausetheymagnifytheriskbornebysocietyasawhole
Theselfshyservingbehaviorthatmanyofourrecommenshy
dations targetmdashwhether by traders senior management
orthefirmrsquosownersmdashneednotbestrategicintentionally
maliciousorevenconsciousConsideratraderwhoinadshy
vertentlydevelopsaninvestmentstrategywithhighlyprobshy
ablegainsandimprobablebutlargelossesLikeafirmthat
hassoldearthquakeinsurancethestrategymayproducea
longstringofimpressivereturnsbeforeoneyearoflosses
wipesoutmanyyearsofprofits12 Ifsoduringthegood
yearsthetraderwillbecelebratedforhisorherbrilliance
rewarded with large bonuses and given more resources
to manageMany sophisticated traders and hedge funds
Copyrighted Material
InTroDuCT Ion bull 21
werenotawareoftheldquoearthquakerisksrdquoinherentinmany
of theirstrategiesSimilarlywhenfirmstakeactionsthat
increasethelikelihoodofagovernmentbailoutinthenext
financialcrisisthemarketrewardsthemwithalowercost
of capitalas firms become too big to fail for example
the implicit government guarantee reduces the riskiness
of their debt and lowers the interest rate demanded by
theircreditorsaCeoworkingtomaximizefirmvaluemay
notevenrealize the importanceof thegovernmentguarshy
anteebut a Darwinian process will encourage behavior
thatexploitsit
Bankruptcy and Resolution Procedures
Itisimpossibletowriteafinancialcontractthatspecifies
everypossiblecontingencyInsteadcontractsrelyonbankshy
ruptcytodetermineoutcomesincertainbadandunlikely
statesoftheworldInbankruptcycontrolofafirmistransshy
ferredfromtheshareholderswhonolongerhaveastake
inlossesbecausetheirsharesareworthlittletothedebtshy
holders It is in societyrsquos interest to develop bankruptcy
proceduresthatmaximizethepostshybankruptcyvalueofa
firmrsquosassetsInparticularsocietyshouldavoidthedestrucshy
tionofvaluethatoccurswithdisorderlyliquidation
Disorderlyliquidationoffinancialinstitutionsisparticushy
larly costlyFirstvaluableknowledge that the institution
hasaccumulatedaboutitscounterpartiesmdashborrowerstradshy
ingpartnersandsoonmdashcandisappearastheinstitution
losesemployeesandceasestooperatenormallyFinancial
Copyrighted Material
22 bull CHapTer 1
economistshavefoundthatthecollapseofabankhasamashy
terialadverseimpactonmanyofitsborrowers1 Second
the prospect of a disorderly liquidation makes it more
likelythatatroubledfinancialinstitutionwillsufferarun
by creditors who conclude they are better off claiming
whatmoney theycan todayrather thanwaiting through
protracted liquidation proceedings Third ldquofire salesrdquo of
specializedassets inadisorderly liquidationcandepress
prices and thereby spread problems to other holders of
theassetclassFourthdisorderlyliquidationincreasesthe
uncertaintyabouttheimpactofafinancialinstitutionrsquosfailshy
ureonitscounterpartiesandotherclaimholdersBecause
financialfirmsaretightlyinterconnectedthisuncertainty
canprecipitateorintensifyafinancialcrisis1
In theunitedStatesthestandardbankruptcycodealshy
lowsbothforliquidationofafirmandthesaleofitsassets
(Chapter7)andforcontinuedoperationofafirmunder
the supervision of a bankruptcy judgewho protects the
firmfromcreditorsrsquoclaimswhileareorganizationplanis
approved(Chapter11)Theseproceduresappeartowork
wellfornonfinancialcorporationsbutnotsowellforfinanshy
cialorganizationsTheChapter11approachofseparatinga
firmrsquosfinancialaffairsfromitsnonfinancialbusinessactivishy
tiesisinfeasiblewhenthebusinessofthefirmisfinancial
transactionsFurthermoremanyfinancialinstitutionsrely
heavily on shortshyterm debtpossibly as a valuable discishy
plineonbankexecutiveswhocanrapidlychangetherisks
theirfirmstakeThismakesfinancialfirmsvulnerabletoa
rapidwithdrawalofshortshytermcreditthatislikelytooccur
beforeanyeventthatwouldtriggerbankruptcy
Copyrighted Material
InTroDuCT Ion bull 2
Wearguebelowthatthereisaneedforaspecialresolushy
tionprocedurethatcanbeappliedtolargeinsolventfinanshy
cialinstitutionsWealsoadvocateregulatorychangesthat
would push financial firms towardmore resilient capital
structures
Bank Runs
Classicbank runs inwhichdepositors race towithdraw
their funds before a bank failswere one of the central
contributors to theGreatDepressionDeposit insurance
whichwasintroducedaftertheDepressiontocounterthis
destructiveprocessmadedemanddepositsoneofthemost
stableformsofbankfinancingduringtheWorldFinancial
CrisisManyfinancialinstitutionshoweversufferedamodshy
ernversionofbankruns
Banksespeciallythosewithinvestmentbankingactivishy
tiestypicallyfinanceasignificantfractionoftheirbusiness
withovernightcommercialpaperreposandothershortshy
terminstrumentsInnormaltimesbanksrolloverthisdebt
asitmaturestakingnewloanstopayofftheoldInacrishy
sishoweveruncertaintyaboutwhetheratroubledinstitushy
tionwouldbeabletopayoffitscreditorstomorrowcauses
lenderstostopextendingcredittodayThusshortshytermfishy
nancingcanleadtoarunthatissimilartoaclassicrunon
deposits
even some secured creditors participated in runs durshy
ingtheWorldFinancialCrisisBanksoftenuserepurchase
agreements to borrow money securing the loan by givshy
ingthelenderafinancialassetsuchasaTreasurybond
Copyrighted Material
2 bull CHapTer 1
ascollateralBecausetheyareovershycollateralizedwithasshy
setsworthperhaps$105guaranteeingevery$100inloans
lendersviewldquoreposrdquoasasafewaytoextendcreditWhen
credit markets froze during the Crisis however lenders
worried that retrieving collateral and selling itwouldbe
difficultandnotworththesmallinterestonanovernight
loanasaresultatvarioustimesduringtheCrisismany
investmentbankshaddifficultyrollingovereventheirseshy
cured loanseven relatively healthy financial institutions
werehamperedbythetroubleintherepomarketafteraushy
gust2007asthemarketbecamemoreandmoreuncertain
about the prices securities would fetch in a forced sale
these institutions found they could borrow less and less
withthesamecollateral15
prime brokerage accounts also saw a runshylike withshy
drawalbycustomersManylargebankshaveprimebrokershy
agegroupsthatassisthedgefundsandotherinstitutionalinshy
vestorsbyprovidingfinancingsecuritieslendingclearing
custodial servicesandoperational supportInexchange
thefundspayfeesandcriticallypostcollateraltosecure
theirloansWithsomerestrictionsthatweexplaininChapshy
ter10theprimebrokercanthenusethecollateralinits
ownbusinessinsomecasescomminglingitwiththefirmrsquos
ownassetsDuringtheCrisishedgefundsmonitoredthe
financial wellshybeing of their prime brokers and like deshy
positorsintheDepressionfledwiththeircollateralatthe
firstsignoftroubleBearStearnsforexamplehadalarge
prime brokerage business according to press accounts
oneofthelargesthedgefundsthatusedBearStearnsasa
Copyrighted Material
InTroDuCT Ion bull 25
primebrokerrenaissanceTechnologieswithdrew$5bilshy
lionofcashintheweekthefirmfailedWithsuchoutflows
it is not surprising that Bear Stearns ran out of money
eventhoughithadmorethan$18billionincashaweek
earlier
Likeclassicbankrunsmodernbankrunsarebothdeshy
structiveandselfshyfulfillingConcernthatabankmightbe
in trouble spurs its creditors and counterparties towithshy
draworwithholdtheircapitalasaresultevenrumorsofa
problemmaybeenoughtodestroyaviableinstitutionThe
importanceofmodernbankrunsduringtheWorldFinanshy
cialCrisisisarecurringthemethroughoutthebookand
wemakeseveralproposalsthatareintendedtoreducethe
frequencyofsuchevents
The Inadequacy of the Regulatory Structure
TheWorldFinancialCrisismadeitclearthatfinancialinnoshy
vationhadoverwhelmedexistingfinancialregulationsnoshy
tableexamplesincludeaIGrsquosdecisiontosellanextremely
large amount of credit default swaps on subprime debt
tobanksintheunitedStatesandabroadtheholdingof
Lehmanpaperbymoneymarketfundsparticularlythereshy
serveprimaryFundthecomplexityofthederivativebooks
atLehmanandotherinvestmentbanksandthedifficultyof
simultaneouslyapplyingseveralcountriesrsquobankruptcycodes
tothesubsidiariesofmultinationalfinancialinstitutions1
Thereisatradeshyoffbetweenfinancialinnovationandstashy
bilityInnovationcanimprovethefinancialsystemrsquosability
Copyrighted Material
2 bull CHapTer 1
toallocateresourcestotheirhighestvaluedusebutitcan
alsoreducethestabilityofthesystemThechallengeisto
developregulationsthatimprovestabilitywithoutstifling
innovation In addition regulation often leads to innoshy
vations designed to evade the regulationswhich makes
thefinancialsystemmorefragileForexamplemanyofthe
specialshypurposevehiclesthatimplodedintheCrisiswere
createdtogetaroundcapitalrequirements
In many countries the response of regulators to the
World Financial Crisis was hampered by the fragmented
nature of their regulatory systems Financial regulations
are typically designed to ensure thehealth of individual
institutionsratherthanthefinancialsystemasawholeIn
thisbookwearguethatsystemicregulationisanimporshy
tantfunctionthatrequiresaspecialmandateandthatthe
central bank is particularly well equipped to fulfill this
function
Finallyeffectivefinancialregulationrequiresthatpolitishy
ciansandultimatelythepublichaveanadequateundershy
standing of the financial system The political turmoil
surroundingtheCrisissuggeststheimportanceofdissemishy
natingexpertknowledgeaboutfinancetoabroaderaudishy
enceThisisoneofourmotivationsforwritingthisbook
What Were the orIgIns oF the World FInancIal crIsIs
LiketheoriginsoftheFirstWorldWarthecausesofthe
Crisiswillbedebatedbyscholarsformanyyears
Copyrighted Material
InTroDuCT Ion bull 27
Most observers agree that the strong runshyup and subshy
sequentsharpdeclineinthepricesofstockshousesand
otherfinancialassetsindevelopedcountrieswasanimporshy
tantcatalystfortheCrisisThereisdisagreementhowever
aboutwhetherthispatterninpricesistheresultofrational
investorbehaviororldquoirrationalbubblesrdquo
SomearguethattherunshyupbeforetheCrisiswasdriven
by investorswhoknowingly acceptedunusually low exshy
pectedreturnsandtheyofferseveralpossiblereasonswhy
Firsttherewasasurgeofsavingsinemergingcountries
drivenbyacombinationofrapideconomicgrowthanddeshy
mographicsperhapsbecauseofadesiretoaccumulateforshy
eignreservesintheaftermathoftheasiacrisisof1997ndash98
muchof thiswealthwas invested indevelopedmarkets
Secondfinancialmarketswereunusually tranquilduring
200to200Withlowvolatilityinvestorsmayhavesettled
for a low risk premiumThird influenced by fears of a
Japaneseshystyledeflation resulting from themarketdownshy
turnof2000ndash2001andbyabeliefthattheyshouldnottry
to usemonetary policy to counteract rising asset prices
central bankers in the united States maintained a loose
monetarypolicythroughouttheperiod17andfromthisrashy
tionalviewofinvestorstheplungeinassetpricesthatacshy
companiedtheCrisiswascausedbybadnewsaboutfuture
cashflowsunexpectedincreasesinthereturnsrequiredby
investorsorboth
otherssuggestamoredirectexplanationThehighprices
before theCrisisweredrivenby an irrational belief that
prices would continue to rise and the collapse of asset
priceswastheinevitableresultofthismistakeWhatever
Copyrighted Material
28 bull CHapTer 1
theexplanationthesharpdropinassetpricesbothconshy
tributedtoandwasasymptomoftheCrisis
other commentators argue that the financial system
becamevulnerablebecausemanymarketparticipantsasshy
sessedrisksinaccuratelyduringtheperiodleadingupto
theWorldFinancialCrisisConsumersbanksandinvestors
ingeneralunderestimatedtheriskofhousepricedeclines
increasingthepricestheywerewillingtopayforrealesshy
tatethecredittheywerewillingtoextendandthevaluashy
tionsofbanksthatextendedsuchcreditBanksputmuch
weight on the recent pastwhen they estimated value at
riskwhichledthemtoconcludethatthelevelofriskwas
lowandthattherewaslittledownsidetohavinghighleshy
verageothermarketparticipantsdidnotfullyappreciate
thathighliquiditywassuppressingvolatilityandthatthe
processmightreversewithliquiditydecreasingandvolatilshy
ityincreasing
More generally the high level of financial innovation
driveninpartbythedecliningcostofinformationtechnolshy
ogymadeithardforriskassessmenttokeeppacewiththe
evolvingfinancialsystem18Thebenignenvironmentofthe
creditboomexacerbatedthisproblembytemptingfinanshy
cialinstitutionstounderinvestinriskmanagement
uSpolicymakersalsocontributedtotheseverityofthe
CrisisbypushingFannieMaeandFreddieMactoincrease
theavailabilityofmortgagefundingtoborrowerswithquesshy
tionableabilitytorepaytheirmortgagesasaresultofthis
pressure both agencies relaxed their standards for the
mortgages they purchased and guaranteedThe demand
Copyrighted Material
InTroDuCT Ion bull 29
forhomesbyborrowerswhoqualifiedformortgagesbeshy
causeoftheselowerstandardspusheduppricesandthe
defaultbymanyofthemduringtherecessioncontributed
tothedropinhomeprices
Thepanicandruninthefallof2008remainthecentral
distinguishingfeaturesoftheWorldFinancialCrisisasset
priceshave risenand fallenbeforeand theworldeconshy
omyhasbornelargefinancial lossesmanytimeswithout
suchasevereeconomicoutcomeConverselylossesfrom
completelydifferentunderlyingsourcesmdashcommercialreal
estateorperhapssovereigndefaultsmdashcouldcauseasimilar
catastrophe if theyagainprovoke tooshybigshytoshyfailchaosor
runs
Thisbookdoesnotseektoprovideacompletediagnosis
oftheWorldFinancialCrisisnordoesittakeastandonthe
relativeimportanceofthecontributingfactorslistedabove
ratherwebelieveourrecommendationswillhelpprevent
ormitigatefuturecriseseventhoughwedonotfullyundershy
standallthecausesofthelastone
CarmenreinhartandKennethrogoff amongothershave
pointedoutthatfinancialcriseshaveoccurredthroughout
thehistoryofcapitalismandthatthesecrisessharemany
commonpatterns19 Thelessonwedrawfromthisisthat
noacceptablesetofregulationscanpreventmarketparticishy
pantsfrommakingmistakesthatcreateeconomicinstability
ourpurposeinthisbookisinsteadtosuggestregulatory
reformsthatwillmakethesystemmorestabledespitethe
mistakesthataresuretocome
Copyrighted Material
1 bull CHapTer 1
novembermdashjust2percentofthevolume18monthsearlier
onlymortgagespooledbyFannieMaeandFreddieMac
withanexplicitgovernmentguaranteeandsubjecttohuge
Federalreservepurchasescontinuedtoflowtothemarket
There isplentyof anecdotal and surveyevidence that
banklendingalsodriedupduringtheCrisisForexample
loanofficerssurveyedbytheFederalreservereportedthat
credit conditionsprogressively tightenedduring2008In
asurveyabouttheirperceptionsofcreditconditionsand
corporatedecisionsasoflatenovember2008morethan
halfofthechieffinancialofficersoflargeamericanfirms
whorespondedsaidthattheirfirmswereeitherldquosomewhat
orveryaffectedbythecostoravailabilityofcreditrdquo8
There is a lively and fundamentally important debate
about why the quantity of lending fell Some financial
economists argue that banks wanted to lend more but
wereunable todosobecausetheyfacedbindingcapital
constraintsInthisviewinformationcostsandotherfricshy
tionsintheloanoriginationprocesskeptcustomersfrom
movingtolessconstrainedbanks
othersarguethattheprimaryreasonbankswereunwillshy
ingtolendisthattheircustomershadbecomelesscreditshy
worthyTheseeconomistspointoutthatthehighlevelof
uncertainty about future economic conditionsduring the
Crisisratchetedupthedefaultriskofeventhemostrelishy
ableclientsThisinterpretationofthedeclineinbanklendshy
ingimpliesthatnoamountofcapitalwouldhaveinduced
banksasagrouptolendmorebecauseallthegoodloans
werebeingmade
Figure shows data on the quantity of bank lending
Jan 20
08
Mar
2008
M
ay 20
08Ju
l 200
8Se
p 2008
Nov 20
08Ja
n 2009
Jan 20
09
May
2009
Jul 2
009
Sep 20
09Nov
2009
Copyrighted Material
InTroDuCT Ion bull 15
1050
1100
1150
1200
1250
1300
FigureCommercialandIndustrialLoansbyuSCommercialBanks2008ndash9inBillionsofDollarsSourceFederalreserve
intheunitedStatesin2008and2009Startinginoctober
2008therewasaspikeinlendingfollowedbyaprotracted
declineVVChariLawrenceChristianoandpatrickKehoe
takethespikeatfacevalueinaggregatebankslentmore
ataminimumthebankingsystemasawholemdashasopposed
to individual banksmdashwas not deleveraging to overcome
loss of capital9 Victoria Ivashina and David Scharfstein
notethatmuchoftheincreaseinbanklendingwasinvolshy
untaryonthepartofthebankstheresultofdrawdowns
byborrowersonexistinglinesofcredit10 Theyalsoshow
thatbanks thatweremorevulnerable todrawdownsbeshy
causetheywereinmoresyndicateswithLehmanreduced
subsequent lending more and conclude that there was
indeed a genuine contraction in the effective supply of
bankcredit
Copyrighted Material
1 bull CHapTer 1
economistswillargueabouttheeventsoftheWorldFishy
nancialCrisisforyearstocomeInfactwestillargueabout
theGreatDepressionnoneoftheanalysisbehindourrecshy
ommendationshoweverdepends onhow these debates
aresettledForexamplenomatterhowcapitalshyconstrained
thebankingsystemreallywasinthefallof2008ourproshy
posalsforchangesthatmakesuchconstraintslessbinding
andgivepolicymakersbettertoolswhentheyfearcapital
constraintsremainvalid
What Was Wrong WIth the FInancIal system durIng the crIsIs
The Crisis revealed a number of serious problems with
ourfinancialsystemSomehadbeeninthebackgroundall
alongothersdidnotappearuntiltheCrisisInthisbook
weemphasizefourcategoriesofproblemsconflictsofinshy
terestknowntoeconomistsasagencyproblemsthediffishy
cultyofapplyingstandardbankruptcyprocedurestofinanshy
cialinstitutionstheemergenceofamodernformofbank
runsandtheinadequacyoftheregulatorystructurewhich
hadnotkeptupwithrecentfinancialinnovation(Infact
muchinnovationservedtoescaperegulations)
Conflicts of Interest Agency Problems
Conflictsofinterestthatcannotberesolvedeasilybyconshy
tractsormarketsoccurthroughouttheeconomybutthey
Copyrighted Material
InTroDuCT Ion bull 17
canbeparticularlyharmfulinthefinancialsystemThere
areseveralreasonsFirstmanyfinancialtransactionsand
contractsinvolveaprincipalsuchasaninvestororshareshy
holderaskingatradermanagerorotheragenttoacton
hisorherbehalfSecondmostfinancial transactions inshy
volvehighlyuncertainfuturepayoffsandinmanytransacshy
tionsonepartyisbetterinformedaboutthepayoffsthan
the otherThird the high volatility of the future payoffs
oftenmakesithardtoassesswhethertheoutcomeofafishy
nancialtransactionisduetotheagentrsquoseffortsorluckand
fourththesumsinvolvedcanbehuge
Someproprietarytradersforexampleearnalotwhen
their tradesdowellbuttheirpersonal lossesare limited
whentheirtradesdopoorlyBecauseoftheasymmetricnashy
tureoftheircompensationthesetraderscanincreasetheir
expectedincomebytakingriskierpositionsThisproblem
isdramaticallyillustratedbyperiodiccasesinwhichldquorogue
tradersrdquoincurlossesthatarebigenoughtodamageoreven
destroy large financial institutions In 1995 nick Leeson
broughtdownBaringsBankwitha$1billionlossandin
2008itwasrevealedthatJeacuterocircmeKervielhadseverelydamshy
agedSocieacuteteacuteGeacuteneacuteralewithalossofover$7billion
Conflictsofinterestorldquoagencyproblemsrdquoalsoexistat
manyotherlevelswithinthefinancialsystemShareholders
offinancialinstitutionshaveaconflictofinterestwiththe
bankrsquosseniorexecutivesespeciallywhenthoseexecutives
arerewardedforgoodperformancebutdonothavealarge
fractionoftheirwealthtiedupinthesharesofthebank
Manyfinancialinstitutionshavelargequantitiesofdebt
Copyrighted Material
18 bull CHapTer 1
which creates a conflict of interest between the bankrsquos
creditorsanditsshareholdersShareholdershaveanincenshy
tivetoauthorizeexcessivelyriskyinvestmentsforexample
especiallyafterabankhasincurredlossesthaterodethe
valueoftheshareholdersrsquoclaimThegainsontheserisky
investmentswillaccruelargelytoshareholderswhilethe
losseswillmostlybebornebycreditorsTheconflictwith
creditorsalsoreducestheincentivesfortheshareholders
of troubled institutions to raisenewcapitalbecause that
wouldstrengthen thepositionofcreditorswhilediluting
theshareholdersrsquopositionThisldquodebtoverhangrdquoproblem
waswidelycitedduringtheWorldFinancialCrisiswhen
many banks that were insolvent or close to insolvency
seemedreluctanteithertoraisenewcapitalortoreduce
theirrisksbysellingdistressedsecurities11
atthehighestlevelthereisaconflictofinterestbetween
societyasawholeandtheprivateownersoffinancialinshy
stitutions Because robust financial institutions promote
economicgrowthandemploymentduringfinancialcrises
governmentsoftenrescuetroubledfirmstheyperceiveto
be systemically importantThe result is privatized gains
andsocializedlossesIfthingsgowellthefirmsrsquoowners
andmanagersclaimtheprofitsbutifthingsgopoorlysoshy
cietysubsidizesthelosses
The candidates for government bailouts are popularly
describedasldquotoobigtofailrdquoMorepreciselytheargument
for government supportmdashwhich many economists chalshy
lengemdashisaboutfirmsthataretoosystemicallyimportantto
failInits200annualreporttheeuropeanCentralBank
describedsystemicriskasldquoTheriskthattheinabilityofone
Copyrighted Material
InTroDuCT Ion bull 19
institutiontomeetitsobligationswhenduewillcauseother
institutions to be unable tomeet their obligationswhen
dueSuchafailuremaycausesignificantliquidityorcredit
problemsandas a resultcould threaten the stabilityof
or confidence in marketsrdquo Systemically important firms
arethosewhosefailurecouldposealargethreattothestashy
bilityoforconfidenceinmarketsThesefirmsarelikelyto
belargebuttheyalsotendtohavecomplexinterconnecshy
tionswithotherfinancialinstitutions
Tooshybigshytoshyfailpoliciesoffersystemicallyimportantfirms
theexplicitorimplicitpromiseofabailoutwhenthingsgo
wrongThesepoliciesaredestructiveforseveralreasons
Firstbecause the possibility of a bailoutmeans a firmrsquos
stakeholders claim all the profits but only some of the
lossesfinancialfirmsthatmightreceivegovernmentsupshy
porthaveanincentivetotakeextrariskThefirmrsquosshareshy
holderscreditorsemployeesandmanagement all share
thetemptationTheresultisanincreaseintherisksborne
bysocietyasawhole
Secondthesepoliciesencouragesmallerfinancialinstishy
tutionstoexpandortobecomemorecloselyinterconnected
with other firms so they move under the tooshybigshytoshyfail
umbrellaFirmshaveanincentivetodowhateverittakes
tomakepolicymakersfeartheirfailurecreatingthevery
fragilitythegovernmentwishestoavoidBeliefthatagovshy
ernmentrescuewillprotectafinancial institutionrsquoscredishy
tors inacrisisalsogivesafirmacompetitiveadvantage
loweringitscostoffinancingandallowingittoofferbetter
prices to its customers than its fundamental productivity
warrants
Copyrighted Material
20 bull CHapTer 1
Thirdinefficientfirmsthatcannotcompeteontheirown
shouldfailotherwisefirmshavelessincentivetobecome
andstayefficientagovernmentpolicythatpropsupinshy
efficientfirmsiswastefulanddestructiveallowingthese
firmstofailfreesupresourcesandprovidesopportunities
formoreefficientandinnovativecompetitorstoflourish
Fourthandmostgenerallycapitalismisunderminedby
policiesthatprivatizegainsbutsocializelossesGovernment
guaranteedinstitutionscanbecomegovernmentruninstishy
tutionsallocatingcreditforexampletomaximizepolitical
gainratherthaneconomicwelfare
The conflictbetween society and theownersoffinanshy
cialfirmsbecomesmoreseriousduringseverecriseswhen
manyfinancialinstitutionsareclosetoinsolventIt isthe
primemotivationforourregulatoryproposalsbutseveral
ofthelowershylevelconflictswehavedescribedarerelevant
becausetheymagnifytheriskbornebysocietyasawhole
Theselfshyservingbehaviorthatmanyofourrecommenshy
dations targetmdashwhether by traders senior management
orthefirmrsquosownersmdashneednotbestrategicintentionally
maliciousorevenconsciousConsideratraderwhoinadshy
vertentlydevelopsaninvestmentstrategywithhighlyprobshy
ablegainsandimprobablebutlargelossesLikeafirmthat
hassoldearthquakeinsurancethestrategymayproducea
longstringofimpressivereturnsbeforeoneyearoflosses
wipesoutmanyyearsofprofits12 Ifsoduringthegood
yearsthetraderwillbecelebratedforhisorherbrilliance
rewarded with large bonuses and given more resources
to manageMany sophisticated traders and hedge funds
Copyrighted Material
InTroDuCT Ion bull 21
werenotawareoftheldquoearthquakerisksrdquoinherentinmany
of theirstrategiesSimilarlywhenfirmstakeactionsthat
increasethelikelihoodofagovernmentbailoutinthenext
financialcrisisthemarketrewardsthemwithalowercost
of capitalas firms become too big to fail for example
the implicit government guarantee reduces the riskiness
of their debt and lowers the interest rate demanded by
theircreditorsaCeoworkingtomaximizefirmvaluemay
notevenrealize the importanceof thegovernmentguarshy
anteebut a Darwinian process will encourage behavior
thatexploitsit
Bankruptcy and Resolution Procedures
Itisimpossibletowriteafinancialcontractthatspecifies
everypossiblecontingencyInsteadcontractsrelyonbankshy
ruptcytodetermineoutcomesincertainbadandunlikely
statesoftheworldInbankruptcycontrolofafirmistransshy
ferredfromtheshareholderswhonolongerhaveastake
inlossesbecausetheirsharesareworthlittletothedebtshy
holders It is in societyrsquos interest to develop bankruptcy
proceduresthatmaximizethepostshybankruptcyvalueofa
firmrsquosassetsInparticularsocietyshouldavoidthedestrucshy
tionofvaluethatoccurswithdisorderlyliquidation
Disorderlyliquidationoffinancialinstitutionsisparticushy
larly costlyFirstvaluableknowledge that the institution
hasaccumulatedaboutitscounterpartiesmdashborrowerstradshy
ingpartnersandsoonmdashcandisappearastheinstitution
losesemployeesandceasestooperatenormallyFinancial
Copyrighted Material
22 bull CHapTer 1
economistshavefoundthatthecollapseofabankhasamashy
terialadverseimpactonmanyofitsborrowers1 Second
the prospect of a disorderly liquidation makes it more
likelythatatroubledfinancialinstitutionwillsufferarun
by creditors who conclude they are better off claiming
whatmoney theycan todayrather thanwaiting through
protracted liquidation proceedings Third ldquofire salesrdquo of
specializedassets inadisorderly liquidationcandepress
prices and thereby spread problems to other holders of
theassetclassFourthdisorderlyliquidationincreasesthe
uncertaintyabouttheimpactofafinancialinstitutionrsquosfailshy
ureonitscounterpartiesandotherclaimholdersBecause
financialfirmsaretightlyinterconnectedthisuncertainty
canprecipitateorintensifyafinancialcrisis1
In theunitedStatesthestandardbankruptcycodealshy
lowsbothforliquidationofafirmandthesaleofitsassets
(Chapter7)andforcontinuedoperationofafirmunder
the supervision of a bankruptcy judgewho protects the
firmfromcreditorsrsquoclaimswhileareorganizationplanis
approved(Chapter11)Theseproceduresappeartowork
wellfornonfinancialcorporationsbutnotsowellforfinanshy
cialorganizationsTheChapter11approachofseparatinga
firmrsquosfinancialaffairsfromitsnonfinancialbusinessactivishy
tiesisinfeasiblewhenthebusinessofthefirmisfinancial
transactionsFurthermoremanyfinancialinstitutionsrely
heavily on shortshyterm debtpossibly as a valuable discishy
plineonbankexecutiveswhocanrapidlychangetherisks
theirfirmstakeThismakesfinancialfirmsvulnerabletoa
rapidwithdrawalofshortshytermcreditthatislikelytooccur
beforeanyeventthatwouldtriggerbankruptcy
Copyrighted Material
InTroDuCT Ion bull 2
Wearguebelowthatthereisaneedforaspecialresolushy
tionprocedurethatcanbeappliedtolargeinsolventfinanshy
cialinstitutionsWealsoadvocateregulatorychangesthat
would push financial firms towardmore resilient capital
structures
Bank Runs
Classicbank runs inwhichdepositors race towithdraw
their funds before a bank failswere one of the central
contributors to theGreatDepressionDeposit insurance
whichwasintroducedaftertheDepressiontocounterthis
destructiveprocessmadedemanddepositsoneofthemost
stableformsofbankfinancingduringtheWorldFinancial
CrisisManyfinancialinstitutionshoweversufferedamodshy
ernversionofbankruns
Banksespeciallythosewithinvestmentbankingactivishy
tiestypicallyfinanceasignificantfractionoftheirbusiness
withovernightcommercialpaperreposandothershortshy
terminstrumentsInnormaltimesbanksrolloverthisdebt
asitmaturestakingnewloanstopayofftheoldInacrishy
sishoweveruncertaintyaboutwhetheratroubledinstitushy
tionwouldbeabletopayoffitscreditorstomorrowcauses
lenderstostopextendingcredittodayThusshortshytermfishy
nancingcanleadtoarunthatissimilartoaclassicrunon
deposits
even some secured creditors participated in runs durshy
ingtheWorldFinancialCrisisBanksoftenuserepurchase
agreements to borrow money securing the loan by givshy
ingthelenderafinancialassetsuchasaTreasurybond
Copyrighted Material
2 bull CHapTer 1
ascollateralBecausetheyareovershycollateralizedwithasshy
setsworthperhaps$105guaranteeingevery$100inloans
lendersviewldquoreposrdquoasasafewaytoextendcreditWhen
credit markets froze during the Crisis however lenders
worried that retrieving collateral and selling itwouldbe
difficultandnotworththesmallinterestonanovernight
loanasaresultatvarioustimesduringtheCrisismany
investmentbankshaddifficultyrollingovereventheirseshy
cured loanseven relatively healthy financial institutions
werehamperedbythetroubleintherepomarketafteraushy
gust2007asthemarketbecamemoreandmoreuncertain
about the prices securities would fetch in a forced sale
these institutions found they could borrow less and less
withthesamecollateral15
prime brokerage accounts also saw a runshylike withshy
drawalbycustomersManylargebankshaveprimebrokershy
agegroupsthatassisthedgefundsandotherinstitutionalinshy
vestorsbyprovidingfinancingsecuritieslendingclearing
custodial servicesandoperational supportInexchange
thefundspayfeesandcriticallypostcollateraltosecure
theirloansWithsomerestrictionsthatweexplaininChapshy
ter10theprimebrokercanthenusethecollateralinits
ownbusinessinsomecasescomminglingitwiththefirmrsquos
ownassetsDuringtheCrisishedgefundsmonitoredthe
financial wellshybeing of their prime brokers and like deshy
positorsintheDepressionfledwiththeircollateralatthe
firstsignoftroubleBearStearnsforexamplehadalarge
prime brokerage business according to press accounts
oneofthelargesthedgefundsthatusedBearStearnsasa
Copyrighted Material
InTroDuCT Ion bull 25
primebrokerrenaissanceTechnologieswithdrew$5bilshy
lionofcashintheweekthefirmfailedWithsuchoutflows
it is not surprising that Bear Stearns ran out of money
eventhoughithadmorethan$18billionincashaweek
earlier
Likeclassicbankrunsmodernbankrunsarebothdeshy
structiveandselfshyfulfillingConcernthatabankmightbe
in trouble spurs its creditors and counterparties towithshy
draworwithholdtheircapitalasaresultevenrumorsofa
problemmaybeenoughtodestroyaviableinstitutionThe
importanceofmodernbankrunsduringtheWorldFinanshy
cialCrisisisarecurringthemethroughoutthebookand
wemakeseveralproposalsthatareintendedtoreducethe
frequencyofsuchevents
The Inadequacy of the Regulatory Structure
TheWorldFinancialCrisismadeitclearthatfinancialinnoshy
vationhadoverwhelmedexistingfinancialregulationsnoshy
tableexamplesincludeaIGrsquosdecisiontosellanextremely
large amount of credit default swaps on subprime debt
tobanksintheunitedStatesandabroadtheholdingof
Lehmanpaperbymoneymarketfundsparticularlythereshy
serveprimaryFundthecomplexityofthederivativebooks
atLehmanandotherinvestmentbanksandthedifficultyof
simultaneouslyapplyingseveralcountriesrsquobankruptcycodes
tothesubsidiariesofmultinationalfinancialinstitutions1
Thereisatradeshyoffbetweenfinancialinnovationandstashy
bilityInnovationcanimprovethefinancialsystemrsquosability
Copyrighted Material
2 bull CHapTer 1
toallocateresourcestotheirhighestvaluedusebutitcan
alsoreducethestabilityofthesystemThechallengeisto
developregulationsthatimprovestabilitywithoutstifling
innovation In addition regulation often leads to innoshy
vations designed to evade the regulationswhich makes
thefinancialsystemmorefragileForexamplemanyofthe
specialshypurposevehiclesthatimplodedintheCrisiswere
createdtogetaroundcapitalrequirements
In many countries the response of regulators to the
World Financial Crisis was hampered by the fragmented
nature of their regulatory systems Financial regulations
are typically designed to ensure thehealth of individual
institutionsratherthanthefinancialsystemasawholeIn
thisbookwearguethatsystemicregulationisanimporshy
tantfunctionthatrequiresaspecialmandateandthatthe
central bank is particularly well equipped to fulfill this
function
Finallyeffectivefinancialregulationrequiresthatpolitishy
ciansandultimatelythepublichaveanadequateundershy
standing of the financial system The political turmoil
surroundingtheCrisissuggeststheimportanceofdissemishy
natingexpertknowledgeaboutfinancetoabroaderaudishy
enceThisisoneofourmotivationsforwritingthisbook
What Were the orIgIns oF the World FInancIal crIsIs
LiketheoriginsoftheFirstWorldWarthecausesofthe
Crisiswillbedebatedbyscholarsformanyyears
Copyrighted Material
InTroDuCT Ion bull 27
Most observers agree that the strong runshyup and subshy
sequentsharpdeclineinthepricesofstockshousesand
otherfinancialassetsindevelopedcountrieswasanimporshy
tantcatalystfortheCrisisThereisdisagreementhowever
aboutwhetherthispatterninpricesistheresultofrational
investorbehaviororldquoirrationalbubblesrdquo
SomearguethattherunshyupbeforetheCrisiswasdriven
by investorswhoknowingly acceptedunusually low exshy
pectedreturnsandtheyofferseveralpossiblereasonswhy
Firsttherewasasurgeofsavingsinemergingcountries
drivenbyacombinationofrapideconomicgrowthanddeshy
mographicsperhapsbecauseofadesiretoaccumulateforshy
eignreservesintheaftermathoftheasiacrisisof1997ndash98
muchof thiswealthwas invested indevelopedmarkets
Secondfinancialmarketswereunusually tranquilduring
200to200Withlowvolatilityinvestorsmayhavesettled
for a low risk premiumThird influenced by fears of a
Japaneseshystyledeflation resulting from themarketdownshy
turnof2000ndash2001andbyabeliefthattheyshouldnottry
to usemonetary policy to counteract rising asset prices
central bankers in the united States maintained a loose
monetarypolicythroughouttheperiod17andfromthisrashy
tionalviewofinvestorstheplungeinassetpricesthatacshy
companiedtheCrisiswascausedbybadnewsaboutfuture
cashflowsunexpectedincreasesinthereturnsrequiredby
investorsorboth
otherssuggestamoredirectexplanationThehighprices
before theCrisisweredrivenby an irrational belief that
prices would continue to rise and the collapse of asset
priceswastheinevitableresultofthismistakeWhatever
Copyrighted Material
28 bull CHapTer 1
theexplanationthesharpdropinassetpricesbothconshy
tributedtoandwasasymptomoftheCrisis
other commentators argue that the financial system
becamevulnerablebecausemanymarketparticipantsasshy
sessedrisksinaccuratelyduringtheperiodleadingupto
theWorldFinancialCrisisConsumersbanksandinvestors
ingeneralunderestimatedtheriskofhousepricedeclines
increasingthepricestheywerewillingtopayforrealesshy
tatethecredittheywerewillingtoextendandthevaluashy
tionsofbanksthatextendedsuchcreditBanksputmuch
weight on the recent pastwhen they estimated value at
riskwhichledthemtoconcludethatthelevelofriskwas
lowandthattherewaslittledownsidetohavinghighleshy
verageothermarketparticipantsdidnotfullyappreciate
thathighliquiditywassuppressingvolatilityandthatthe
processmightreversewithliquiditydecreasingandvolatilshy
ityincreasing
More generally the high level of financial innovation
driveninpartbythedecliningcostofinformationtechnolshy
ogymadeithardforriskassessmenttokeeppacewiththe
evolvingfinancialsystem18Thebenignenvironmentofthe
creditboomexacerbatedthisproblembytemptingfinanshy
cialinstitutionstounderinvestinriskmanagement
uSpolicymakersalsocontributedtotheseverityofthe
CrisisbypushingFannieMaeandFreddieMactoincrease
theavailabilityofmortgagefundingtoborrowerswithquesshy
tionableabilitytorepaytheirmortgagesasaresultofthis
pressure both agencies relaxed their standards for the
mortgages they purchased and guaranteedThe demand
Copyrighted Material
InTroDuCT Ion bull 29
forhomesbyborrowerswhoqualifiedformortgagesbeshy
causeoftheselowerstandardspusheduppricesandthe
defaultbymanyofthemduringtherecessioncontributed
tothedropinhomeprices
Thepanicandruninthefallof2008remainthecentral
distinguishingfeaturesoftheWorldFinancialCrisisasset
priceshave risenand fallenbeforeand theworldeconshy
omyhasbornelargefinancial lossesmanytimeswithout
suchasevereeconomicoutcomeConverselylossesfrom
completelydifferentunderlyingsourcesmdashcommercialreal
estateorperhapssovereigndefaultsmdashcouldcauseasimilar
catastrophe if theyagainprovoke tooshybigshytoshyfailchaosor
runs
Thisbookdoesnotseektoprovideacompletediagnosis
oftheWorldFinancialCrisisnordoesittakeastandonthe
relativeimportanceofthecontributingfactorslistedabove
ratherwebelieveourrecommendationswillhelpprevent
ormitigatefuturecriseseventhoughwedonotfullyundershy
standallthecausesofthelastone
CarmenreinhartandKennethrogoff amongothershave
pointedoutthatfinancialcriseshaveoccurredthroughout
thehistoryofcapitalismandthatthesecrisessharemany
commonpatterns19 Thelessonwedrawfromthisisthat
noacceptablesetofregulationscanpreventmarketparticishy
pantsfrommakingmistakesthatcreateeconomicinstability
ourpurposeinthisbookisinsteadtosuggestregulatory
reformsthatwillmakethesystemmorestabledespitethe
mistakesthataresuretocome
Jan 20
08
Mar
2008
M
ay 20
08Ju
l 200
8Se
p 2008
Nov 20
08Ja
n 2009
Jan 20
09
May
2009
Jul 2
009
Sep 20
09Nov
2009
Copyrighted Material
InTroDuCT Ion bull 15
1050
1100
1150
1200
1250
1300
FigureCommercialandIndustrialLoansbyuSCommercialBanks2008ndash9inBillionsofDollarsSourceFederalreserve
intheunitedStatesin2008and2009Startinginoctober
2008therewasaspikeinlendingfollowedbyaprotracted
declineVVChariLawrenceChristianoandpatrickKehoe
takethespikeatfacevalueinaggregatebankslentmore
ataminimumthebankingsystemasawholemdashasopposed
to individual banksmdashwas not deleveraging to overcome
loss of capital9 Victoria Ivashina and David Scharfstein
notethatmuchoftheincreaseinbanklendingwasinvolshy
untaryonthepartofthebankstheresultofdrawdowns
byborrowersonexistinglinesofcredit10 Theyalsoshow
thatbanks thatweremorevulnerable todrawdownsbeshy
causetheywereinmoresyndicateswithLehmanreduced
subsequent lending more and conclude that there was
indeed a genuine contraction in the effective supply of
bankcredit
Copyrighted Material
1 bull CHapTer 1
economistswillargueabouttheeventsoftheWorldFishy
nancialCrisisforyearstocomeInfactwestillargueabout
theGreatDepressionnoneoftheanalysisbehindourrecshy
ommendationshoweverdepends onhow these debates
aresettledForexamplenomatterhowcapitalshyconstrained
thebankingsystemreallywasinthefallof2008ourproshy
posalsforchangesthatmakesuchconstraintslessbinding
andgivepolicymakersbettertoolswhentheyfearcapital
constraintsremainvalid
What Was Wrong WIth the FInancIal system durIng the crIsIs
The Crisis revealed a number of serious problems with
ourfinancialsystemSomehadbeeninthebackgroundall
alongothersdidnotappearuntiltheCrisisInthisbook
weemphasizefourcategoriesofproblemsconflictsofinshy
terestknowntoeconomistsasagencyproblemsthediffishy
cultyofapplyingstandardbankruptcyprocedurestofinanshy
cialinstitutionstheemergenceofamodernformofbank
runsandtheinadequacyoftheregulatorystructurewhich
hadnotkeptupwithrecentfinancialinnovation(Infact
muchinnovationservedtoescaperegulations)
Conflicts of Interest Agency Problems
Conflictsofinterestthatcannotberesolvedeasilybyconshy
tractsormarketsoccurthroughouttheeconomybutthey
Copyrighted Material
InTroDuCT Ion bull 17
canbeparticularlyharmfulinthefinancialsystemThere
areseveralreasonsFirstmanyfinancialtransactionsand
contractsinvolveaprincipalsuchasaninvestororshareshy
holderaskingatradermanagerorotheragenttoacton
hisorherbehalfSecondmostfinancial transactions inshy
volvehighlyuncertainfuturepayoffsandinmanytransacshy
tionsonepartyisbetterinformedaboutthepayoffsthan
the otherThird the high volatility of the future payoffs
oftenmakesithardtoassesswhethertheoutcomeofafishy
nancialtransactionisduetotheagentrsquoseffortsorluckand
fourththesumsinvolvedcanbehuge
Someproprietarytradersforexampleearnalotwhen
their tradesdowellbuttheirpersonal lossesare limited
whentheirtradesdopoorlyBecauseoftheasymmetricnashy
tureoftheircompensationthesetraderscanincreasetheir
expectedincomebytakingriskierpositionsThisproblem
isdramaticallyillustratedbyperiodiccasesinwhichldquorogue
tradersrdquoincurlossesthatarebigenoughtodamageoreven
destroy large financial institutions In 1995 nick Leeson
broughtdownBaringsBankwitha$1billionlossandin
2008itwasrevealedthatJeacuterocircmeKervielhadseverelydamshy
agedSocieacuteteacuteGeacuteneacuteralewithalossofover$7billion
Conflictsofinterestorldquoagencyproblemsrdquoalsoexistat
manyotherlevelswithinthefinancialsystemShareholders
offinancialinstitutionshaveaconflictofinterestwiththe
bankrsquosseniorexecutivesespeciallywhenthoseexecutives
arerewardedforgoodperformancebutdonothavealarge
fractionoftheirwealthtiedupinthesharesofthebank
Manyfinancialinstitutionshavelargequantitiesofdebt
Copyrighted Material
18 bull CHapTer 1
which creates a conflict of interest between the bankrsquos
creditorsanditsshareholdersShareholdershaveanincenshy
tivetoauthorizeexcessivelyriskyinvestmentsforexample
especiallyafterabankhasincurredlossesthaterodethe
valueoftheshareholdersrsquoclaimThegainsontheserisky
investmentswillaccruelargelytoshareholderswhilethe
losseswillmostlybebornebycreditorsTheconflictwith
creditorsalsoreducestheincentivesfortheshareholders
of troubled institutions to raisenewcapitalbecause that
wouldstrengthen thepositionofcreditorswhilediluting
theshareholdersrsquopositionThisldquodebtoverhangrdquoproblem
waswidelycitedduringtheWorldFinancialCrisiswhen
many banks that were insolvent or close to insolvency
seemedreluctanteithertoraisenewcapitalortoreduce
theirrisksbysellingdistressedsecurities11
atthehighestlevelthereisaconflictofinterestbetween
societyasawholeandtheprivateownersoffinancialinshy
stitutions Because robust financial institutions promote
economicgrowthandemploymentduringfinancialcrises
governmentsoftenrescuetroubledfirmstheyperceiveto
be systemically importantThe result is privatized gains
andsocializedlossesIfthingsgowellthefirmsrsquoowners
andmanagersclaimtheprofitsbutifthingsgopoorlysoshy
cietysubsidizesthelosses
The candidates for government bailouts are popularly
describedasldquotoobigtofailrdquoMorepreciselytheargument
for government supportmdashwhich many economists chalshy
lengemdashisaboutfirmsthataretoosystemicallyimportantto
failInits200annualreporttheeuropeanCentralBank
describedsystemicriskasldquoTheriskthattheinabilityofone
Copyrighted Material
InTroDuCT Ion bull 19
institutiontomeetitsobligationswhenduewillcauseother
institutions to be unable tomeet their obligationswhen
dueSuchafailuremaycausesignificantliquidityorcredit
problemsandas a resultcould threaten the stabilityof
or confidence in marketsrdquo Systemically important firms
arethosewhosefailurecouldposealargethreattothestashy
bilityoforconfidenceinmarketsThesefirmsarelikelyto
belargebuttheyalsotendtohavecomplexinterconnecshy
tionswithotherfinancialinstitutions
Tooshybigshytoshyfailpoliciesoffersystemicallyimportantfirms
theexplicitorimplicitpromiseofabailoutwhenthingsgo
wrongThesepoliciesaredestructiveforseveralreasons
Firstbecause the possibility of a bailoutmeans a firmrsquos
stakeholders claim all the profits but only some of the
lossesfinancialfirmsthatmightreceivegovernmentsupshy
porthaveanincentivetotakeextrariskThefirmrsquosshareshy
holderscreditorsemployeesandmanagement all share
thetemptationTheresultisanincreaseintherisksborne
bysocietyasawhole
Secondthesepoliciesencouragesmallerfinancialinstishy
tutionstoexpandortobecomemorecloselyinterconnected
with other firms so they move under the tooshybigshytoshyfail
umbrellaFirmshaveanincentivetodowhateverittakes
tomakepolicymakersfeartheirfailurecreatingthevery
fragilitythegovernmentwishestoavoidBeliefthatagovshy
ernmentrescuewillprotectafinancial institutionrsquoscredishy
tors inacrisisalsogivesafirmacompetitiveadvantage
loweringitscostoffinancingandallowingittoofferbetter
prices to its customers than its fundamental productivity
warrants
Copyrighted Material
20 bull CHapTer 1
Thirdinefficientfirmsthatcannotcompeteontheirown
shouldfailotherwisefirmshavelessincentivetobecome
andstayefficientagovernmentpolicythatpropsupinshy
efficientfirmsiswastefulanddestructiveallowingthese
firmstofailfreesupresourcesandprovidesopportunities
formoreefficientandinnovativecompetitorstoflourish
Fourthandmostgenerallycapitalismisunderminedby
policiesthatprivatizegainsbutsocializelossesGovernment
guaranteedinstitutionscanbecomegovernmentruninstishy
tutionsallocatingcreditforexampletomaximizepolitical
gainratherthaneconomicwelfare
The conflictbetween society and theownersoffinanshy
cialfirmsbecomesmoreseriousduringseverecriseswhen
manyfinancialinstitutionsareclosetoinsolventIt isthe
primemotivationforourregulatoryproposalsbutseveral
ofthelowershylevelconflictswehavedescribedarerelevant
becausetheymagnifytheriskbornebysocietyasawhole
Theselfshyservingbehaviorthatmanyofourrecommenshy
dations targetmdashwhether by traders senior management
orthefirmrsquosownersmdashneednotbestrategicintentionally
maliciousorevenconsciousConsideratraderwhoinadshy
vertentlydevelopsaninvestmentstrategywithhighlyprobshy
ablegainsandimprobablebutlargelossesLikeafirmthat
hassoldearthquakeinsurancethestrategymayproducea
longstringofimpressivereturnsbeforeoneyearoflosses
wipesoutmanyyearsofprofits12 Ifsoduringthegood
yearsthetraderwillbecelebratedforhisorherbrilliance
rewarded with large bonuses and given more resources
to manageMany sophisticated traders and hedge funds
Copyrighted Material
InTroDuCT Ion bull 21
werenotawareoftheldquoearthquakerisksrdquoinherentinmany
of theirstrategiesSimilarlywhenfirmstakeactionsthat
increasethelikelihoodofagovernmentbailoutinthenext
financialcrisisthemarketrewardsthemwithalowercost
of capitalas firms become too big to fail for example
the implicit government guarantee reduces the riskiness
of their debt and lowers the interest rate demanded by
theircreditorsaCeoworkingtomaximizefirmvaluemay
notevenrealize the importanceof thegovernmentguarshy
anteebut a Darwinian process will encourage behavior
thatexploitsit
Bankruptcy and Resolution Procedures
Itisimpossibletowriteafinancialcontractthatspecifies
everypossiblecontingencyInsteadcontractsrelyonbankshy
ruptcytodetermineoutcomesincertainbadandunlikely
statesoftheworldInbankruptcycontrolofafirmistransshy
ferredfromtheshareholderswhonolongerhaveastake
inlossesbecausetheirsharesareworthlittletothedebtshy
holders It is in societyrsquos interest to develop bankruptcy
proceduresthatmaximizethepostshybankruptcyvalueofa
firmrsquosassetsInparticularsocietyshouldavoidthedestrucshy
tionofvaluethatoccurswithdisorderlyliquidation
Disorderlyliquidationoffinancialinstitutionsisparticushy
larly costlyFirstvaluableknowledge that the institution
hasaccumulatedaboutitscounterpartiesmdashborrowerstradshy
ingpartnersandsoonmdashcandisappearastheinstitution
losesemployeesandceasestooperatenormallyFinancial
Copyrighted Material
22 bull CHapTer 1
economistshavefoundthatthecollapseofabankhasamashy
terialadverseimpactonmanyofitsborrowers1 Second
the prospect of a disorderly liquidation makes it more
likelythatatroubledfinancialinstitutionwillsufferarun
by creditors who conclude they are better off claiming
whatmoney theycan todayrather thanwaiting through
protracted liquidation proceedings Third ldquofire salesrdquo of
specializedassets inadisorderly liquidationcandepress
prices and thereby spread problems to other holders of
theassetclassFourthdisorderlyliquidationincreasesthe
uncertaintyabouttheimpactofafinancialinstitutionrsquosfailshy
ureonitscounterpartiesandotherclaimholdersBecause
financialfirmsaretightlyinterconnectedthisuncertainty
canprecipitateorintensifyafinancialcrisis1
In theunitedStatesthestandardbankruptcycodealshy
lowsbothforliquidationofafirmandthesaleofitsassets
(Chapter7)andforcontinuedoperationofafirmunder
the supervision of a bankruptcy judgewho protects the
firmfromcreditorsrsquoclaimswhileareorganizationplanis
approved(Chapter11)Theseproceduresappeartowork
wellfornonfinancialcorporationsbutnotsowellforfinanshy
cialorganizationsTheChapter11approachofseparatinga
firmrsquosfinancialaffairsfromitsnonfinancialbusinessactivishy
tiesisinfeasiblewhenthebusinessofthefirmisfinancial
transactionsFurthermoremanyfinancialinstitutionsrely
heavily on shortshyterm debtpossibly as a valuable discishy
plineonbankexecutiveswhocanrapidlychangetherisks
theirfirmstakeThismakesfinancialfirmsvulnerabletoa
rapidwithdrawalofshortshytermcreditthatislikelytooccur
beforeanyeventthatwouldtriggerbankruptcy
Copyrighted Material
InTroDuCT Ion bull 2
Wearguebelowthatthereisaneedforaspecialresolushy
tionprocedurethatcanbeappliedtolargeinsolventfinanshy
cialinstitutionsWealsoadvocateregulatorychangesthat
would push financial firms towardmore resilient capital
structures
Bank Runs
Classicbank runs inwhichdepositors race towithdraw
their funds before a bank failswere one of the central
contributors to theGreatDepressionDeposit insurance
whichwasintroducedaftertheDepressiontocounterthis
destructiveprocessmadedemanddepositsoneofthemost
stableformsofbankfinancingduringtheWorldFinancial
CrisisManyfinancialinstitutionshoweversufferedamodshy
ernversionofbankruns
Banksespeciallythosewithinvestmentbankingactivishy
tiestypicallyfinanceasignificantfractionoftheirbusiness
withovernightcommercialpaperreposandothershortshy
terminstrumentsInnormaltimesbanksrolloverthisdebt
asitmaturestakingnewloanstopayofftheoldInacrishy
sishoweveruncertaintyaboutwhetheratroubledinstitushy
tionwouldbeabletopayoffitscreditorstomorrowcauses
lenderstostopextendingcredittodayThusshortshytermfishy
nancingcanleadtoarunthatissimilartoaclassicrunon
deposits
even some secured creditors participated in runs durshy
ingtheWorldFinancialCrisisBanksoftenuserepurchase
agreements to borrow money securing the loan by givshy
ingthelenderafinancialassetsuchasaTreasurybond
Copyrighted Material
2 bull CHapTer 1
ascollateralBecausetheyareovershycollateralizedwithasshy
setsworthperhaps$105guaranteeingevery$100inloans
lendersviewldquoreposrdquoasasafewaytoextendcreditWhen
credit markets froze during the Crisis however lenders
worried that retrieving collateral and selling itwouldbe
difficultandnotworththesmallinterestonanovernight
loanasaresultatvarioustimesduringtheCrisismany
investmentbankshaddifficultyrollingovereventheirseshy
cured loanseven relatively healthy financial institutions
werehamperedbythetroubleintherepomarketafteraushy
gust2007asthemarketbecamemoreandmoreuncertain
about the prices securities would fetch in a forced sale
these institutions found they could borrow less and less
withthesamecollateral15
prime brokerage accounts also saw a runshylike withshy
drawalbycustomersManylargebankshaveprimebrokershy
agegroupsthatassisthedgefundsandotherinstitutionalinshy
vestorsbyprovidingfinancingsecuritieslendingclearing
custodial servicesandoperational supportInexchange
thefundspayfeesandcriticallypostcollateraltosecure
theirloansWithsomerestrictionsthatweexplaininChapshy
ter10theprimebrokercanthenusethecollateralinits
ownbusinessinsomecasescomminglingitwiththefirmrsquos
ownassetsDuringtheCrisishedgefundsmonitoredthe
financial wellshybeing of their prime brokers and like deshy
positorsintheDepressionfledwiththeircollateralatthe
firstsignoftroubleBearStearnsforexamplehadalarge
prime brokerage business according to press accounts
oneofthelargesthedgefundsthatusedBearStearnsasa
Copyrighted Material
InTroDuCT Ion bull 25
primebrokerrenaissanceTechnologieswithdrew$5bilshy
lionofcashintheweekthefirmfailedWithsuchoutflows
it is not surprising that Bear Stearns ran out of money
eventhoughithadmorethan$18billionincashaweek
earlier
Likeclassicbankrunsmodernbankrunsarebothdeshy
structiveandselfshyfulfillingConcernthatabankmightbe
in trouble spurs its creditors and counterparties towithshy
draworwithholdtheircapitalasaresultevenrumorsofa
problemmaybeenoughtodestroyaviableinstitutionThe
importanceofmodernbankrunsduringtheWorldFinanshy
cialCrisisisarecurringthemethroughoutthebookand
wemakeseveralproposalsthatareintendedtoreducethe
frequencyofsuchevents
The Inadequacy of the Regulatory Structure
TheWorldFinancialCrisismadeitclearthatfinancialinnoshy
vationhadoverwhelmedexistingfinancialregulationsnoshy
tableexamplesincludeaIGrsquosdecisiontosellanextremely
large amount of credit default swaps on subprime debt
tobanksintheunitedStatesandabroadtheholdingof
Lehmanpaperbymoneymarketfundsparticularlythereshy
serveprimaryFundthecomplexityofthederivativebooks
atLehmanandotherinvestmentbanksandthedifficultyof
simultaneouslyapplyingseveralcountriesrsquobankruptcycodes
tothesubsidiariesofmultinationalfinancialinstitutions1
Thereisatradeshyoffbetweenfinancialinnovationandstashy
bilityInnovationcanimprovethefinancialsystemrsquosability
Copyrighted Material
2 bull CHapTer 1
toallocateresourcestotheirhighestvaluedusebutitcan
alsoreducethestabilityofthesystemThechallengeisto
developregulationsthatimprovestabilitywithoutstifling
innovation In addition regulation often leads to innoshy
vations designed to evade the regulationswhich makes
thefinancialsystemmorefragileForexamplemanyofthe
specialshypurposevehiclesthatimplodedintheCrisiswere
createdtogetaroundcapitalrequirements
In many countries the response of regulators to the
World Financial Crisis was hampered by the fragmented
nature of their regulatory systems Financial regulations
are typically designed to ensure thehealth of individual
institutionsratherthanthefinancialsystemasawholeIn
thisbookwearguethatsystemicregulationisanimporshy
tantfunctionthatrequiresaspecialmandateandthatthe
central bank is particularly well equipped to fulfill this
function
Finallyeffectivefinancialregulationrequiresthatpolitishy
ciansandultimatelythepublichaveanadequateundershy
standing of the financial system The political turmoil
surroundingtheCrisissuggeststheimportanceofdissemishy
natingexpertknowledgeaboutfinancetoabroaderaudishy
enceThisisoneofourmotivationsforwritingthisbook
What Were the orIgIns oF the World FInancIal crIsIs
LiketheoriginsoftheFirstWorldWarthecausesofthe
Crisiswillbedebatedbyscholarsformanyyears
Copyrighted Material
InTroDuCT Ion bull 27
Most observers agree that the strong runshyup and subshy
sequentsharpdeclineinthepricesofstockshousesand
otherfinancialassetsindevelopedcountrieswasanimporshy
tantcatalystfortheCrisisThereisdisagreementhowever
aboutwhetherthispatterninpricesistheresultofrational
investorbehaviororldquoirrationalbubblesrdquo
SomearguethattherunshyupbeforetheCrisiswasdriven
by investorswhoknowingly acceptedunusually low exshy
pectedreturnsandtheyofferseveralpossiblereasonswhy
Firsttherewasasurgeofsavingsinemergingcountries
drivenbyacombinationofrapideconomicgrowthanddeshy
mographicsperhapsbecauseofadesiretoaccumulateforshy
eignreservesintheaftermathoftheasiacrisisof1997ndash98
muchof thiswealthwas invested indevelopedmarkets
Secondfinancialmarketswereunusually tranquilduring
200to200Withlowvolatilityinvestorsmayhavesettled
for a low risk premiumThird influenced by fears of a
Japaneseshystyledeflation resulting from themarketdownshy
turnof2000ndash2001andbyabeliefthattheyshouldnottry
to usemonetary policy to counteract rising asset prices
central bankers in the united States maintained a loose
monetarypolicythroughouttheperiod17andfromthisrashy
tionalviewofinvestorstheplungeinassetpricesthatacshy
companiedtheCrisiswascausedbybadnewsaboutfuture
cashflowsunexpectedincreasesinthereturnsrequiredby
investorsorboth
otherssuggestamoredirectexplanationThehighprices
before theCrisisweredrivenby an irrational belief that
prices would continue to rise and the collapse of asset
priceswastheinevitableresultofthismistakeWhatever
Copyrighted Material
28 bull CHapTer 1
theexplanationthesharpdropinassetpricesbothconshy
tributedtoandwasasymptomoftheCrisis
other commentators argue that the financial system
becamevulnerablebecausemanymarketparticipantsasshy
sessedrisksinaccuratelyduringtheperiodleadingupto
theWorldFinancialCrisisConsumersbanksandinvestors
ingeneralunderestimatedtheriskofhousepricedeclines
increasingthepricestheywerewillingtopayforrealesshy
tatethecredittheywerewillingtoextendandthevaluashy
tionsofbanksthatextendedsuchcreditBanksputmuch
weight on the recent pastwhen they estimated value at
riskwhichledthemtoconcludethatthelevelofriskwas
lowandthattherewaslittledownsidetohavinghighleshy
verageothermarketparticipantsdidnotfullyappreciate
thathighliquiditywassuppressingvolatilityandthatthe
processmightreversewithliquiditydecreasingandvolatilshy
ityincreasing
More generally the high level of financial innovation
driveninpartbythedecliningcostofinformationtechnolshy
ogymadeithardforriskassessmenttokeeppacewiththe
evolvingfinancialsystem18Thebenignenvironmentofthe
creditboomexacerbatedthisproblembytemptingfinanshy
cialinstitutionstounderinvestinriskmanagement
uSpolicymakersalsocontributedtotheseverityofthe
CrisisbypushingFannieMaeandFreddieMactoincrease
theavailabilityofmortgagefundingtoborrowerswithquesshy
tionableabilitytorepaytheirmortgagesasaresultofthis
pressure both agencies relaxed their standards for the
mortgages they purchased and guaranteedThe demand
Copyrighted Material
InTroDuCT Ion bull 29
forhomesbyborrowerswhoqualifiedformortgagesbeshy
causeoftheselowerstandardspusheduppricesandthe
defaultbymanyofthemduringtherecessioncontributed
tothedropinhomeprices
Thepanicandruninthefallof2008remainthecentral
distinguishingfeaturesoftheWorldFinancialCrisisasset
priceshave risenand fallenbeforeand theworldeconshy
omyhasbornelargefinancial lossesmanytimeswithout
suchasevereeconomicoutcomeConverselylossesfrom
completelydifferentunderlyingsourcesmdashcommercialreal
estateorperhapssovereigndefaultsmdashcouldcauseasimilar
catastrophe if theyagainprovoke tooshybigshytoshyfailchaosor
runs
Thisbookdoesnotseektoprovideacompletediagnosis
oftheWorldFinancialCrisisnordoesittakeastandonthe
relativeimportanceofthecontributingfactorslistedabove
ratherwebelieveourrecommendationswillhelpprevent
ormitigatefuturecriseseventhoughwedonotfullyundershy
standallthecausesofthelastone
CarmenreinhartandKennethrogoff amongothershave
pointedoutthatfinancialcriseshaveoccurredthroughout
thehistoryofcapitalismandthatthesecrisessharemany
commonpatterns19 Thelessonwedrawfromthisisthat
noacceptablesetofregulationscanpreventmarketparticishy
pantsfrommakingmistakesthatcreateeconomicinstability
ourpurposeinthisbookisinsteadtosuggestregulatory
reformsthatwillmakethesystemmorestabledespitethe
mistakesthataresuretocome
Copyrighted Material
1 bull CHapTer 1
economistswillargueabouttheeventsoftheWorldFishy
nancialCrisisforyearstocomeInfactwestillargueabout
theGreatDepressionnoneoftheanalysisbehindourrecshy
ommendationshoweverdepends onhow these debates
aresettledForexamplenomatterhowcapitalshyconstrained
thebankingsystemreallywasinthefallof2008ourproshy
posalsforchangesthatmakesuchconstraintslessbinding
andgivepolicymakersbettertoolswhentheyfearcapital
constraintsremainvalid
What Was Wrong WIth the FInancIal system durIng the crIsIs
The Crisis revealed a number of serious problems with
ourfinancialsystemSomehadbeeninthebackgroundall
alongothersdidnotappearuntiltheCrisisInthisbook
weemphasizefourcategoriesofproblemsconflictsofinshy
terestknowntoeconomistsasagencyproblemsthediffishy
cultyofapplyingstandardbankruptcyprocedurestofinanshy
cialinstitutionstheemergenceofamodernformofbank
runsandtheinadequacyoftheregulatorystructurewhich
hadnotkeptupwithrecentfinancialinnovation(Infact
muchinnovationservedtoescaperegulations)
Conflicts of Interest Agency Problems
Conflictsofinterestthatcannotberesolvedeasilybyconshy
tractsormarketsoccurthroughouttheeconomybutthey
Copyrighted Material
InTroDuCT Ion bull 17
canbeparticularlyharmfulinthefinancialsystemThere
areseveralreasonsFirstmanyfinancialtransactionsand
contractsinvolveaprincipalsuchasaninvestororshareshy
holderaskingatradermanagerorotheragenttoacton
hisorherbehalfSecondmostfinancial transactions inshy
volvehighlyuncertainfuturepayoffsandinmanytransacshy
tionsonepartyisbetterinformedaboutthepayoffsthan
the otherThird the high volatility of the future payoffs
oftenmakesithardtoassesswhethertheoutcomeofafishy
nancialtransactionisduetotheagentrsquoseffortsorluckand
fourththesumsinvolvedcanbehuge
Someproprietarytradersforexampleearnalotwhen
their tradesdowellbuttheirpersonal lossesare limited
whentheirtradesdopoorlyBecauseoftheasymmetricnashy
tureoftheircompensationthesetraderscanincreasetheir
expectedincomebytakingriskierpositionsThisproblem
isdramaticallyillustratedbyperiodiccasesinwhichldquorogue
tradersrdquoincurlossesthatarebigenoughtodamageoreven
destroy large financial institutions In 1995 nick Leeson
broughtdownBaringsBankwitha$1billionlossandin
2008itwasrevealedthatJeacuterocircmeKervielhadseverelydamshy
agedSocieacuteteacuteGeacuteneacuteralewithalossofover$7billion
Conflictsofinterestorldquoagencyproblemsrdquoalsoexistat
manyotherlevelswithinthefinancialsystemShareholders
offinancialinstitutionshaveaconflictofinterestwiththe
bankrsquosseniorexecutivesespeciallywhenthoseexecutives
arerewardedforgoodperformancebutdonothavealarge
fractionoftheirwealthtiedupinthesharesofthebank
Manyfinancialinstitutionshavelargequantitiesofdebt
Copyrighted Material
18 bull CHapTer 1
which creates a conflict of interest between the bankrsquos
creditorsanditsshareholdersShareholdershaveanincenshy
tivetoauthorizeexcessivelyriskyinvestmentsforexample
especiallyafterabankhasincurredlossesthaterodethe
valueoftheshareholdersrsquoclaimThegainsontheserisky
investmentswillaccruelargelytoshareholderswhilethe
losseswillmostlybebornebycreditorsTheconflictwith
creditorsalsoreducestheincentivesfortheshareholders
of troubled institutions to raisenewcapitalbecause that
wouldstrengthen thepositionofcreditorswhilediluting
theshareholdersrsquopositionThisldquodebtoverhangrdquoproblem
waswidelycitedduringtheWorldFinancialCrisiswhen
many banks that were insolvent or close to insolvency
seemedreluctanteithertoraisenewcapitalortoreduce
theirrisksbysellingdistressedsecurities11
atthehighestlevelthereisaconflictofinterestbetween
societyasawholeandtheprivateownersoffinancialinshy
stitutions Because robust financial institutions promote
economicgrowthandemploymentduringfinancialcrises
governmentsoftenrescuetroubledfirmstheyperceiveto
be systemically importantThe result is privatized gains
andsocializedlossesIfthingsgowellthefirmsrsquoowners
andmanagersclaimtheprofitsbutifthingsgopoorlysoshy
cietysubsidizesthelosses
The candidates for government bailouts are popularly
describedasldquotoobigtofailrdquoMorepreciselytheargument
for government supportmdashwhich many economists chalshy
lengemdashisaboutfirmsthataretoosystemicallyimportantto
failInits200annualreporttheeuropeanCentralBank
describedsystemicriskasldquoTheriskthattheinabilityofone
Copyrighted Material
InTroDuCT Ion bull 19
institutiontomeetitsobligationswhenduewillcauseother
institutions to be unable tomeet their obligationswhen
dueSuchafailuremaycausesignificantliquidityorcredit
problemsandas a resultcould threaten the stabilityof
or confidence in marketsrdquo Systemically important firms
arethosewhosefailurecouldposealargethreattothestashy
bilityoforconfidenceinmarketsThesefirmsarelikelyto
belargebuttheyalsotendtohavecomplexinterconnecshy
tionswithotherfinancialinstitutions
Tooshybigshytoshyfailpoliciesoffersystemicallyimportantfirms
theexplicitorimplicitpromiseofabailoutwhenthingsgo
wrongThesepoliciesaredestructiveforseveralreasons
Firstbecause the possibility of a bailoutmeans a firmrsquos
stakeholders claim all the profits but only some of the
lossesfinancialfirmsthatmightreceivegovernmentsupshy
porthaveanincentivetotakeextrariskThefirmrsquosshareshy
holderscreditorsemployeesandmanagement all share
thetemptationTheresultisanincreaseintherisksborne
bysocietyasawhole
Secondthesepoliciesencouragesmallerfinancialinstishy
tutionstoexpandortobecomemorecloselyinterconnected
with other firms so they move under the tooshybigshytoshyfail
umbrellaFirmshaveanincentivetodowhateverittakes
tomakepolicymakersfeartheirfailurecreatingthevery
fragilitythegovernmentwishestoavoidBeliefthatagovshy
ernmentrescuewillprotectafinancial institutionrsquoscredishy
tors inacrisisalsogivesafirmacompetitiveadvantage
loweringitscostoffinancingandallowingittoofferbetter
prices to its customers than its fundamental productivity
warrants
Copyrighted Material
20 bull CHapTer 1
Thirdinefficientfirmsthatcannotcompeteontheirown
shouldfailotherwisefirmshavelessincentivetobecome
andstayefficientagovernmentpolicythatpropsupinshy
efficientfirmsiswastefulanddestructiveallowingthese
firmstofailfreesupresourcesandprovidesopportunities
formoreefficientandinnovativecompetitorstoflourish
Fourthandmostgenerallycapitalismisunderminedby
policiesthatprivatizegainsbutsocializelossesGovernment
guaranteedinstitutionscanbecomegovernmentruninstishy
tutionsallocatingcreditforexampletomaximizepolitical
gainratherthaneconomicwelfare
The conflictbetween society and theownersoffinanshy
cialfirmsbecomesmoreseriousduringseverecriseswhen
manyfinancialinstitutionsareclosetoinsolventIt isthe
primemotivationforourregulatoryproposalsbutseveral
ofthelowershylevelconflictswehavedescribedarerelevant
becausetheymagnifytheriskbornebysocietyasawhole
Theselfshyservingbehaviorthatmanyofourrecommenshy
dations targetmdashwhether by traders senior management
orthefirmrsquosownersmdashneednotbestrategicintentionally
maliciousorevenconsciousConsideratraderwhoinadshy
vertentlydevelopsaninvestmentstrategywithhighlyprobshy
ablegainsandimprobablebutlargelossesLikeafirmthat
hassoldearthquakeinsurancethestrategymayproducea
longstringofimpressivereturnsbeforeoneyearoflosses
wipesoutmanyyearsofprofits12 Ifsoduringthegood
yearsthetraderwillbecelebratedforhisorherbrilliance
rewarded with large bonuses and given more resources
to manageMany sophisticated traders and hedge funds
Copyrighted Material
InTroDuCT Ion bull 21
werenotawareoftheldquoearthquakerisksrdquoinherentinmany
of theirstrategiesSimilarlywhenfirmstakeactionsthat
increasethelikelihoodofagovernmentbailoutinthenext
financialcrisisthemarketrewardsthemwithalowercost
of capitalas firms become too big to fail for example
the implicit government guarantee reduces the riskiness
of their debt and lowers the interest rate demanded by
theircreditorsaCeoworkingtomaximizefirmvaluemay
notevenrealize the importanceof thegovernmentguarshy
anteebut a Darwinian process will encourage behavior
thatexploitsit
Bankruptcy and Resolution Procedures
Itisimpossibletowriteafinancialcontractthatspecifies
everypossiblecontingencyInsteadcontractsrelyonbankshy
ruptcytodetermineoutcomesincertainbadandunlikely
statesoftheworldInbankruptcycontrolofafirmistransshy
ferredfromtheshareholderswhonolongerhaveastake
inlossesbecausetheirsharesareworthlittletothedebtshy
holders It is in societyrsquos interest to develop bankruptcy
proceduresthatmaximizethepostshybankruptcyvalueofa
firmrsquosassetsInparticularsocietyshouldavoidthedestrucshy
tionofvaluethatoccurswithdisorderlyliquidation
Disorderlyliquidationoffinancialinstitutionsisparticushy
larly costlyFirstvaluableknowledge that the institution
hasaccumulatedaboutitscounterpartiesmdashborrowerstradshy
ingpartnersandsoonmdashcandisappearastheinstitution
losesemployeesandceasestooperatenormallyFinancial
Copyrighted Material
22 bull CHapTer 1
economistshavefoundthatthecollapseofabankhasamashy
terialadverseimpactonmanyofitsborrowers1 Second
the prospect of a disorderly liquidation makes it more
likelythatatroubledfinancialinstitutionwillsufferarun
by creditors who conclude they are better off claiming
whatmoney theycan todayrather thanwaiting through
protracted liquidation proceedings Third ldquofire salesrdquo of
specializedassets inadisorderly liquidationcandepress
prices and thereby spread problems to other holders of
theassetclassFourthdisorderlyliquidationincreasesthe
uncertaintyabouttheimpactofafinancialinstitutionrsquosfailshy
ureonitscounterpartiesandotherclaimholdersBecause
financialfirmsaretightlyinterconnectedthisuncertainty
canprecipitateorintensifyafinancialcrisis1
In theunitedStatesthestandardbankruptcycodealshy
lowsbothforliquidationofafirmandthesaleofitsassets
(Chapter7)andforcontinuedoperationofafirmunder
the supervision of a bankruptcy judgewho protects the
firmfromcreditorsrsquoclaimswhileareorganizationplanis
approved(Chapter11)Theseproceduresappeartowork
wellfornonfinancialcorporationsbutnotsowellforfinanshy
cialorganizationsTheChapter11approachofseparatinga
firmrsquosfinancialaffairsfromitsnonfinancialbusinessactivishy
tiesisinfeasiblewhenthebusinessofthefirmisfinancial
transactionsFurthermoremanyfinancialinstitutionsrely
heavily on shortshyterm debtpossibly as a valuable discishy
plineonbankexecutiveswhocanrapidlychangetherisks
theirfirmstakeThismakesfinancialfirmsvulnerabletoa
rapidwithdrawalofshortshytermcreditthatislikelytooccur
beforeanyeventthatwouldtriggerbankruptcy
Copyrighted Material
InTroDuCT Ion bull 2
Wearguebelowthatthereisaneedforaspecialresolushy
tionprocedurethatcanbeappliedtolargeinsolventfinanshy
cialinstitutionsWealsoadvocateregulatorychangesthat
would push financial firms towardmore resilient capital
structures
Bank Runs
Classicbank runs inwhichdepositors race towithdraw
their funds before a bank failswere one of the central
contributors to theGreatDepressionDeposit insurance
whichwasintroducedaftertheDepressiontocounterthis
destructiveprocessmadedemanddepositsoneofthemost
stableformsofbankfinancingduringtheWorldFinancial
CrisisManyfinancialinstitutionshoweversufferedamodshy
ernversionofbankruns
Banksespeciallythosewithinvestmentbankingactivishy
tiestypicallyfinanceasignificantfractionoftheirbusiness
withovernightcommercialpaperreposandothershortshy
terminstrumentsInnormaltimesbanksrolloverthisdebt
asitmaturestakingnewloanstopayofftheoldInacrishy
sishoweveruncertaintyaboutwhetheratroubledinstitushy
tionwouldbeabletopayoffitscreditorstomorrowcauses
lenderstostopextendingcredittodayThusshortshytermfishy
nancingcanleadtoarunthatissimilartoaclassicrunon
deposits
even some secured creditors participated in runs durshy
ingtheWorldFinancialCrisisBanksoftenuserepurchase
agreements to borrow money securing the loan by givshy
ingthelenderafinancialassetsuchasaTreasurybond
Copyrighted Material
2 bull CHapTer 1
ascollateralBecausetheyareovershycollateralizedwithasshy
setsworthperhaps$105guaranteeingevery$100inloans
lendersviewldquoreposrdquoasasafewaytoextendcreditWhen
credit markets froze during the Crisis however lenders
worried that retrieving collateral and selling itwouldbe
difficultandnotworththesmallinterestonanovernight
loanasaresultatvarioustimesduringtheCrisismany
investmentbankshaddifficultyrollingovereventheirseshy
cured loanseven relatively healthy financial institutions
werehamperedbythetroubleintherepomarketafteraushy
gust2007asthemarketbecamemoreandmoreuncertain
about the prices securities would fetch in a forced sale
these institutions found they could borrow less and less
withthesamecollateral15
prime brokerage accounts also saw a runshylike withshy
drawalbycustomersManylargebankshaveprimebrokershy
agegroupsthatassisthedgefundsandotherinstitutionalinshy
vestorsbyprovidingfinancingsecuritieslendingclearing
custodial servicesandoperational supportInexchange
thefundspayfeesandcriticallypostcollateraltosecure
theirloansWithsomerestrictionsthatweexplaininChapshy
ter10theprimebrokercanthenusethecollateralinits
ownbusinessinsomecasescomminglingitwiththefirmrsquos
ownassetsDuringtheCrisishedgefundsmonitoredthe
financial wellshybeing of their prime brokers and like deshy
positorsintheDepressionfledwiththeircollateralatthe
firstsignoftroubleBearStearnsforexamplehadalarge
prime brokerage business according to press accounts
oneofthelargesthedgefundsthatusedBearStearnsasa
Copyrighted Material
InTroDuCT Ion bull 25
primebrokerrenaissanceTechnologieswithdrew$5bilshy
lionofcashintheweekthefirmfailedWithsuchoutflows
it is not surprising that Bear Stearns ran out of money
eventhoughithadmorethan$18billionincashaweek
earlier
Likeclassicbankrunsmodernbankrunsarebothdeshy
structiveandselfshyfulfillingConcernthatabankmightbe
in trouble spurs its creditors and counterparties towithshy
draworwithholdtheircapitalasaresultevenrumorsofa
problemmaybeenoughtodestroyaviableinstitutionThe
importanceofmodernbankrunsduringtheWorldFinanshy
cialCrisisisarecurringthemethroughoutthebookand
wemakeseveralproposalsthatareintendedtoreducethe
frequencyofsuchevents
The Inadequacy of the Regulatory Structure
TheWorldFinancialCrisismadeitclearthatfinancialinnoshy
vationhadoverwhelmedexistingfinancialregulationsnoshy
tableexamplesincludeaIGrsquosdecisiontosellanextremely
large amount of credit default swaps on subprime debt
tobanksintheunitedStatesandabroadtheholdingof
Lehmanpaperbymoneymarketfundsparticularlythereshy
serveprimaryFundthecomplexityofthederivativebooks
atLehmanandotherinvestmentbanksandthedifficultyof
simultaneouslyapplyingseveralcountriesrsquobankruptcycodes
tothesubsidiariesofmultinationalfinancialinstitutions1
Thereisatradeshyoffbetweenfinancialinnovationandstashy
bilityInnovationcanimprovethefinancialsystemrsquosability
Copyrighted Material
2 bull CHapTer 1
toallocateresourcestotheirhighestvaluedusebutitcan
alsoreducethestabilityofthesystemThechallengeisto
developregulationsthatimprovestabilitywithoutstifling
innovation In addition regulation often leads to innoshy
vations designed to evade the regulationswhich makes
thefinancialsystemmorefragileForexamplemanyofthe
specialshypurposevehiclesthatimplodedintheCrisiswere
createdtogetaroundcapitalrequirements
In many countries the response of regulators to the
World Financial Crisis was hampered by the fragmented
nature of their regulatory systems Financial regulations
are typically designed to ensure thehealth of individual
institutionsratherthanthefinancialsystemasawholeIn
thisbookwearguethatsystemicregulationisanimporshy
tantfunctionthatrequiresaspecialmandateandthatthe
central bank is particularly well equipped to fulfill this
function
Finallyeffectivefinancialregulationrequiresthatpolitishy
ciansandultimatelythepublichaveanadequateundershy
standing of the financial system The political turmoil
surroundingtheCrisissuggeststheimportanceofdissemishy
natingexpertknowledgeaboutfinancetoabroaderaudishy
enceThisisoneofourmotivationsforwritingthisbook
What Were the orIgIns oF the World FInancIal crIsIs
LiketheoriginsoftheFirstWorldWarthecausesofthe
Crisiswillbedebatedbyscholarsformanyyears
Copyrighted Material
InTroDuCT Ion bull 27
Most observers agree that the strong runshyup and subshy
sequentsharpdeclineinthepricesofstockshousesand
otherfinancialassetsindevelopedcountrieswasanimporshy
tantcatalystfortheCrisisThereisdisagreementhowever
aboutwhetherthispatterninpricesistheresultofrational
investorbehaviororldquoirrationalbubblesrdquo
SomearguethattherunshyupbeforetheCrisiswasdriven
by investorswhoknowingly acceptedunusually low exshy
pectedreturnsandtheyofferseveralpossiblereasonswhy
Firsttherewasasurgeofsavingsinemergingcountries
drivenbyacombinationofrapideconomicgrowthanddeshy
mographicsperhapsbecauseofadesiretoaccumulateforshy
eignreservesintheaftermathoftheasiacrisisof1997ndash98
muchof thiswealthwas invested indevelopedmarkets
Secondfinancialmarketswereunusually tranquilduring
200to200Withlowvolatilityinvestorsmayhavesettled
for a low risk premiumThird influenced by fears of a
Japaneseshystyledeflation resulting from themarketdownshy
turnof2000ndash2001andbyabeliefthattheyshouldnottry
to usemonetary policy to counteract rising asset prices
central bankers in the united States maintained a loose
monetarypolicythroughouttheperiod17andfromthisrashy
tionalviewofinvestorstheplungeinassetpricesthatacshy
companiedtheCrisiswascausedbybadnewsaboutfuture
cashflowsunexpectedincreasesinthereturnsrequiredby
investorsorboth
otherssuggestamoredirectexplanationThehighprices
before theCrisisweredrivenby an irrational belief that
prices would continue to rise and the collapse of asset
priceswastheinevitableresultofthismistakeWhatever
Copyrighted Material
28 bull CHapTer 1
theexplanationthesharpdropinassetpricesbothconshy
tributedtoandwasasymptomoftheCrisis
other commentators argue that the financial system
becamevulnerablebecausemanymarketparticipantsasshy
sessedrisksinaccuratelyduringtheperiodleadingupto
theWorldFinancialCrisisConsumersbanksandinvestors
ingeneralunderestimatedtheriskofhousepricedeclines
increasingthepricestheywerewillingtopayforrealesshy
tatethecredittheywerewillingtoextendandthevaluashy
tionsofbanksthatextendedsuchcreditBanksputmuch
weight on the recent pastwhen they estimated value at
riskwhichledthemtoconcludethatthelevelofriskwas
lowandthattherewaslittledownsidetohavinghighleshy
verageothermarketparticipantsdidnotfullyappreciate
thathighliquiditywassuppressingvolatilityandthatthe
processmightreversewithliquiditydecreasingandvolatilshy
ityincreasing
More generally the high level of financial innovation
driveninpartbythedecliningcostofinformationtechnolshy
ogymadeithardforriskassessmenttokeeppacewiththe
evolvingfinancialsystem18Thebenignenvironmentofthe
creditboomexacerbatedthisproblembytemptingfinanshy
cialinstitutionstounderinvestinriskmanagement
uSpolicymakersalsocontributedtotheseverityofthe
CrisisbypushingFannieMaeandFreddieMactoincrease
theavailabilityofmortgagefundingtoborrowerswithquesshy
tionableabilitytorepaytheirmortgagesasaresultofthis
pressure both agencies relaxed their standards for the
mortgages they purchased and guaranteedThe demand
Copyrighted Material
InTroDuCT Ion bull 29
forhomesbyborrowerswhoqualifiedformortgagesbeshy
causeoftheselowerstandardspusheduppricesandthe
defaultbymanyofthemduringtherecessioncontributed
tothedropinhomeprices
Thepanicandruninthefallof2008remainthecentral
distinguishingfeaturesoftheWorldFinancialCrisisasset
priceshave risenand fallenbeforeand theworldeconshy
omyhasbornelargefinancial lossesmanytimeswithout
suchasevereeconomicoutcomeConverselylossesfrom
completelydifferentunderlyingsourcesmdashcommercialreal
estateorperhapssovereigndefaultsmdashcouldcauseasimilar
catastrophe if theyagainprovoke tooshybigshytoshyfailchaosor
runs
Thisbookdoesnotseektoprovideacompletediagnosis
oftheWorldFinancialCrisisnordoesittakeastandonthe
relativeimportanceofthecontributingfactorslistedabove
ratherwebelieveourrecommendationswillhelpprevent
ormitigatefuturecriseseventhoughwedonotfullyundershy
standallthecausesofthelastone
CarmenreinhartandKennethrogoff amongothershave
pointedoutthatfinancialcriseshaveoccurredthroughout
thehistoryofcapitalismandthatthesecrisessharemany
commonpatterns19 Thelessonwedrawfromthisisthat
noacceptablesetofregulationscanpreventmarketparticishy
pantsfrommakingmistakesthatcreateeconomicinstability
ourpurposeinthisbookisinsteadtosuggestregulatory
reformsthatwillmakethesystemmorestabledespitethe
mistakesthataresuretocome
Copyrighted Material
InTroDuCT Ion bull 17
canbeparticularlyharmfulinthefinancialsystemThere
areseveralreasonsFirstmanyfinancialtransactionsand
contractsinvolveaprincipalsuchasaninvestororshareshy
holderaskingatradermanagerorotheragenttoacton
hisorherbehalfSecondmostfinancial transactions inshy
volvehighlyuncertainfuturepayoffsandinmanytransacshy
tionsonepartyisbetterinformedaboutthepayoffsthan
the otherThird the high volatility of the future payoffs
oftenmakesithardtoassesswhethertheoutcomeofafishy
nancialtransactionisduetotheagentrsquoseffortsorluckand
fourththesumsinvolvedcanbehuge
Someproprietarytradersforexampleearnalotwhen
their tradesdowellbuttheirpersonal lossesare limited
whentheirtradesdopoorlyBecauseoftheasymmetricnashy
tureoftheircompensationthesetraderscanincreasetheir
expectedincomebytakingriskierpositionsThisproblem
isdramaticallyillustratedbyperiodiccasesinwhichldquorogue
tradersrdquoincurlossesthatarebigenoughtodamageoreven
destroy large financial institutions In 1995 nick Leeson
broughtdownBaringsBankwitha$1billionlossandin
2008itwasrevealedthatJeacuterocircmeKervielhadseverelydamshy
agedSocieacuteteacuteGeacuteneacuteralewithalossofover$7billion
Conflictsofinterestorldquoagencyproblemsrdquoalsoexistat
manyotherlevelswithinthefinancialsystemShareholders
offinancialinstitutionshaveaconflictofinterestwiththe
bankrsquosseniorexecutivesespeciallywhenthoseexecutives
arerewardedforgoodperformancebutdonothavealarge
fractionoftheirwealthtiedupinthesharesofthebank
Manyfinancialinstitutionshavelargequantitiesofdebt
Copyrighted Material
18 bull CHapTer 1
which creates a conflict of interest between the bankrsquos
creditorsanditsshareholdersShareholdershaveanincenshy
tivetoauthorizeexcessivelyriskyinvestmentsforexample
especiallyafterabankhasincurredlossesthaterodethe
valueoftheshareholdersrsquoclaimThegainsontheserisky
investmentswillaccruelargelytoshareholderswhilethe
losseswillmostlybebornebycreditorsTheconflictwith
creditorsalsoreducestheincentivesfortheshareholders
of troubled institutions to raisenewcapitalbecause that
wouldstrengthen thepositionofcreditorswhilediluting
theshareholdersrsquopositionThisldquodebtoverhangrdquoproblem
waswidelycitedduringtheWorldFinancialCrisiswhen
many banks that were insolvent or close to insolvency
seemedreluctanteithertoraisenewcapitalortoreduce
theirrisksbysellingdistressedsecurities11
atthehighestlevelthereisaconflictofinterestbetween
societyasawholeandtheprivateownersoffinancialinshy
stitutions Because robust financial institutions promote
economicgrowthandemploymentduringfinancialcrises
governmentsoftenrescuetroubledfirmstheyperceiveto
be systemically importantThe result is privatized gains
andsocializedlossesIfthingsgowellthefirmsrsquoowners
andmanagersclaimtheprofitsbutifthingsgopoorlysoshy
cietysubsidizesthelosses
The candidates for government bailouts are popularly
describedasldquotoobigtofailrdquoMorepreciselytheargument
for government supportmdashwhich many economists chalshy
lengemdashisaboutfirmsthataretoosystemicallyimportantto
failInits200annualreporttheeuropeanCentralBank
describedsystemicriskasldquoTheriskthattheinabilityofone
Copyrighted Material
InTroDuCT Ion bull 19
institutiontomeetitsobligationswhenduewillcauseother
institutions to be unable tomeet their obligationswhen
dueSuchafailuremaycausesignificantliquidityorcredit
problemsandas a resultcould threaten the stabilityof
or confidence in marketsrdquo Systemically important firms
arethosewhosefailurecouldposealargethreattothestashy
bilityoforconfidenceinmarketsThesefirmsarelikelyto
belargebuttheyalsotendtohavecomplexinterconnecshy
tionswithotherfinancialinstitutions
Tooshybigshytoshyfailpoliciesoffersystemicallyimportantfirms
theexplicitorimplicitpromiseofabailoutwhenthingsgo
wrongThesepoliciesaredestructiveforseveralreasons
Firstbecause the possibility of a bailoutmeans a firmrsquos
stakeholders claim all the profits but only some of the
lossesfinancialfirmsthatmightreceivegovernmentsupshy
porthaveanincentivetotakeextrariskThefirmrsquosshareshy
holderscreditorsemployeesandmanagement all share
thetemptationTheresultisanincreaseintherisksborne
bysocietyasawhole
Secondthesepoliciesencouragesmallerfinancialinstishy
tutionstoexpandortobecomemorecloselyinterconnected
with other firms so they move under the tooshybigshytoshyfail
umbrellaFirmshaveanincentivetodowhateverittakes
tomakepolicymakersfeartheirfailurecreatingthevery
fragilitythegovernmentwishestoavoidBeliefthatagovshy
ernmentrescuewillprotectafinancial institutionrsquoscredishy
tors inacrisisalsogivesafirmacompetitiveadvantage
loweringitscostoffinancingandallowingittoofferbetter
prices to its customers than its fundamental productivity
warrants
Copyrighted Material
20 bull CHapTer 1
Thirdinefficientfirmsthatcannotcompeteontheirown
shouldfailotherwisefirmshavelessincentivetobecome
andstayefficientagovernmentpolicythatpropsupinshy
efficientfirmsiswastefulanddestructiveallowingthese
firmstofailfreesupresourcesandprovidesopportunities
formoreefficientandinnovativecompetitorstoflourish
Fourthandmostgenerallycapitalismisunderminedby
policiesthatprivatizegainsbutsocializelossesGovernment
guaranteedinstitutionscanbecomegovernmentruninstishy
tutionsallocatingcreditforexampletomaximizepolitical
gainratherthaneconomicwelfare
The conflictbetween society and theownersoffinanshy
cialfirmsbecomesmoreseriousduringseverecriseswhen
manyfinancialinstitutionsareclosetoinsolventIt isthe
primemotivationforourregulatoryproposalsbutseveral
ofthelowershylevelconflictswehavedescribedarerelevant
becausetheymagnifytheriskbornebysocietyasawhole
Theselfshyservingbehaviorthatmanyofourrecommenshy
dations targetmdashwhether by traders senior management
orthefirmrsquosownersmdashneednotbestrategicintentionally
maliciousorevenconsciousConsideratraderwhoinadshy
vertentlydevelopsaninvestmentstrategywithhighlyprobshy
ablegainsandimprobablebutlargelossesLikeafirmthat
hassoldearthquakeinsurancethestrategymayproducea
longstringofimpressivereturnsbeforeoneyearoflosses
wipesoutmanyyearsofprofits12 Ifsoduringthegood
yearsthetraderwillbecelebratedforhisorherbrilliance
rewarded with large bonuses and given more resources
to manageMany sophisticated traders and hedge funds
Copyrighted Material
InTroDuCT Ion bull 21
werenotawareoftheldquoearthquakerisksrdquoinherentinmany
of theirstrategiesSimilarlywhenfirmstakeactionsthat
increasethelikelihoodofagovernmentbailoutinthenext
financialcrisisthemarketrewardsthemwithalowercost
of capitalas firms become too big to fail for example
the implicit government guarantee reduces the riskiness
of their debt and lowers the interest rate demanded by
theircreditorsaCeoworkingtomaximizefirmvaluemay
notevenrealize the importanceof thegovernmentguarshy
anteebut a Darwinian process will encourage behavior
thatexploitsit
Bankruptcy and Resolution Procedures
Itisimpossibletowriteafinancialcontractthatspecifies
everypossiblecontingencyInsteadcontractsrelyonbankshy
ruptcytodetermineoutcomesincertainbadandunlikely
statesoftheworldInbankruptcycontrolofafirmistransshy
ferredfromtheshareholderswhonolongerhaveastake
inlossesbecausetheirsharesareworthlittletothedebtshy
holders It is in societyrsquos interest to develop bankruptcy
proceduresthatmaximizethepostshybankruptcyvalueofa
firmrsquosassetsInparticularsocietyshouldavoidthedestrucshy
tionofvaluethatoccurswithdisorderlyliquidation
Disorderlyliquidationoffinancialinstitutionsisparticushy
larly costlyFirstvaluableknowledge that the institution
hasaccumulatedaboutitscounterpartiesmdashborrowerstradshy
ingpartnersandsoonmdashcandisappearastheinstitution
losesemployeesandceasestooperatenormallyFinancial
Copyrighted Material
22 bull CHapTer 1
economistshavefoundthatthecollapseofabankhasamashy
terialadverseimpactonmanyofitsborrowers1 Second
the prospect of a disorderly liquidation makes it more
likelythatatroubledfinancialinstitutionwillsufferarun
by creditors who conclude they are better off claiming
whatmoney theycan todayrather thanwaiting through
protracted liquidation proceedings Third ldquofire salesrdquo of
specializedassets inadisorderly liquidationcandepress
prices and thereby spread problems to other holders of
theassetclassFourthdisorderlyliquidationincreasesthe
uncertaintyabouttheimpactofafinancialinstitutionrsquosfailshy
ureonitscounterpartiesandotherclaimholdersBecause
financialfirmsaretightlyinterconnectedthisuncertainty
canprecipitateorintensifyafinancialcrisis1
In theunitedStatesthestandardbankruptcycodealshy
lowsbothforliquidationofafirmandthesaleofitsassets
(Chapter7)andforcontinuedoperationofafirmunder
the supervision of a bankruptcy judgewho protects the
firmfromcreditorsrsquoclaimswhileareorganizationplanis
approved(Chapter11)Theseproceduresappeartowork
wellfornonfinancialcorporationsbutnotsowellforfinanshy
cialorganizationsTheChapter11approachofseparatinga
firmrsquosfinancialaffairsfromitsnonfinancialbusinessactivishy
tiesisinfeasiblewhenthebusinessofthefirmisfinancial
transactionsFurthermoremanyfinancialinstitutionsrely
heavily on shortshyterm debtpossibly as a valuable discishy
plineonbankexecutiveswhocanrapidlychangetherisks
theirfirmstakeThismakesfinancialfirmsvulnerabletoa
rapidwithdrawalofshortshytermcreditthatislikelytooccur
beforeanyeventthatwouldtriggerbankruptcy
Copyrighted Material
InTroDuCT Ion bull 2
Wearguebelowthatthereisaneedforaspecialresolushy
tionprocedurethatcanbeappliedtolargeinsolventfinanshy
cialinstitutionsWealsoadvocateregulatorychangesthat
would push financial firms towardmore resilient capital
structures
Bank Runs
Classicbank runs inwhichdepositors race towithdraw
their funds before a bank failswere one of the central
contributors to theGreatDepressionDeposit insurance
whichwasintroducedaftertheDepressiontocounterthis
destructiveprocessmadedemanddepositsoneofthemost
stableformsofbankfinancingduringtheWorldFinancial
CrisisManyfinancialinstitutionshoweversufferedamodshy
ernversionofbankruns
Banksespeciallythosewithinvestmentbankingactivishy
tiestypicallyfinanceasignificantfractionoftheirbusiness
withovernightcommercialpaperreposandothershortshy
terminstrumentsInnormaltimesbanksrolloverthisdebt
asitmaturestakingnewloanstopayofftheoldInacrishy
sishoweveruncertaintyaboutwhetheratroubledinstitushy
tionwouldbeabletopayoffitscreditorstomorrowcauses
lenderstostopextendingcredittodayThusshortshytermfishy
nancingcanleadtoarunthatissimilartoaclassicrunon
deposits
even some secured creditors participated in runs durshy
ingtheWorldFinancialCrisisBanksoftenuserepurchase
agreements to borrow money securing the loan by givshy
ingthelenderafinancialassetsuchasaTreasurybond
Copyrighted Material
2 bull CHapTer 1
ascollateralBecausetheyareovershycollateralizedwithasshy
setsworthperhaps$105guaranteeingevery$100inloans
lendersviewldquoreposrdquoasasafewaytoextendcreditWhen
credit markets froze during the Crisis however lenders
worried that retrieving collateral and selling itwouldbe
difficultandnotworththesmallinterestonanovernight
loanasaresultatvarioustimesduringtheCrisismany
investmentbankshaddifficultyrollingovereventheirseshy
cured loanseven relatively healthy financial institutions
werehamperedbythetroubleintherepomarketafteraushy
gust2007asthemarketbecamemoreandmoreuncertain
about the prices securities would fetch in a forced sale
these institutions found they could borrow less and less
withthesamecollateral15
prime brokerage accounts also saw a runshylike withshy
drawalbycustomersManylargebankshaveprimebrokershy
agegroupsthatassisthedgefundsandotherinstitutionalinshy
vestorsbyprovidingfinancingsecuritieslendingclearing
custodial servicesandoperational supportInexchange
thefundspayfeesandcriticallypostcollateraltosecure
theirloansWithsomerestrictionsthatweexplaininChapshy
ter10theprimebrokercanthenusethecollateralinits
ownbusinessinsomecasescomminglingitwiththefirmrsquos
ownassetsDuringtheCrisishedgefundsmonitoredthe
financial wellshybeing of their prime brokers and like deshy
positorsintheDepressionfledwiththeircollateralatthe
firstsignoftroubleBearStearnsforexamplehadalarge
prime brokerage business according to press accounts
oneofthelargesthedgefundsthatusedBearStearnsasa
Copyrighted Material
InTroDuCT Ion bull 25
primebrokerrenaissanceTechnologieswithdrew$5bilshy
lionofcashintheweekthefirmfailedWithsuchoutflows
it is not surprising that Bear Stearns ran out of money
eventhoughithadmorethan$18billionincashaweek
earlier
Likeclassicbankrunsmodernbankrunsarebothdeshy
structiveandselfshyfulfillingConcernthatabankmightbe
in trouble spurs its creditors and counterparties towithshy
draworwithholdtheircapitalasaresultevenrumorsofa
problemmaybeenoughtodestroyaviableinstitutionThe
importanceofmodernbankrunsduringtheWorldFinanshy
cialCrisisisarecurringthemethroughoutthebookand
wemakeseveralproposalsthatareintendedtoreducethe
frequencyofsuchevents
The Inadequacy of the Regulatory Structure
TheWorldFinancialCrisismadeitclearthatfinancialinnoshy
vationhadoverwhelmedexistingfinancialregulationsnoshy
tableexamplesincludeaIGrsquosdecisiontosellanextremely
large amount of credit default swaps on subprime debt
tobanksintheunitedStatesandabroadtheholdingof
Lehmanpaperbymoneymarketfundsparticularlythereshy
serveprimaryFundthecomplexityofthederivativebooks
atLehmanandotherinvestmentbanksandthedifficultyof
simultaneouslyapplyingseveralcountriesrsquobankruptcycodes
tothesubsidiariesofmultinationalfinancialinstitutions1
Thereisatradeshyoffbetweenfinancialinnovationandstashy
bilityInnovationcanimprovethefinancialsystemrsquosability
Copyrighted Material
2 bull CHapTer 1
toallocateresourcestotheirhighestvaluedusebutitcan
alsoreducethestabilityofthesystemThechallengeisto
developregulationsthatimprovestabilitywithoutstifling
innovation In addition regulation often leads to innoshy
vations designed to evade the regulationswhich makes
thefinancialsystemmorefragileForexamplemanyofthe
specialshypurposevehiclesthatimplodedintheCrisiswere
createdtogetaroundcapitalrequirements
In many countries the response of regulators to the
World Financial Crisis was hampered by the fragmented
nature of their regulatory systems Financial regulations
are typically designed to ensure thehealth of individual
institutionsratherthanthefinancialsystemasawholeIn
thisbookwearguethatsystemicregulationisanimporshy
tantfunctionthatrequiresaspecialmandateandthatthe
central bank is particularly well equipped to fulfill this
function
Finallyeffectivefinancialregulationrequiresthatpolitishy
ciansandultimatelythepublichaveanadequateundershy
standing of the financial system The political turmoil
surroundingtheCrisissuggeststheimportanceofdissemishy
natingexpertknowledgeaboutfinancetoabroaderaudishy
enceThisisoneofourmotivationsforwritingthisbook
What Were the orIgIns oF the World FInancIal crIsIs
LiketheoriginsoftheFirstWorldWarthecausesofthe
Crisiswillbedebatedbyscholarsformanyyears
Copyrighted Material
InTroDuCT Ion bull 27
Most observers agree that the strong runshyup and subshy
sequentsharpdeclineinthepricesofstockshousesand
otherfinancialassetsindevelopedcountrieswasanimporshy
tantcatalystfortheCrisisThereisdisagreementhowever
aboutwhetherthispatterninpricesistheresultofrational
investorbehaviororldquoirrationalbubblesrdquo
SomearguethattherunshyupbeforetheCrisiswasdriven
by investorswhoknowingly acceptedunusually low exshy
pectedreturnsandtheyofferseveralpossiblereasonswhy
Firsttherewasasurgeofsavingsinemergingcountries
drivenbyacombinationofrapideconomicgrowthanddeshy
mographicsperhapsbecauseofadesiretoaccumulateforshy
eignreservesintheaftermathoftheasiacrisisof1997ndash98
muchof thiswealthwas invested indevelopedmarkets
Secondfinancialmarketswereunusually tranquilduring
200to200Withlowvolatilityinvestorsmayhavesettled
for a low risk premiumThird influenced by fears of a
Japaneseshystyledeflation resulting from themarketdownshy
turnof2000ndash2001andbyabeliefthattheyshouldnottry
to usemonetary policy to counteract rising asset prices
central bankers in the united States maintained a loose
monetarypolicythroughouttheperiod17andfromthisrashy
tionalviewofinvestorstheplungeinassetpricesthatacshy
companiedtheCrisiswascausedbybadnewsaboutfuture
cashflowsunexpectedincreasesinthereturnsrequiredby
investorsorboth
otherssuggestamoredirectexplanationThehighprices
before theCrisisweredrivenby an irrational belief that
prices would continue to rise and the collapse of asset
priceswastheinevitableresultofthismistakeWhatever
Copyrighted Material
28 bull CHapTer 1
theexplanationthesharpdropinassetpricesbothconshy
tributedtoandwasasymptomoftheCrisis
other commentators argue that the financial system
becamevulnerablebecausemanymarketparticipantsasshy
sessedrisksinaccuratelyduringtheperiodleadingupto
theWorldFinancialCrisisConsumersbanksandinvestors
ingeneralunderestimatedtheriskofhousepricedeclines
increasingthepricestheywerewillingtopayforrealesshy
tatethecredittheywerewillingtoextendandthevaluashy
tionsofbanksthatextendedsuchcreditBanksputmuch
weight on the recent pastwhen they estimated value at
riskwhichledthemtoconcludethatthelevelofriskwas
lowandthattherewaslittledownsidetohavinghighleshy
verageothermarketparticipantsdidnotfullyappreciate
thathighliquiditywassuppressingvolatilityandthatthe
processmightreversewithliquiditydecreasingandvolatilshy
ityincreasing
More generally the high level of financial innovation
driveninpartbythedecliningcostofinformationtechnolshy
ogymadeithardforriskassessmenttokeeppacewiththe
evolvingfinancialsystem18Thebenignenvironmentofthe
creditboomexacerbatedthisproblembytemptingfinanshy
cialinstitutionstounderinvestinriskmanagement
uSpolicymakersalsocontributedtotheseverityofthe
CrisisbypushingFannieMaeandFreddieMactoincrease
theavailabilityofmortgagefundingtoborrowerswithquesshy
tionableabilitytorepaytheirmortgagesasaresultofthis
pressure both agencies relaxed their standards for the
mortgages they purchased and guaranteedThe demand
Copyrighted Material
InTroDuCT Ion bull 29
forhomesbyborrowerswhoqualifiedformortgagesbeshy
causeoftheselowerstandardspusheduppricesandthe
defaultbymanyofthemduringtherecessioncontributed
tothedropinhomeprices
Thepanicandruninthefallof2008remainthecentral
distinguishingfeaturesoftheWorldFinancialCrisisasset
priceshave risenand fallenbeforeand theworldeconshy
omyhasbornelargefinancial lossesmanytimeswithout
suchasevereeconomicoutcomeConverselylossesfrom
completelydifferentunderlyingsourcesmdashcommercialreal
estateorperhapssovereigndefaultsmdashcouldcauseasimilar
catastrophe if theyagainprovoke tooshybigshytoshyfailchaosor
runs
Thisbookdoesnotseektoprovideacompletediagnosis
oftheWorldFinancialCrisisnordoesittakeastandonthe
relativeimportanceofthecontributingfactorslistedabove
ratherwebelieveourrecommendationswillhelpprevent
ormitigatefuturecriseseventhoughwedonotfullyundershy
standallthecausesofthelastone
CarmenreinhartandKennethrogoff amongothershave
pointedoutthatfinancialcriseshaveoccurredthroughout
thehistoryofcapitalismandthatthesecrisessharemany
commonpatterns19 Thelessonwedrawfromthisisthat
noacceptablesetofregulationscanpreventmarketparticishy
pantsfrommakingmistakesthatcreateeconomicinstability
ourpurposeinthisbookisinsteadtosuggestregulatory
reformsthatwillmakethesystemmorestabledespitethe
mistakesthataresuretocome
Copyrighted Material
18 bull CHapTer 1
which creates a conflict of interest between the bankrsquos
creditorsanditsshareholdersShareholdershaveanincenshy
tivetoauthorizeexcessivelyriskyinvestmentsforexample
especiallyafterabankhasincurredlossesthaterodethe
valueoftheshareholdersrsquoclaimThegainsontheserisky
investmentswillaccruelargelytoshareholderswhilethe
losseswillmostlybebornebycreditorsTheconflictwith
creditorsalsoreducestheincentivesfortheshareholders
of troubled institutions to raisenewcapitalbecause that
wouldstrengthen thepositionofcreditorswhilediluting
theshareholdersrsquopositionThisldquodebtoverhangrdquoproblem
waswidelycitedduringtheWorldFinancialCrisiswhen
many banks that were insolvent or close to insolvency
seemedreluctanteithertoraisenewcapitalortoreduce
theirrisksbysellingdistressedsecurities11
atthehighestlevelthereisaconflictofinterestbetween
societyasawholeandtheprivateownersoffinancialinshy
stitutions Because robust financial institutions promote
economicgrowthandemploymentduringfinancialcrises
governmentsoftenrescuetroubledfirmstheyperceiveto
be systemically importantThe result is privatized gains
andsocializedlossesIfthingsgowellthefirmsrsquoowners
andmanagersclaimtheprofitsbutifthingsgopoorlysoshy
cietysubsidizesthelosses
The candidates for government bailouts are popularly
describedasldquotoobigtofailrdquoMorepreciselytheargument
for government supportmdashwhich many economists chalshy
lengemdashisaboutfirmsthataretoosystemicallyimportantto
failInits200annualreporttheeuropeanCentralBank
describedsystemicriskasldquoTheriskthattheinabilityofone
Copyrighted Material
InTroDuCT Ion bull 19
institutiontomeetitsobligationswhenduewillcauseother
institutions to be unable tomeet their obligationswhen
dueSuchafailuremaycausesignificantliquidityorcredit
problemsandas a resultcould threaten the stabilityof
or confidence in marketsrdquo Systemically important firms
arethosewhosefailurecouldposealargethreattothestashy
bilityoforconfidenceinmarketsThesefirmsarelikelyto
belargebuttheyalsotendtohavecomplexinterconnecshy
tionswithotherfinancialinstitutions
Tooshybigshytoshyfailpoliciesoffersystemicallyimportantfirms
theexplicitorimplicitpromiseofabailoutwhenthingsgo
wrongThesepoliciesaredestructiveforseveralreasons
Firstbecause the possibility of a bailoutmeans a firmrsquos
stakeholders claim all the profits but only some of the
lossesfinancialfirmsthatmightreceivegovernmentsupshy
porthaveanincentivetotakeextrariskThefirmrsquosshareshy
holderscreditorsemployeesandmanagement all share
thetemptationTheresultisanincreaseintherisksborne
bysocietyasawhole
Secondthesepoliciesencouragesmallerfinancialinstishy
tutionstoexpandortobecomemorecloselyinterconnected
with other firms so they move under the tooshybigshytoshyfail
umbrellaFirmshaveanincentivetodowhateverittakes
tomakepolicymakersfeartheirfailurecreatingthevery
fragilitythegovernmentwishestoavoidBeliefthatagovshy
ernmentrescuewillprotectafinancial institutionrsquoscredishy
tors inacrisisalsogivesafirmacompetitiveadvantage
loweringitscostoffinancingandallowingittoofferbetter
prices to its customers than its fundamental productivity
warrants
Copyrighted Material
20 bull CHapTer 1
Thirdinefficientfirmsthatcannotcompeteontheirown
shouldfailotherwisefirmshavelessincentivetobecome
andstayefficientagovernmentpolicythatpropsupinshy
efficientfirmsiswastefulanddestructiveallowingthese
firmstofailfreesupresourcesandprovidesopportunities
formoreefficientandinnovativecompetitorstoflourish
Fourthandmostgenerallycapitalismisunderminedby
policiesthatprivatizegainsbutsocializelossesGovernment
guaranteedinstitutionscanbecomegovernmentruninstishy
tutionsallocatingcreditforexampletomaximizepolitical
gainratherthaneconomicwelfare
The conflictbetween society and theownersoffinanshy
cialfirmsbecomesmoreseriousduringseverecriseswhen
manyfinancialinstitutionsareclosetoinsolventIt isthe
primemotivationforourregulatoryproposalsbutseveral
ofthelowershylevelconflictswehavedescribedarerelevant
becausetheymagnifytheriskbornebysocietyasawhole
Theselfshyservingbehaviorthatmanyofourrecommenshy
dations targetmdashwhether by traders senior management
orthefirmrsquosownersmdashneednotbestrategicintentionally
maliciousorevenconsciousConsideratraderwhoinadshy
vertentlydevelopsaninvestmentstrategywithhighlyprobshy
ablegainsandimprobablebutlargelossesLikeafirmthat
hassoldearthquakeinsurancethestrategymayproducea
longstringofimpressivereturnsbeforeoneyearoflosses
wipesoutmanyyearsofprofits12 Ifsoduringthegood
yearsthetraderwillbecelebratedforhisorherbrilliance
rewarded with large bonuses and given more resources
to manageMany sophisticated traders and hedge funds
Copyrighted Material
InTroDuCT Ion bull 21
werenotawareoftheldquoearthquakerisksrdquoinherentinmany
of theirstrategiesSimilarlywhenfirmstakeactionsthat
increasethelikelihoodofagovernmentbailoutinthenext
financialcrisisthemarketrewardsthemwithalowercost
of capitalas firms become too big to fail for example
the implicit government guarantee reduces the riskiness
of their debt and lowers the interest rate demanded by
theircreditorsaCeoworkingtomaximizefirmvaluemay
notevenrealize the importanceof thegovernmentguarshy
anteebut a Darwinian process will encourage behavior
thatexploitsit
Bankruptcy and Resolution Procedures
Itisimpossibletowriteafinancialcontractthatspecifies
everypossiblecontingencyInsteadcontractsrelyonbankshy
ruptcytodetermineoutcomesincertainbadandunlikely
statesoftheworldInbankruptcycontrolofafirmistransshy
ferredfromtheshareholderswhonolongerhaveastake
inlossesbecausetheirsharesareworthlittletothedebtshy
holders It is in societyrsquos interest to develop bankruptcy
proceduresthatmaximizethepostshybankruptcyvalueofa
firmrsquosassetsInparticularsocietyshouldavoidthedestrucshy
tionofvaluethatoccurswithdisorderlyliquidation
Disorderlyliquidationoffinancialinstitutionsisparticushy
larly costlyFirstvaluableknowledge that the institution
hasaccumulatedaboutitscounterpartiesmdashborrowerstradshy
ingpartnersandsoonmdashcandisappearastheinstitution
losesemployeesandceasestooperatenormallyFinancial
Copyrighted Material
22 bull CHapTer 1
economistshavefoundthatthecollapseofabankhasamashy
terialadverseimpactonmanyofitsborrowers1 Second
the prospect of a disorderly liquidation makes it more
likelythatatroubledfinancialinstitutionwillsufferarun
by creditors who conclude they are better off claiming
whatmoney theycan todayrather thanwaiting through
protracted liquidation proceedings Third ldquofire salesrdquo of
specializedassets inadisorderly liquidationcandepress
prices and thereby spread problems to other holders of
theassetclassFourthdisorderlyliquidationincreasesthe
uncertaintyabouttheimpactofafinancialinstitutionrsquosfailshy
ureonitscounterpartiesandotherclaimholdersBecause
financialfirmsaretightlyinterconnectedthisuncertainty
canprecipitateorintensifyafinancialcrisis1
In theunitedStatesthestandardbankruptcycodealshy
lowsbothforliquidationofafirmandthesaleofitsassets
(Chapter7)andforcontinuedoperationofafirmunder
the supervision of a bankruptcy judgewho protects the
firmfromcreditorsrsquoclaimswhileareorganizationplanis
approved(Chapter11)Theseproceduresappeartowork
wellfornonfinancialcorporationsbutnotsowellforfinanshy
cialorganizationsTheChapter11approachofseparatinga
firmrsquosfinancialaffairsfromitsnonfinancialbusinessactivishy
tiesisinfeasiblewhenthebusinessofthefirmisfinancial
transactionsFurthermoremanyfinancialinstitutionsrely
heavily on shortshyterm debtpossibly as a valuable discishy
plineonbankexecutiveswhocanrapidlychangetherisks
theirfirmstakeThismakesfinancialfirmsvulnerabletoa
rapidwithdrawalofshortshytermcreditthatislikelytooccur
beforeanyeventthatwouldtriggerbankruptcy
Copyrighted Material
InTroDuCT Ion bull 2
Wearguebelowthatthereisaneedforaspecialresolushy
tionprocedurethatcanbeappliedtolargeinsolventfinanshy
cialinstitutionsWealsoadvocateregulatorychangesthat
would push financial firms towardmore resilient capital
structures
Bank Runs
Classicbank runs inwhichdepositors race towithdraw
their funds before a bank failswere one of the central
contributors to theGreatDepressionDeposit insurance
whichwasintroducedaftertheDepressiontocounterthis
destructiveprocessmadedemanddepositsoneofthemost
stableformsofbankfinancingduringtheWorldFinancial
CrisisManyfinancialinstitutionshoweversufferedamodshy
ernversionofbankruns
Banksespeciallythosewithinvestmentbankingactivishy
tiestypicallyfinanceasignificantfractionoftheirbusiness
withovernightcommercialpaperreposandothershortshy
terminstrumentsInnormaltimesbanksrolloverthisdebt
asitmaturestakingnewloanstopayofftheoldInacrishy
sishoweveruncertaintyaboutwhetheratroubledinstitushy
tionwouldbeabletopayoffitscreditorstomorrowcauses
lenderstostopextendingcredittodayThusshortshytermfishy
nancingcanleadtoarunthatissimilartoaclassicrunon
deposits
even some secured creditors participated in runs durshy
ingtheWorldFinancialCrisisBanksoftenuserepurchase
agreements to borrow money securing the loan by givshy
ingthelenderafinancialassetsuchasaTreasurybond
Copyrighted Material
2 bull CHapTer 1
ascollateralBecausetheyareovershycollateralizedwithasshy
setsworthperhaps$105guaranteeingevery$100inloans
lendersviewldquoreposrdquoasasafewaytoextendcreditWhen
credit markets froze during the Crisis however lenders
worried that retrieving collateral and selling itwouldbe
difficultandnotworththesmallinterestonanovernight
loanasaresultatvarioustimesduringtheCrisismany
investmentbankshaddifficultyrollingovereventheirseshy
cured loanseven relatively healthy financial institutions
werehamperedbythetroubleintherepomarketafteraushy
gust2007asthemarketbecamemoreandmoreuncertain
about the prices securities would fetch in a forced sale
these institutions found they could borrow less and less
withthesamecollateral15
prime brokerage accounts also saw a runshylike withshy
drawalbycustomersManylargebankshaveprimebrokershy
agegroupsthatassisthedgefundsandotherinstitutionalinshy
vestorsbyprovidingfinancingsecuritieslendingclearing
custodial servicesandoperational supportInexchange
thefundspayfeesandcriticallypostcollateraltosecure
theirloansWithsomerestrictionsthatweexplaininChapshy
ter10theprimebrokercanthenusethecollateralinits
ownbusinessinsomecasescomminglingitwiththefirmrsquos
ownassetsDuringtheCrisishedgefundsmonitoredthe
financial wellshybeing of their prime brokers and like deshy
positorsintheDepressionfledwiththeircollateralatthe
firstsignoftroubleBearStearnsforexamplehadalarge
prime brokerage business according to press accounts
oneofthelargesthedgefundsthatusedBearStearnsasa
Copyrighted Material
InTroDuCT Ion bull 25
primebrokerrenaissanceTechnologieswithdrew$5bilshy
lionofcashintheweekthefirmfailedWithsuchoutflows
it is not surprising that Bear Stearns ran out of money
eventhoughithadmorethan$18billionincashaweek
earlier
Likeclassicbankrunsmodernbankrunsarebothdeshy
structiveandselfshyfulfillingConcernthatabankmightbe
in trouble spurs its creditors and counterparties towithshy
draworwithholdtheircapitalasaresultevenrumorsofa
problemmaybeenoughtodestroyaviableinstitutionThe
importanceofmodernbankrunsduringtheWorldFinanshy
cialCrisisisarecurringthemethroughoutthebookand
wemakeseveralproposalsthatareintendedtoreducethe
frequencyofsuchevents
The Inadequacy of the Regulatory Structure
TheWorldFinancialCrisismadeitclearthatfinancialinnoshy
vationhadoverwhelmedexistingfinancialregulationsnoshy
tableexamplesincludeaIGrsquosdecisiontosellanextremely
large amount of credit default swaps on subprime debt
tobanksintheunitedStatesandabroadtheholdingof
Lehmanpaperbymoneymarketfundsparticularlythereshy
serveprimaryFundthecomplexityofthederivativebooks
atLehmanandotherinvestmentbanksandthedifficultyof
simultaneouslyapplyingseveralcountriesrsquobankruptcycodes
tothesubsidiariesofmultinationalfinancialinstitutions1
Thereisatradeshyoffbetweenfinancialinnovationandstashy
bilityInnovationcanimprovethefinancialsystemrsquosability
Copyrighted Material
2 bull CHapTer 1
toallocateresourcestotheirhighestvaluedusebutitcan
alsoreducethestabilityofthesystemThechallengeisto
developregulationsthatimprovestabilitywithoutstifling
innovation In addition regulation often leads to innoshy
vations designed to evade the regulationswhich makes
thefinancialsystemmorefragileForexamplemanyofthe
specialshypurposevehiclesthatimplodedintheCrisiswere
createdtogetaroundcapitalrequirements
In many countries the response of regulators to the
World Financial Crisis was hampered by the fragmented
nature of their regulatory systems Financial regulations
are typically designed to ensure thehealth of individual
institutionsratherthanthefinancialsystemasawholeIn
thisbookwearguethatsystemicregulationisanimporshy
tantfunctionthatrequiresaspecialmandateandthatthe
central bank is particularly well equipped to fulfill this
function
Finallyeffectivefinancialregulationrequiresthatpolitishy
ciansandultimatelythepublichaveanadequateundershy
standing of the financial system The political turmoil
surroundingtheCrisissuggeststheimportanceofdissemishy
natingexpertknowledgeaboutfinancetoabroaderaudishy
enceThisisoneofourmotivationsforwritingthisbook
What Were the orIgIns oF the World FInancIal crIsIs
LiketheoriginsoftheFirstWorldWarthecausesofthe
Crisiswillbedebatedbyscholarsformanyyears
Copyrighted Material
InTroDuCT Ion bull 27
Most observers agree that the strong runshyup and subshy
sequentsharpdeclineinthepricesofstockshousesand
otherfinancialassetsindevelopedcountrieswasanimporshy
tantcatalystfortheCrisisThereisdisagreementhowever
aboutwhetherthispatterninpricesistheresultofrational
investorbehaviororldquoirrationalbubblesrdquo
SomearguethattherunshyupbeforetheCrisiswasdriven
by investorswhoknowingly acceptedunusually low exshy
pectedreturnsandtheyofferseveralpossiblereasonswhy
Firsttherewasasurgeofsavingsinemergingcountries
drivenbyacombinationofrapideconomicgrowthanddeshy
mographicsperhapsbecauseofadesiretoaccumulateforshy
eignreservesintheaftermathoftheasiacrisisof1997ndash98
muchof thiswealthwas invested indevelopedmarkets
Secondfinancialmarketswereunusually tranquilduring
200to200Withlowvolatilityinvestorsmayhavesettled
for a low risk premiumThird influenced by fears of a
Japaneseshystyledeflation resulting from themarketdownshy
turnof2000ndash2001andbyabeliefthattheyshouldnottry
to usemonetary policy to counteract rising asset prices
central bankers in the united States maintained a loose
monetarypolicythroughouttheperiod17andfromthisrashy
tionalviewofinvestorstheplungeinassetpricesthatacshy
companiedtheCrisiswascausedbybadnewsaboutfuture
cashflowsunexpectedincreasesinthereturnsrequiredby
investorsorboth
otherssuggestamoredirectexplanationThehighprices
before theCrisisweredrivenby an irrational belief that
prices would continue to rise and the collapse of asset
priceswastheinevitableresultofthismistakeWhatever
Copyrighted Material
28 bull CHapTer 1
theexplanationthesharpdropinassetpricesbothconshy
tributedtoandwasasymptomoftheCrisis
other commentators argue that the financial system
becamevulnerablebecausemanymarketparticipantsasshy
sessedrisksinaccuratelyduringtheperiodleadingupto
theWorldFinancialCrisisConsumersbanksandinvestors
ingeneralunderestimatedtheriskofhousepricedeclines
increasingthepricestheywerewillingtopayforrealesshy
tatethecredittheywerewillingtoextendandthevaluashy
tionsofbanksthatextendedsuchcreditBanksputmuch
weight on the recent pastwhen they estimated value at
riskwhichledthemtoconcludethatthelevelofriskwas
lowandthattherewaslittledownsidetohavinghighleshy
verageothermarketparticipantsdidnotfullyappreciate
thathighliquiditywassuppressingvolatilityandthatthe
processmightreversewithliquiditydecreasingandvolatilshy
ityincreasing
More generally the high level of financial innovation
driveninpartbythedecliningcostofinformationtechnolshy
ogymadeithardforriskassessmenttokeeppacewiththe
evolvingfinancialsystem18Thebenignenvironmentofthe
creditboomexacerbatedthisproblembytemptingfinanshy
cialinstitutionstounderinvestinriskmanagement
uSpolicymakersalsocontributedtotheseverityofthe
CrisisbypushingFannieMaeandFreddieMactoincrease
theavailabilityofmortgagefundingtoborrowerswithquesshy
tionableabilitytorepaytheirmortgagesasaresultofthis
pressure both agencies relaxed their standards for the
mortgages they purchased and guaranteedThe demand
Copyrighted Material
InTroDuCT Ion bull 29
forhomesbyborrowerswhoqualifiedformortgagesbeshy
causeoftheselowerstandardspusheduppricesandthe
defaultbymanyofthemduringtherecessioncontributed
tothedropinhomeprices
Thepanicandruninthefallof2008remainthecentral
distinguishingfeaturesoftheWorldFinancialCrisisasset
priceshave risenand fallenbeforeand theworldeconshy
omyhasbornelargefinancial lossesmanytimeswithout
suchasevereeconomicoutcomeConverselylossesfrom
completelydifferentunderlyingsourcesmdashcommercialreal
estateorperhapssovereigndefaultsmdashcouldcauseasimilar
catastrophe if theyagainprovoke tooshybigshytoshyfailchaosor
runs
Thisbookdoesnotseektoprovideacompletediagnosis
oftheWorldFinancialCrisisnordoesittakeastandonthe
relativeimportanceofthecontributingfactorslistedabove
ratherwebelieveourrecommendationswillhelpprevent
ormitigatefuturecriseseventhoughwedonotfullyundershy
standallthecausesofthelastone
CarmenreinhartandKennethrogoff amongothershave
pointedoutthatfinancialcriseshaveoccurredthroughout
thehistoryofcapitalismandthatthesecrisessharemany
commonpatterns19 Thelessonwedrawfromthisisthat
noacceptablesetofregulationscanpreventmarketparticishy
pantsfrommakingmistakesthatcreateeconomicinstability
ourpurposeinthisbookisinsteadtosuggestregulatory
reformsthatwillmakethesystemmorestabledespitethe
mistakesthataresuretocome
Copyrighted Material
InTroDuCT Ion bull 19
institutiontomeetitsobligationswhenduewillcauseother
institutions to be unable tomeet their obligationswhen
dueSuchafailuremaycausesignificantliquidityorcredit
problemsandas a resultcould threaten the stabilityof
or confidence in marketsrdquo Systemically important firms
arethosewhosefailurecouldposealargethreattothestashy
bilityoforconfidenceinmarketsThesefirmsarelikelyto
belargebuttheyalsotendtohavecomplexinterconnecshy
tionswithotherfinancialinstitutions
Tooshybigshytoshyfailpoliciesoffersystemicallyimportantfirms
theexplicitorimplicitpromiseofabailoutwhenthingsgo
wrongThesepoliciesaredestructiveforseveralreasons
Firstbecause the possibility of a bailoutmeans a firmrsquos
stakeholders claim all the profits but only some of the
lossesfinancialfirmsthatmightreceivegovernmentsupshy
porthaveanincentivetotakeextrariskThefirmrsquosshareshy
holderscreditorsemployeesandmanagement all share
thetemptationTheresultisanincreaseintherisksborne
bysocietyasawhole
Secondthesepoliciesencouragesmallerfinancialinstishy
tutionstoexpandortobecomemorecloselyinterconnected
with other firms so they move under the tooshybigshytoshyfail
umbrellaFirmshaveanincentivetodowhateverittakes
tomakepolicymakersfeartheirfailurecreatingthevery
fragilitythegovernmentwishestoavoidBeliefthatagovshy
ernmentrescuewillprotectafinancial institutionrsquoscredishy
tors inacrisisalsogivesafirmacompetitiveadvantage
loweringitscostoffinancingandallowingittoofferbetter
prices to its customers than its fundamental productivity
warrants
Copyrighted Material
20 bull CHapTer 1
Thirdinefficientfirmsthatcannotcompeteontheirown
shouldfailotherwisefirmshavelessincentivetobecome
andstayefficientagovernmentpolicythatpropsupinshy
efficientfirmsiswastefulanddestructiveallowingthese
firmstofailfreesupresourcesandprovidesopportunities
formoreefficientandinnovativecompetitorstoflourish
Fourthandmostgenerallycapitalismisunderminedby
policiesthatprivatizegainsbutsocializelossesGovernment
guaranteedinstitutionscanbecomegovernmentruninstishy
tutionsallocatingcreditforexampletomaximizepolitical
gainratherthaneconomicwelfare
The conflictbetween society and theownersoffinanshy
cialfirmsbecomesmoreseriousduringseverecriseswhen
manyfinancialinstitutionsareclosetoinsolventIt isthe
primemotivationforourregulatoryproposalsbutseveral
ofthelowershylevelconflictswehavedescribedarerelevant
becausetheymagnifytheriskbornebysocietyasawhole
Theselfshyservingbehaviorthatmanyofourrecommenshy
dations targetmdashwhether by traders senior management
orthefirmrsquosownersmdashneednotbestrategicintentionally
maliciousorevenconsciousConsideratraderwhoinadshy
vertentlydevelopsaninvestmentstrategywithhighlyprobshy
ablegainsandimprobablebutlargelossesLikeafirmthat
hassoldearthquakeinsurancethestrategymayproducea
longstringofimpressivereturnsbeforeoneyearoflosses
wipesoutmanyyearsofprofits12 Ifsoduringthegood
yearsthetraderwillbecelebratedforhisorherbrilliance
rewarded with large bonuses and given more resources
to manageMany sophisticated traders and hedge funds
Copyrighted Material
InTroDuCT Ion bull 21
werenotawareoftheldquoearthquakerisksrdquoinherentinmany
of theirstrategiesSimilarlywhenfirmstakeactionsthat
increasethelikelihoodofagovernmentbailoutinthenext
financialcrisisthemarketrewardsthemwithalowercost
of capitalas firms become too big to fail for example
the implicit government guarantee reduces the riskiness
of their debt and lowers the interest rate demanded by
theircreditorsaCeoworkingtomaximizefirmvaluemay
notevenrealize the importanceof thegovernmentguarshy
anteebut a Darwinian process will encourage behavior
thatexploitsit
Bankruptcy and Resolution Procedures
Itisimpossibletowriteafinancialcontractthatspecifies
everypossiblecontingencyInsteadcontractsrelyonbankshy
ruptcytodetermineoutcomesincertainbadandunlikely
statesoftheworldInbankruptcycontrolofafirmistransshy
ferredfromtheshareholderswhonolongerhaveastake
inlossesbecausetheirsharesareworthlittletothedebtshy
holders It is in societyrsquos interest to develop bankruptcy
proceduresthatmaximizethepostshybankruptcyvalueofa
firmrsquosassetsInparticularsocietyshouldavoidthedestrucshy
tionofvaluethatoccurswithdisorderlyliquidation
Disorderlyliquidationoffinancialinstitutionsisparticushy
larly costlyFirstvaluableknowledge that the institution
hasaccumulatedaboutitscounterpartiesmdashborrowerstradshy
ingpartnersandsoonmdashcandisappearastheinstitution
losesemployeesandceasestooperatenormallyFinancial
Copyrighted Material
22 bull CHapTer 1
economistshavefoundthatthecollapseofabankhasamashy
terialadverseimpactonmanyofitsborrowers1 Second
the prospect of a disorderly liquidation makes it more
likelythatatroubledfinancialinstitutionwillsufferarun
by creditors who conclude they are better off claiming
whatmoney theycan todayrather thanwaiting through
protracted liquidation proceedings Third ldquofire salesrdquo of
specializedassets inadisorderly liquidationcandepress
prices and thereby spread problems to other holders of
theassetclassFourthdisorderlyliquidationincreasesthe
uncertaintyabouttheimpactofafinancialinstitutionrsquosfailshy
ureonitscounterpartiesandotherclaimholdersBecause
financialfirmsaretightlyinterconnectedthisuncertainty
canprecipitateorintensifyafinancialcrisis1
In theunitedStatesthestandardbankruptcycodealshy
lowsbothforliquidationofafirmandthesaleofitsassets
(Chapter7)andforcontinuedoperationofafirmunder
the supervision of a bankruptcy judgewho protects the
firmfromcreditorsrsquoclaimswhileareorganizationplanis
approved(Chapter11)Theseproceduresappeartowork
wellfornonfinancialcorporationsbutnotsowellforfinanshy
cialorganizationsTheChapter11approachofseparatinga
firmrsquosfinancialaffairsfromitsnonfinancialbusinessactivishy
tiesisinfeasiblewhenthebusinessofthefirmisfinancial
transactionsFurthermoremanyfinancialinstitutionsrely
heavily on shortshyterm debtpossibly as a valuable discishy
plineonbankexecutiveswhocanrapidlychangetherisks
theirfirmstakeThismakesfinancialfirmsvulnerabletoa
rapidwithdrawalofshortshytermcreditthatislikelytooccur
beforeanyeventthatwouldtriggerbankruptcy
Copyrighted Material
InTroDuCT Ion bull 2
Wearguebelowthatthereisaneedforaspecialresolushy
tionprocedurethatcanbeappliedtolargeinsolventfinanshy
cialinstitutionsWealsoadvocateregulatorychangesthat
would push financial firms towardmore resilient capital
structures
Bank Runs
Classicbank runs inwhichdepositors race towithdraw
their funds before a bank failswere one of the central
contributors to theGreatDepressionDeposit insurance
whichwasintroducedaftertheDepressiontocounterthis
destructiveprocessmadedemanddepositsoneofthemost
stableformsofbankfinancingduringtheWorldFinancial
CrisisManyfinancialinstitutionshoweversufferedamodshy
ernversionofbankruns
Banksespeciallythosewithinvestmentbankingactivishy
tiestypicallyfinanceasignificantfractionoftheirbusiness
withovernightcommercialpaperreposandothershortshy
terminstrumentsInnormaltimesbanksrolloverthisdebt
asitmaturestakingnewloanstopayofftheoldInacrishy
sishoweveruncertaintyaboutwhetheratroubledinstitushy
tionwouldbeabletopayoffitscreditorstomorrowcauses
lenderstostopextendingcredittodayThusshortshytermfishy
nancingcanleadtoarunthatissimilartoaclassicrunon
deposits
even some secured creditors participated in runs durshy
ingtheWorldFinancialCrisisBanksoftenuserepurchase
agreements to borrow money securing the loan by givshy
ingthelenderafinancialassetsuchasaTreasurybond
Copyrighted Material
2 bull CHapTer 1
ascollateralBecausetheyareovershycollateralizedwithasshy
setsworthperhaps$105guaranteeingevery$100inloans
lendersviewldquoreposrdquoasasafewaytoextendcreditWhen
credit markets froze during the Crisis however lenders
worried that retrieving collateral and selling itwouldbe
difficultandnotworththesmallinterestonanovernight
loanasaresultatvarioustimesduringtheCrisismany
investmentbankshaddifficultyrollingovereventheirseshy
cured loanseven relatively healthy financial institutions
werehamperedbythetroubleintherepomarketafteraushy
gust2007asthemarketbecamemoreandmoreuncertain
about the prices securities would fetch in a forced sale
these institutions found they could borrow less and less
withthesamecollateral15
prime brokerage accounts also saw a runshylike withshy
drawalbycustomersManylargebankshaveprimebrokershy
agegroupsthatassisthedgefundsandotherinstitutionalinshy
vestorsbyprovidingfinancingsecuritieslendingclearing
custodial servicesandoperational supportInexchange
thefundspayfeesandcriticallypostcollateraltosecure
theirloansWithsomerestrictionsthatweexplaininChapshy
ter10theprimebrokercanthenusethecollateralinits
ownbusinessinsomecasescomminglingitwiththefirmrsquos
ownassetsDuringtheCrisishedgefundsmonitoredthe
financial wellshybeing of their prime brokers and like deshy
positorsintheDepressionfledwiththeircollateralatthe
firstsignoftroubleBearStearnsforexamplehadalarge
prime brokerage business according to press accounts
oneofthelargesthedgefundsthatusedBearStearnsasa
Copyrighted Material
InTroDuCT Ion bull 25
primebrokerrenaissanceTechnologieswithdrew$5bilshy
lionofcashintheweekthefirmfailedWithsuchoutflows
it is not surprising that Bear Stearns ran out of money
eventhoughithadmorethan$18billionincashaweek
earlier
Likeclassicbankrunsmodernbankrunsarebothdeshy
structiveandselfshyfulfillingConcernthatabankmightbe
in trouble spurs its creditors and counterparties towithshy
draworwithholdtheircapitalasaresultevenrumorsofa
problemmaybeenoughtodestroyaviableinstitutionThe
importanceofmodernbankrunsduringtheWorldFinanshy
cialCrisisisarecurringthemethroughoutthebookand
wemakeseveralproposalsthatareintendedtoreducethe
frequencyofsuchevents
The Inadequacy of the Regulatory Structure
TheWorldFinancialCrisismadeitclearthatfinancialinnoshy
vationhadoverwhelmedexistingfinancialregulationsnoshy
tableexamplesincludeaIGrsquosdecisiontosellanextremely
large amount of credit default swaps on subprime debt
tobanksintheunitedStatesandabroadtheholdingof
Lehmanpaperbymoneymarketfundsparticularlythereshy
serveprimaryFundthecomplexityofthederivativebooks
atLehmanandotherinvestmentbanksandthedifficultyof
simultaneouslyapplyingseveralcountriesrsquobankruptcycodes
tothesubsidiariesofmultinationalfinancialinstitutions1
Thereisatradeshyoffbetweenfinancialinnovationandstashy
bilityInnovationcanimprovethefinancialsystemrsquosability
Copyrighted Material
2 bull CHapTer 1
toallocateresourcestotheirhighestvaluedusebutitcan
alsoreducethestabilityofthesystemThechallengeisto
developregulationsthatimprovestabilitywithoutstifling
innovation In addition regulation often leads to innoshy
vations designed to evade the regulationswhich makes
thefinancialsystemmorefragileForexamplemanyofthe
specialshypurposevehiclesthatimplodedintheCrisiswere
createdtogetaroundcapitalrequirements
In many countries the response of regulators to the
World Financial Crisis was hampered by the fragmented
nature of their regulatory systems Financial regulations
are typically designed to ensure thehealth of individual
institutionsratherthanthefinancialsystemasawholeIn
thisbookwearguethatsystemicregulationisanimporshy
tantfunctionthatrequiresaspecialmandateandthatthe
central bank is particularly well equipped to fulfill this
function
Finallyeffectivefinancialregulationrequiresthatpolitishy
ciansandultimatelythepublichaveanadequateundershy
standing of the financial system The political turmoil
surroundingtheCrisissuggeststheimportanceofdissemishy
natingexpertknowledgeaboutfinancetoabroaderaudishy
enceThisisoneofourmotivationsforwritingthisbook
What Were the orIgIns oF the World FInancIal crIsIs
LiketheoriginsoftheFirstWorldWarthecausesofthe
Crisiswillbedebatedbyscholarsformanyyears
Copyrighted Material
InTroDuCT Ion bull 27
Most observers agree that the strong runshyup and subshy
sequentsharpdeclineinthepricesofstockshousesand
otherfinancialassetsindevelopedcountrieswasanimporshy
tantcatalystfortheCrisisThereisdisagreementhowever
aboutwhetherthispatterninpricesistheresultofrational
investorbehaviororldquoirrationalbubblesrdquo
SomearguethattherunshyupbeforetheCrisiswasdriven
by investorswhoknowingly acceptedunusually low exshy
pectedreturnsandtheyofferseveralpossiblereasonswhy
Firsttherewasasurgeofsavingsinemergingcountries
drivenbyacombinationofrapideconomicgrowthanddeshy
mographicsperhapsbecauseofadesiretoaccumulateforshy
eignreservesintheaftermathoftheasiacrisisof1997ndash98
muchof thiswealthwas invested indevelopedmarkets
Secondfinancialmarketswereunusually tranquilduring
200to200Withlowvolatilityinvestorsmayhavesettled
for a low risk premiumThird influenced by fears of a
Japaneseshystyledeflation resulting from themarketdownshy
turnof2000ndash2001andbyabeliefthattheyshouldnottry
to usemonetary policy to counteract rising asset prices
central bankers in the united States maintained a loose
monetarypolicythroughouttheperiod17andfromthisrashy
tionalviewofinvestorstheplungeinassetpricesthatacshy
companiedtheCrisiswascausedbybadnewsaboutfuture
cashflowsunexpectedincreasesinthereturnsrequiredby
investorsorboth
otherssuggestamoredirectexplanationThehighprices
before theCrisisweredrivenby an irrational belief that
prices would continue to rise and the collapse of asset
priceswastheinevitableresultofthismistakeWhatever
Copyrighted Material
28 bull CHapTer 1
theexplanationthesharpdropinassetpricesbothconshy
tributedtoandwasasymptomoftheCrisis
other commentators argue that the financial system
becamevulnerablebecausemanymarketparticipantsasshy
sessedrisksinaccuratelyduringtheperiodleadingupto
theWorldFinancialCrisisConsumersbanksandinvestors
ingeneralunderestimatedtheriskofhousepricedeclines
increasingthepricestheywerewillingtopayforrealesshy
tatethecredittheywerewillingtoextendandthevaluashy
tionsofbanksthatextendedsuchcreditBanksputmuch
weight on the recent pastwhen they estimated value at
riskwhichledthemtoconcludethatthelevelofriskwas
lowandthattherewaslittledownsidetohavinghighleshy
verageothermarketparticipantsdidnotfullyappreciate
thathighliquiditywassuppressingvolatilityandthatthe
processmightreversewithliquiditydecreasingandvolatilshy
ityincreasing
More generally the high level of financial innovation
driveninpartbythedecliningcostofinformationtechnolshy
ogymadeithardforriskassessmenttokeeppacewiththe
evolvingfinancialsystem18Thebenignenvironmentofthe
creditboomexacerbatedthisproblembytemptingfinanshy
cialinstitutionstounderinvestinriskmanagement
uSpolicymakersalsocontributedtotheseverityofthe
CrisisbypushingFannieMaeandFreddieMactoincrease
theavailabilityofmortgagefundingtoborrowerswithquesshy
tionableabilitytorepaytheirmortgagesasaresultofthis
pressure both agencies relaxed their standards for the
mortgages they purchased and guaranteedThe demand
Copyrighted Material
InTroDuCT Ion bull 29
forhomesbyborrowerswhoqualifiedformortgagesbeshy
causeoftheselowerstandardspusheduppricesandthe
defaultbymanyofthemduringtherecessioncontributed
tothedropinhomeprices
Thepanicandruninthefallof2008remainthecentral
distinguishingfeaturesoftheWorldFinancialCrisisasset
priceshave risenand fallenbeforeand theworldeconshy
omyhasbornelargefinancial lossesmanytimeswithout
suchasevereeconomicoutcomeConverselylossesfrom
completelydifferentunderlyingsourcesmdashcommercialreal
estateorperhapssovereigndefaultsmdashcouldcauseasimilar
catastrophe if theyagainprovoke tooshybigshytoshyfailchaosor
runs
Thisbookdoesnotseektoprovideacompletediagnosis
oftheWorldFinancialCrisisnordoesittakeastandonthe
relativeimportanceofthecontributingfactorslistedabove
ratherwebelieveourrecommendationswillhelpprevent
ormitigatefuturecriseseventhoughwedonotfullyundershy
standallthecausesofthelastone
CarmenreinhartandKennethrogoff amongothershave
pointedoutthatfinancialcriseshaveoccurredthroughout
thehistoryofcapitalismandthatthesecrisessharemany
commonpatterns19 Thelessonwedrawfromthisisthat
noacceptablesetofregulationscanpreventmarketparticishy
pantsfrommakingmistakesthatcreateeconomicinstability
ourpurposeinthisbookisinsteadtosuggestregulatory
reformsthatwillmakethesystemmorestabledespitethe
mistakesthataresuretocome
Copyrighted Material
20 bull CHapTer 1
Thirdinefficientfirmsthatcannotcompeteontheirown
shouldfailotherwisefirmshavelessincentivetobecome
andstayefficientagovernmentpolicythatpropsupinshy
efficientfirmsiswastefulanddestructiveallowingthese
firmstofailfreesupresourcesandprovidesopportunities
formoreefficientandinnovativecompetitorstoflourish
Fourthandmostgenerallycapitalismisunderminedby
policiesthatprivatizegainsbutsocializelossesGovernment
guaranteedinstitutionscanbecomegovernmentruninstishy
tutionsallocatingcreditforexampletomaximizepolitical
gainratherthaneconomicwelfare
The conflictbetween society and theownersoffinanshy
cialfirmsbecomesmoreseriousduringseverecriseswhen
manyfinancialinstitutionsareclosetoinsolventIt isthe
primemotivationforourregulatoryproposalsbutseveral
ofthelowershylevelconflictswehavedescribedarerelevant
becausetheymagnifytheriskbornebysocietyasawhole
Theselfshyservingbehaviorthatmanyofourrecommenshy
dations targetmdashwhether by traders senior management
orthefirmrsquosownersmdashneednotbestrategicintentionally
maliciousorevenconsciousConsideratraderwhoinadshy
vertentlydevelopsaninvestmentstrategywithhighlyprobshy
ablegainsandimprobablebutlargelossesLikeafirmthat
hassoldearthquakeinsurancethestrategymayproducea
longstringofimpressivereturnsbeforeoneyearoflosses
wipesoutmanyyearsofprofits12 Ifsoduringthegood
yearsthetraderwillbecelebratedforhisorherbrilliance
rewarded with large bonuses and given more resources
to manageMany sophisticated traders and hedge funds
Copyrighted Material
InTroDuCT Ion bull 21
werenotawareoftheldquoearthquakerisksrdquoinherentinmany
of theirstrategiesSimilarlywhenfirmstakeactionsthat
increasethelikelihoodofagovernmentbailoutinthenext
financialcrisisthemarketrewardsthemwithalowercost
of capitalas firms become too big to fail for example
the implicit government guarantee reduces the riskiness
of their debt and lowers the interest rate demanded by
theircreditorsaCeoworkingtomaximizefirmvaluemay
notevenrealize the importanceof thegovernmentguarshy
anteebut a Darwinian process will encourage behavior
thatexploitsit
Bankruptcy and Resolution Procedures
Itisimpossibletowriteafinancialcontractthatspecifies
everypossiblecontingencyInsteadcontractsrelyonbankshy
ruptcytodetermineoutcomesincertainbadandunlikely
statesoftheworldInbankruptcycontrolofafirmistransshy
ferredfromtheshareholderswhonolongerhaveastake
inlossesbecausetheirsharesareworthlittletothedebtshy
holders It is in societyrsquos interest to develop bankruptcy
proceduresthatmaximizethepostshybankruptcyvalueofa
firmrsquosassetsInparticularsocietyshouldavoidthedestrucshy
tionofvaluethatoccurswithdisorderlyliquidation
Disorderlyliquidationoffinancialinstitutionsisparticushy
larly costlyFirstvaluableknowledge that the institution
hasaccumulatedaboutitscounterpartiesmdashborrowerstradshy
ingpartnersandsoonmdashcandisappearastheinstitution
losesemployeesandceasestooperatenormallyFinancial
Copyrighted Material
22 bull CHapTer 1
economistshavefoundthatthecollapseofabankhasamashy
terialadverseimpactonmanyofitsborrowers1 Second
the prospect of a disorderly liquidation makes it more
likelythatatroubledfinancialinstitutionwillsufferarun
by creditors who conclude they are better off claiming
whatmoney theycan todayrather thanwaiting through
protracted liquidation proceedings Third ldquofire salesrdquo of
specializedassets inadisorderly liquidationcandepress
prices and thereby spread problems to other holders of
theassetclassFourthdisorderlyliquidationincreasesthe
uncertaintyabouttheimpactofafinancialinstitutionrsquosfailshy
ureonitscounterpartiesandotherclaimholdersBecause
financialfirmsaretightlyinterconnectedthisuncertainty
canprecipitateorintensifyafinancialcrisis1
In theunitedStatesthestandardbankruptcycodealshy
lowsbothforliquidationofafirmandthesaleofitsassets
(Chapter7)andforcontinuedoperationofafirmunder
the supervision of a bankruptcy judgewho protects the
firmfromcreditorsrsquoclaimswhileareorganizationplanis
approved(Chapter11)Theseproceduresappeartowork
wellfornonfinancialcorporationsbutnotsowellforfinanshy
cialorganizationsTheChapter11approachofseparatinga
firmrsquosfinancialaffairsfromitsnonfinancialbusinessactivishy
tiesisinfeasiblewhenthebusinessofthefirmisfinancial
transactionsFurthermoremanyfinancialinstitutionsrely
heavily on shortshyterm debtpossibly as a valuable discishy
plineonbankexecutiveswhocanrapidlychangetherisks
theirfirmstakeThismakesfinancialfirmsvulnerabletoa
rapidwithdrawalofshortshytermcreditthatislikelytooccur
beforeanyeventthatwouldtriggerbankruptcy
Copyrighted Material
InTroDuCT Ion bull 2
Wearguebelowthatthereisaneedforaspecialresolushy
tionprocedurethatcanbeappliedtolargeinsolventfinanshy
cialinstitutionsWealsoadvocateregulatorychangesthat
would push financial firms towardmore resilient capital
structures
Bank Runs
Classicbank runs inwhichdepositors race towithdraw
their funds before a bank failswere one of the central
contributors to theGreatDepressionDeposit insurance
whichwasintroducedaftertheDepressiontocounterthis
destructiveprocessmadedemanddepositsoneofthemost
stableformsofbankfinancingduringtheWorldFinancial
CrisisManyfinancialinstitutionshoweversufferedamodshy
ernversionofbankruns
Banksespeciallythosewithinvestmentbankingactivishy
tiestypicallyfinanceasignificantfractionoftheirbusiness
withovernightcommercialpaperreposandothershortshy
terminstrumentsInnormaltimesbanksrolloverthisdebt
asitmaturestakingnewloanstopayofftheoldInacrishy
sishoweveruncertaintyaboutwhetheratroubledinstitushy
tionwouldbeabletopayoffitscreditorstomorrowcauses
lenderstostopextendingcredittodayThusshortshytermfishy
nancingcanleadtoarunthatissimilartoaclassicrunon
deposits
even some secured creditors participated in runs durshy
ingtheWorldFinancialCrisisBanksoftenuserepurchase
agreements to borrow money securing the loan by givshy
ingthelenderafinancialassetsuchasaTreasurybond
Copyrighted Material
2 bull CHapTer 1
ascollateralBecausetheyareovershycollateralizedwithasshy
setsworthperhaps$105guaranteeingevery$100inloans
lendersviewldquoreposrdquoasasafewaytoextendcreditWhen
credit markets froze during the Crisis however lenders
worried that retrieving collateral and selling itwouldbe
difficultandnotworththesmallinterestonanovernight
loanasaresultatvarioustimesduringtheCrisismany
investmentbankshaddifficultyrollingovereventheirseshy
cured loanseven relatively healthy financial institutions
werehamperedbythetroubleintherepomarketafteraushy
gust2007asthemarketbecamemoreandmoreuncertain
about the prices securities would fetch in a forced sale
these institutions found they could borrow less and less
withthesamecollateral15
prime brokerage accounts also saw a runshylike withshy
drawalbycustomersManylargebankshaveprimebrokershy
agegroupsthatassisthedgefundsandotherinstitutionalinshy
vestorsbyprovidingfinancingsecuritieslendingclearing
custodial servicesandoperational supportInexchange
thefundspayfeesandcriticallypostcollateraltosecure
theirloansWithsomerestrictionsthatweexplaininChapshy
ter10theprimebrokercanthenusethecollateralinits
ownbusinessinsomecasescomminglingitwiththefirmrsquos
ownassetsDuringtheCrisishedgefundsmonitoredthe
financial wellshybeing of their prime brokers and like deshy
positorsintheDepressionfledwiththeircollateralatthe
firstsignoftroubleBearStearnsforexamplehadalarge
prime brokerage business according to press accounts
oneofthelargesthedgefundsthatusedBearStearnsasa
Copyrighted Material
InTroDuCT Ion bull 25
primebrokerrenaissanceTechnologieswithdrew$5bilshy
lionofcashintheweekthefirmfailedWithsuchoutflows
it is not surprising that Bear Stearns ran out of money
eventhoughithadmorethan$18billionincashaweek
earlier
Likeclassicbankrunsmodernbankrunsarebothdeshy
structiveandselfshyfulfillingConcernthatabankmightbe
in trouble spurs its creditors and counterparties towithshy
draworwithholdtheircapitalasaresultevenrumorsofa
problemmaybeenoughtodestroyaviableinstitutionThe
importanceofmodernbankrunsduringtheWorldFinanshy
cialCrisisisarecurringthemethroughoutthebookand
wemakeseveralproposalsthatareintendedtoreducethe
frequencyofsuchevents
The Inadequacy of the Regulatory Structure
TheWorldFinancialCrisismadeitclearthatfinancialinnoshy
vationhadoverwhelmedexistingfinancialregulationsnoshy
tableexamplesincludeaIGrsquosdecisiontosellanextremely
large amount of credit default swaps on subprime debt
tobanksintheunitedStatesandabroadtheholdingof
Lehmanpaperbymoneymarketfundsparticularlythereshy
serveprimaryFundthecomplexityofthederivativebooks
atLehmanandotherinvestmentbanksandthedifficultyof
simultaneouslyapplyingseveralcountriesrsquobankruptcycodes
tothesubsidiariesofmultinationalfinancialinstitutions1
Thereisatradeshyoffbetweenfinancialinnovationandstashy
bilityInnovationcanimprovethefinancialsystemrsquosability
Copyrighted Material
2 bull CHapTer 1
toallocateresourcestotheirhighestvaluedusebutitcan
alsoreducethestabilityofthesystemThechallengeisto
developregulationsthatimprovestabilitywithoutstifling
innovation In addition regulation often leads to innoshy
vations designed to evade the regulationswhich makes
thefinancialsystemmorefragileForexamplemanyofthe
specialshypurposevehiclesthatimplodedintheCrisiswere
createdtogetaroundcapitalrequirements
In many countries the response of regulators to the
World Financial Crisis was hampered by the fragmented
nature of their regulatory systems Financial regulations
are typically designed to ensure thehealth of individual
institutionsratherthanthefinancialsystemasawholeIn
thisbookwearguethatsystemicregulationisanimporshy
tantfunctionthatrequiresaspecialmandateandthatthe
central bank is particularly well equipped to fulfill this
function
Finallyeffectivefinancialregulationrequiresthatpolitishy
ciansandultimatelythepublichaveanadequateundershy
standing of the financial system The political turmoil
surroundingtheCrisissuggeststheimportanceofdissemishy
natingexpertknowledgeaboutfinancetoabroaderaudishy
enceThisisoneofourmotivationsforwritingthisbook
What Were the orIgIns oF the World FInancIal crIsIs
LiketheoriginsoftheFirstWorldWarthecausesofthe
Crisiswillbedebatedbyscholarsformanyyears
Copyrighted Material
InTroDuCT Ion bull 27
Most observers agree that the strong runshyup and subshy
sequentsharpdeclineinthepricesofstockshousesand
otherfinancialassetsindevelopedcountrieswasanimporshy
tantcatalystfortheCrisisThereisdisagreementhowever
aboutwhetherthispatterninpricesistheresultofrational
investorbehaviororldquoirrationalbubblesrdquo
SomearguethattherunshyupbeforetheCrisiswasdriven
by investorswhoknowingly acceptedunusually low exshy
pectedreturnsandtheyofferseveralpossiblereasonswhy
Firsttherewasasurgeofsavingsinemergingcountries
drivenbyacombinationofrapideconomicgrowthanddeshy
mographicsperhapsbecauseofadesiretoaccumulateforshy
eignreservesintheaftermathoftheasiacrisisof1997ndash98
muchof thiswealthwas invested indevelopedmarkets
Secondfinancialmarketswereunusually tranquilduring
200to200Withlowvolatilityinvestorsmayhavesettled
for a low risk premiumThird influenced by fears of a
Japaneseshystyledeflation resulting from themarketdownshy
turnof2000ndash2001andbyabeliefthattheyshouldnottry
to usemonetary policy to counteract rising asset prices
central bankers in the united States maintained a loose
monetarypolicythroughouttheperiod17andfromthisrashy
tionalviewofinvestorstheplungeinassetpricesthatacshy
companiedtheCrisiswascausedbybadnewsaboutfuture
cashflowsunexpectedincreasesinthereturnsrequiredby
investorsorboth
otherssuggestamoredirectexplanationThehighprices
before theCrisisweredrivenby an irrational belief that
prices would continue to rise and the collapse of asset
priceswastheinevitableresultofthismistakeWhatever
Copyrighted Material
28 bull CHapTer 1
theexplanationthesharpdropinassetpricesbothconshy
tributedtoandwasasymptomoftheCrisis
other commentators argue that the financial system
becamevulnerablebecausemanymarketparticipantsasshy
sessedrisksinaccuratelyduringtheperiodleadingupto
theWorldFinancialCrisisConsumersbanksandinvestors
ingeneralunderestimatedtheriskofhousepricedeclines
increasingthepricestheywerewillingtopayforrealesshy
tatethecredittheywerewillingtoextendandthevaluashy
tionsofbanksthatextendedsuchcreditBanksputmuch
weight on the recent pastwhen they estimated value at
riskwhichledthemtoconcludethatthelevelofriskwas
lowandthattherewaslittledownsidetohavinghighleshy
verageothermarketparticipantsdidnotfullyappreciate
thathighliquiditywassuppressingvolatilityandthatthe
processmightreversewithliquiditydecreasingandvolatilshy
ityincreasing
More generally the high level of financial innovation
driveninpartbythedecliningcostofinformationtechnolshy
ogymadeithardforriskassessmenttokeeppacewiththe
evolvingfinancialsystem18Thebenignenvironmentofthe
creditboomexacerbatedthisproblembytemptingfinanshy
cialinstitutionstounderinvestinriskmanagement
uSpolicymakersalsocontributedtotheseverityofthe
CrisisbypushingFannieMaeandFreddieMactoincrease
theavailabilityofmortgagefundingtoborrowerswithquesshy
tionableabilitytorepaytheirmortgagesasaresultofthis
pressure both agencies relaxed their standards for the
mortgages they purchased and guaranteedThe demand
Copyrighted Material
InTroDuCT Ion bull 29
forhomesbyborrowerswhoqualifiedformortgagesbeshy
causeoftheselowerstandardspusheduppricesandthe
defaultbymanyofthemduringtherecessioncontributed
tothedropinhomeprices
Thepanicandruninthefallof2008remainthecentral
distinguishingfeaturesoftheWorldFinancialCrisisasset
priceshave risenand fallenbeforeand theworldeconshy
omyhasbornelargefinancial lossesmanytimeswithout
suchasevereeconomicoutcomeConverselylossesfrom
completelydifferentunderlyingsourcesmdashcommercialreal
estateorperhapssovereigndefaultsmdashcouldcauseasimilar
catastrophe if theyagainprovoke tooshybigshytoshyfailchaosor
runs
Thisbookdoesnotseektoprovideacompletediagnosis
oftheWorldFinancialCrisisnordoesittakeastandonthe
relativeimportanceofthecontributingfactorslistedabove
ratherwebelieveourrecommendationswillhelpprevent
ormitigatefuturecriseseventhoughwedonotfullyundershy
standallthecausesofthelastone
CarmenreinhartandKennethrogoff amongothershave
pointedoutthatfinancialcriseshaveoccurredthroughout
thehistoryofcapitalismandthatthesecrisessharemany
commonpatterns19 Thelessonwedrawfromthisisthat
noacceptablesetofregulationscanpreventmarketparticishy
pantsfrommakingmistakesthatcreateeconomicinstability
ourpurposeinthisbookisinsteadtosuggestregulatory
reformsthatwillmakethesystemmorestabledespitethe
mistakesthataresuretocome
Copyrighted Material
InTroDuCT Ion bull 21
werenotawareoftheldquoearthquakerisksrdquoinherentinmany
of theirstrategiesSimilarlywhenfirmstakeactionsthat
increasethelikelihoodofagovernmentbailoutinthenext
financialcrisisthemarketrewardsthemwithalowercost
of capitalas firms become too big to fail for example
the implicit government guarantee reduces the riskiness
of their debt and lowers the interest rate demanded by
theircreditorsaCeoworkingtomaximizefirmvaluemay
notevenrealize the importanceof thegovernmentguarshy
anteebut a Darwinian process will encourage behavior
thatexploitsit
Bankruptcy and Resolution Procedures
Itisimpossibletowriteafinancialcontractthatspecifies
everypossiblecontingencyInsteadcontractsrelyonbankshy
ruptcytodetermineoutcomesincertainbadandunlikely
statesoftheworldInbankruptcycontrolofafirmistransshy
ferredfromtheshareholderswhonolongerhaveastake
inlossesbecausetheirsharesareworthlittletothedebtshy
holders It is in societyrsquos interest to develop bankruptcy
proceduresthatmaximizethepostshybankruptcyvalueofa
firmrsquosassetsInparticularsocietyshouldavoidthedestrucshy
tionofvaluethatoccurswithdisorderlyliquidation
Disorderlyliquidationoffinancialinstitutionsisparticushy
larly costlyFirstvaluableknowledge that the institution
hasaccumulatedaboutitscounterpartiesmdashborrowerstradshy
ingpartnersandsoonmdashcandisappearastheinstitution
losesemployeesandceasestooperatenormallyFinancial
Copyrighted Material
22 bull CHapTer 1
economistshavefoundthatthecollapseofabankhasamashy
terialadverseimpactonmanyofitsborrowers1 Second
the prospect of a disorderly liquidation makes it more
likelythatatroubledfinancialinstitutionwillsufferarun
by creditors who conclude they are better off claiming
whatmoney theycan todayrather thanwaiting through
protracted liquidation proceedings Third ldquofire salesrdquo of
specializedassets inadisorderly liquidationcandepress
prices and thereby spread problems to other holders of
theassetclassFourthdisorderlyliquidationincreasesthe
uncertaintyabouttheimpactofafinancialinstitutionrsquosfailshy
ureonitscounterpartiesandotherclaimholdersBecause
financialfirmsaretightlyinterconnectedthisuncertainty
canprecipitateorintensifyafinancialcrisis1
In theunitedStatesthestandardbankruptcycodealshy
lowsbothforliquidationofafirmandthesaleofitsassets
(Chapter7)andforcontinuedoperationofafirmunder
the supervision of a bankruptcy judgewho protects the
firmfromcreditorsrsquoclaimswhileareorganizationplanis
approved(Chapter11)Theseproceduresappeartowork
wellfornonfinancialcorporationsbutnotsowellforfinanshy
cialorganizationsTheChapter11approachofseparatinga
firmrsquosfinancialaffairsfromitsnonfinancialbusinessactivishy
tiesisinfeasiblewhenthebusinessofthefirmisfinancial
transactionsFurthermoremanyfinancialinstitutionsrely
heavily on shortshyterm debtpossibly as a valuable discishy
plineonbankexecutiveswhocanrapidlychangetherisks
theirfirmstakeThismakesfinancialfirmsvulnerabletoa
rapidwithdrawalofshortshytermcreditthatislikelytooccur
beforeanyeventthatwouldtriggerbankruptcy
Copyrighted Material
InTroDuCT Ion bull 2
Wearguebelowthatthereisaneedforaspecialresolushy
tionprocedurethatcanbeappliedtolargeinsolventfinanshy
cialinstitutionsWealsoadvocateregulatorychangesthat
would push financial firms towardmore resilient capital
structures
Bank Runs
Classicbank runs inwhichdepositors race towithdraw
their funds before a bank failswere one of the central
contributors to theGreatDepressionDeposit insurance
whichwasintroducedaftertheDepressiontocounterthis
destructiveprocessmadedemanddepositsoneofthemost
stableformsofbankfinancingduringtheWorldFinancial
CrisisManyfinancialinstitutionshoweversufferedamodshy
ernversionofbankruns
Banksespeciallythosewithinvestmentbankingactivishy
tiestypicallyfinanceasignificantfractionoftheirbusiness
withovernightcommercialpaperreposandothershortshy
terminstrumentsInnormaltimesbanksrolloverthisdebt
asitmaturestakingnewloanstopayofftheoldInacrishy
sishoweveruncertaintyaboutwhetheratroubledinstitushy
tionwouldbeabletopayoffitscreditorstomorrowcauses
lenderstostopextendingcredittodayThusshortshytermfishy
nancingcanleadtoarunthatissimilartoaclassicrunon
deposits
even some secured creditors participated in runs durshy
ingtheWorldFinancialCrisisBanksoftenuserepurchase
agreements to borrow money securing the loan by givshy
ingthelenderafinancialassetsuchasaTreasurybond
Copyrighted Material
2 bull CHapTer 1
ascollateralBecausetheyareovershycollateralizedwithasshy
setsworthperhaps$105guaranteeingevery$100inloans
lendersviewldquoreposrdquoasasafewaytoextendcreditWhen
credit markets froze during the Crisis however lenders
worried that retrieving collateral and selling itwouldbe
difficultandnotworththesmallinterestonanovernight
loanasaresultatvarioustimesduringtheCrisismany
investmentbankshaddifficultyrollingovereventheirseshy
cured loanseven relatively healthy financial institutions
werehamperedbythetroubleintherepomarketafteraushy
gust2007asthemarketbecamemoreandmoreuncertain
about the prices securities would fetch in a forced sale
these institutions found they could borrow less and less
withthesamecollateral15
prime brokerage accounts also saw a runshylike withshy
drawalbycustomersManylargebankshaveprimebrokershy
agegroupsthatassisthedgefundsandotherinstitutionalinshy
vestorsbyprovidingfinancingsecuritieslendingclearing
custodial servicesandoperational supportInexchange
thefundspayfeesandcriticallypostcollateraltosecure
theirloansWithsomerestrictionsthatweexplaininChapshy
ter10theprimebrokercanthenusethecollateralinits
ownbusinessinsomecasescomminglingitwiththefirmrsquos
ownassetsDuringtheCrisishedgefundsmonitoredthe
financial wellshybeing of their prime brokers and like deshy
positorsintheDepressionfledwiththeircollateralatthe
firstsignoftroubleBearStearnsforexamplehadalarge
prime brokerage business according to press accounts
oneofthelargesthedgefundsthatusedBearStearnsasa
Copyrighted Material
InTroDuCT Ion bull 25
primebrokerrenaissanceTechnologieswithdrew$5bilshy
lionofcashintheweekthefirmfailedWithsuchoutflows
it is not surprising that Bear Stearns ran out of money
eventhoughithadmorethan$18billionincashaweek
earlier
Likeclassicbankrunsmodernbankrunsarebothdeshy
structiveandselfshyfulfillingConcernthatabankmightbe
in trouble spurs its creditors and counterparties towithshy
draworwithholdtheircapitalasaresultevenrumorsofa
problemmaybeenoughtodestroyaviableinstitutionThe
importanceofmodernbankrunsduringtheWorldFinanshy
cialCrisisisarecurringthemethroughoutthebookand
wemakeseveralproposalsthatareintendedtoreducethe
frequencyofsuchevents
The Inadequacy of the Regulatory Structure
TheWorldFinancialCrisismadeitclearthatfinancialinnoshy
vationhadoverwhelmedexistingfinancialregulationsnoshy
tableexamplesincludeaIGrsquosdecisiontosellanextremely
large amount of credit default swaps on subprime debt
tobanksintheunitedStatesandabroadtheholdingof
Lehmanpaperbymoneymarketfundsparticularlythereshy
serveprimaryFundthecomplexityofthederivativebooks
atLehmanandotherinvestmentbanksandthedifficultyof
simultaneouslyapplyingseveralcountriesrsquobankruptcycodes
tothesubsidiariesofmultinationalfinancialinstitutions1
Thereisatradeshyoffbetweenfinancialinnovationandstashy
bilityInnovationcanimprovethefinancialsystemrsquosability
Copyrighted Material
2 bull CHapTer 1
toallocateresourcestotheirhighestvaluedusebutitcan
alsoreducethestabilityofthesystemThechallengeisto
developregulationsthatimprovestabilitywithoutstifling
innovation In addition regulation often leads to innoshy
vations designed to evade the regulationswhich makes
thefinancialsystemmorefragileForexamplemanyofthe
specialshypurposevehiclesthatimplodedintheCrisiswere
createdtogetaroundcapitalrequirements
In many countries the response of regulators to the
World Financial Crisis was hampered by the fragmented
nature of their regulatory systems Financial regulations
are typically designed to ensure thehealth of individual
institutionsratherthanthefinancialsystemasawholeIn
thisbookwearguethatsystemicregulationisanimporshy
tantfunctionthatrequiresaspecialmandateandthatthe
central bank is particularly well equipped to fulfill this
function
Finallyeffectivefinancialregulationrequiresthatpolitishy
ciansandultimatelythepublichaveanadequateundershy
standing of the financial system The political turmoil
surroundingtheCrisissuggeststheimportanceofdissemishy
natingexpertknowledgeaboutfinancetoabroaderaudishy
enceThisisoneofourmotivationsforwritingthisbook
What Were the orIgIns oF the World FInancIal crIsIs
LiketheoriginsoftheFirstWorldWarthecausesofthe
Crisiswillbedebatedbyscholarsformanyyears
Copyrighted Material
InTroDuCT Ion bull 27
Most observers agree that the strong runshyup and subshy
sequentsharpdeclineinthepricesofstockshousesand
otherfinancialassetsindevelopedcountrieswasanimporshy
tantcatalystfortheCrisisThereisdisagreementhowever
aboutwhetherthispatterninpricesistheresultofrational
investorbehaviororldquoirrationalbubblesrdquo
SomearguethattherunshyupbeforetheCrisiswasdriven
by investorswhoknowingly acceptedunusually low exshy
pectedreturnsandtheyofferseveralpossiblereasonswhy
Firsttherewasasurgeofsavingsinemergingcountries
drivenbyacombinationofrapideconomicgrowthanddeshy
mographicsperhapsbecauseofadesiretoaccumulateforshy
eignreservesintheaftermathoftheasiacrisisof1997ndash98
muchof thiswealthwas invested indevelopedmarkets
Secondfinancialmarketswereunusually tranquilduring
200to200Withlowvolatilityinvestorsmayhavesettled
for a low risk premiumThird influenced by fears of a
Japaneseshystyledeflation resulting from themarketdownshy
turnof2000ndash2001andbyabeliefthattheyshouldnottry
to usemonetary policy to counteract rising asset prices
central bankers in the united States maintained a loose
monetarypolicythroughouttheperiod17andfromthisrashy
tionalviewofinvestorstheplungeinassetpricesthatacshy
companiedtheCrisiswascausedbybadnewsaboutfuture
cashflowsunexpectedincreasesinthereturnsrequiredby
investorsorboth
otherssuggestamoredirectexplanationThehighprices
before theCrisisweredrivenby an irrational belief that
prices would continue to rise and the collapse of asset
priceswastheinevitableresultofthismistakeWhatever
Copyrighted Material
28 bull CHapTer 1
theexplanationthesharpdropinassetpricesbothconshy
tributedtoandwasasymptomoftheCrisis
other commentators argue that the financial system
becamevulnerablebecausemanymarketparticipantsasshy
sessedrisksinaccuratelyduringtheperiodleadingupto
theWorldFinancialCrisisConsumersbanksandinvestors
ingeneralunderestimatedtheriskofhousepricedeclines
increasingthepricestheywerewillingtopayforrealesshy
tatethecredittheywerewillingtoextendandthevaluashy
tionsofbanksthatextendedsuchcreditBanksputmuch
weight on the recent pastwhen they estimated value at
riskwhichledthemtoconcludethatthelevelofriskwas
lowandthattherewaslittledownsidetohavinghighleshy
verageothermarketparticipantsdidnotfullyappreciate
thathighliquiditywassuppressingvolatilityandthatthe
processmightreversewithliquiditydecreasingandvolatilshy
ityincreasing
More generally the high level of financial innovation
driveninpartbythedecliningcostofinformationtechnolshy
ogymadeithardforriskassessmenttokeeppacewiththe
evolvingfinancialsystem18Thebenignenvironmentofthe
creditboomexacerbatedthisproblembytemptingfinanshy
cialinstitutionstounderinvestinriskmanagement
uSpolicymakersalsocontributedtotheseverityofthe
CrisisbypushingFannieMaeandFreddieMactoincrease
theavailabilityofmortgagefundingtoborrowerswithquesshy
tionableabilitytorepaytheirmortgagesasaresultofthis
pressure both agencies relaxed their standards for the
mortgages they purchased and guaranteedThe demand
Copyrighted Material
InTroDuCT Ion bull 29
forhomesbyborrowerswhoqualifiedformortgagesbeshy
causeoftheselowerstandardspusheduppricesandthe
defaultbymanyofthemduringtherecessioncontributed
tothedropinhomeprices
Thepanicandruninthefallof2008remainthecentral
distinguishingfeaturesoftheWorldFinancialCrisisasset
priceshave risenand fallenbeforeand theworldeconshy
omyhasbornelargefinancial lossesmanytimeswithout
suchasevereeconomicoutcomeConverselylossesfrom
completelydifferentunderlyingsourcesmdashcommercialreal
estateorperhapssovereigndefaultsmdashcouldcauseasimilar
catastrophe if theyagainprovoke tooshybigshytoshyfailchaosor
runs
Thisbookdoesnotseektoprovideacompletediagnosis
oftheWorldFinancialCrisisnordoesittakeastandonthe
relativeimportanceofthecontributingfactorslistedabove
ratherwebelieveourrecommendationswillhelpprevent
ormitigatefuturecriseseventhoughwedonotfullyundershy
standallthecausesofthelastone
CarmenreinhartandKennethrogoff amongothershave
pointedoutthatfinancialcriseshaveoccurredthroughout
thehistoryofcapitalismandthatthesecrisessharemany
commonpatterns19 Thelessonwedrawfromthisisthat
noacceptablesetofregulationscanpreventmarketparticishy
pantsfrommakingmistakesthatcreateeconomicinstability
ourpurposeinthisbookisinsteadtosuggestregulatory
reformsthatwillmakethesystemmorestabledespitethe
mistakesthataresuretocome
Copyrighted Material
22 bull CHapTer 1
economistshavefoundthatthecollapseofabankhasamashy
terialadverseimpactonmanyofitsborrowers1 Second
the prospect of a disorderly liquidation makes it more
likelythatatroubledfinancialinstitutionwillsufferarun
by creditors who conclude they are better off claiming
whatmoney theycan todayrather thanwaiting through
protracted liquidation proceedings Third ldquofire salesrdquo of
specializedassets inadisorderly liquidationcandepress
prices and thereby spread problems to other holders of
theassetclassFourthdisorderlyliquidationincreasesthe
uncertaintyabouttheimpactofafinancialinstitutionrsquosfailshy
ureonitscounterpartiesandotherclaimholdersBecause
financialfirmsaretightlyinterconnectedthisuncertainty
canprecipitateorintensifyafinancialcrisis1
In theunitedStatesthestandardbankruptcycodealshy
lowsbothforliquidationofafirmandthesaleofitsassets
(Chapter7)andforcontinuedoperationofafirmunder
the supervision of a bankruptcy judgewho protects the
firmfromcreditorsrsquoclaimswhileareorganizationplanis
approved(Chapter11)Theseproceduresappeartowork
wellfornonfinancialcorporationsbutnotsowellforfinanshy
cialorganizationsTheChapter11approachofseparatinga
firmrsquosfinancialaffairsfromitsnonfinancialbusinessactivishy
tiesisinfeasiblewhenthebusinessofthefirmisfinancial
transactionsFurthermoremanyfinancialinstitutionsrely
heavily on shortshyterm debtpossibly as a valuable discishy
plineonbankexecutiveswhocanrapidlychangetherisks
theirfirmstakeThismakesfinancialfirmsvulnerabletoa
rapidwithdrawalofshortshytermcreditthatislikelytooccur
beforeanyeventthatwouldtriggerbankruptcy
Copyrighted Material
InTroDuCT Ion bull 2
Wearguebelowthatthereisaneedforaspecialresolushy
tionprocedurethatcanbeappliedtolargeinsolventfinanshy
cialinstitutionsWealsoadvocateregulatorychangesthat
would push financial firms towardmore resilient capital
structures
Bank Runs
Classicbank runs inwhichdepositors race towithdraw
their funds before a bank failswere one of the central
contributors to theGreatDepressionDeposit insurance
whichwasintroducedaftertheDepressiontocounterthis
destructiveprocessmadedemanddepositsoneofthemost
stableformsofbankfinancingduringtheWorldFinancial
CrisisManyfinancialinstitutionshoweversufferedamodshy
ernversionofbankruns
Banksespeciallythosewithinvestmentbankingactivishy
tiestypicallyfinanceasignificantfractionoftheirbusiness
withovernightcommercialpaperreposandothershortshy
terminstrumentsInnormaltimesbanksrolloverthisdebt
asitmaturestakingnewloanstopayofftheoldInacrishy
sishoweveruncertaintyaboutwhetheratroubledinstitushy
tionwouldbeabletopayoffitscreditorstomorrowcauses
lenderstostopextendingcredittodayThusshortshytermfishy
nancingcanleadtoarunthatissimilartoaclassicrunon
deposits
even some secured creditors participated in runs durshy
ingtheWorldFinancialCrisisBanksoftenuserepurchase
agreements to borrow money securing the loan by givshy
ingthelenderafinancialassetsuchasaTreasurybond
Copyrighted Material
2 bull CHapTer 1
ascollateralBecausetheyareovershycollateralizedwithasshy
setsworthperhaps$105guaranteeingevery$100inloans
lendersviewldquoreposrdquoasasafewaytoextendcreditWhen
credit markets froze during the Crisis however lenders
worried that retrieving collateral and selling itwouldbe
difficultandnotworththesmallinterestonanovernight
loanasaresultatvarioustimesduringtheCrisismany
investmentbankshaddifficultyrollingovereventheirseshy
cured loanseven relatively healthy financial institutions
werehamperedbythetroubleintherepomarketafteraushy
gust2007asthemarketbecamemoreandmoreuncertain
about the prices securities would fetch in a forced sale
these institutions found they could borrow less and less
withthesamecollateral15
prime brokerage accounts also saw a runshylike withshy
drawalbycustomersManylargebankshaveprimebrokershy
agegroupsthatassisthedgefundsandotherinstitutionalinshy
vestorsbyprovidingfinancingsecuritieslendingclearing
custodial servicesandoperational supportInexchange
thefundspayfeesandcriticallypostcollateraltosecure
theirloansWithsomerestrictionsthatweexplaininChapshy
ter10theprimebrokercanthenusethecollateralinits
ownbusinessinsomecasescomminglingitwiththefirmrsquos
ownassetsDuringtheCrisishedgefundsmonitoredthe
financial wellshybeing of their prime brokers and like deshy
positorsintheDepressionfledwiththeircollateralatthe
firstsignoftroubleBearStearnsforexamplehadalarge
prime brokerage business according to press accounts
oneofthelargesthedgefundsthatusedBearStearnsasa
Copyrighted Material
InTroDuCT Ion bull 25
primebrokerrenaissanceTechnologieswithdrew$5bilshy
lionofcashintheweekthefirmfailedWithsuchoutflows
it is not surprising that Bear Stearns ran out of money
eventhoughithadmorethan$18billionincashaweek
earlier
Likeclassicbankrunsmodernbankrunsarebothdeshy
structiveandselfshyfulfillingConcernthatabankmightbe
in trouble spurs its creditors and counterparties towithshy
draworwithholdtheircapitalasaresultevenrumorsofa
problemmaybeenoughtodestroyaviableinstitutionThe
importanceofmodernbankrunsduringtheWorldFinanshy
cialCrisisisarecurringthemethroughoutthebookand
wemakeseveralproposalsthatareintendedtoreducethe
frequencyofsuchevents
The Inadequacy of the Regulatory Structure
TheWorldFinancialCrisismadeitclearthatfinancialinnoshy
vationhadoverwhelmedexistingfinancialregulationsnoshy
tableexamplesincludeaIGrsquosdecisiontosellanextremely
large amount of credit default swaps on subprime debt
tobanksintheunitedStatesandabroadtheholdingof
Lehmanpaperbymoneymarketfundsparticularlythereshy
serveprimaryFundthecomplexityofthederivativebooks
atLehmanandotherinvestmentbanksandthedifficultyof
simultaneouslyapplyingseveralcountriesrsquobankruptcycodes
tothesubsidiariesofmultinationalfinancialinstitutions1
Thereisatradeshyoffbetweenfinancialinnovationandstashy
bilityInnovationcanimprovethefinancialsystemrsquosability
Copyrighted Material
2 bull CHapTer 1
toallocateresourcestotheirhighestvaluedusebutitcan
alsoreducethestabilityofthesystemThechallengeisto
developregulationsthatimprovestabilitywithoutstifling
innovation In addition regulation often leads to innoshy
vations designed to evade the regulationswhich makes
thefinancialsystemmorefragileForexamplemanyofthe
specialshypurposevehiclesthatimplodedintheCrisiswere
createdtogetaroundcapitalrequirements
In many countries the response of regulators to the
World Financial Crisis was hampered by the fragmented
nature of their regulatory systems Financial regulations
are typically designed to ensure thehealth of individual
institutionsratherthanthefinancialsystemasawholeIn
thisbookwearguethatsystemicregulationisanimporshy
tantfunctionthatrequiresaspecialmandateandthatthe
central bank is particularly well equipped to fulfill this
function
Finallyeffectivefinancialregulationrequiresthatpolitishy
ciansandultimatelythepublichaveanadequateundershy
standing of the financial system The political turmoil
surroundingtheCrisissuggeststheimportanceofdissemishy
natingexpertknowledgeaboutfinancetoabroaderaudishy
enceThisisoneofourmotivationsforwritingthisbook
What Were the orIgIns oF the World FInancIal crIsIs
LiketheoriginsoftheFirstWorldWarthecausesofthe
Crisiswillbedebatedbyscholarsformanyyears
Copyrighted Material
InTroDuCT Ion bull 27
Most observers agree that the strong runshyup and subshy
sequentsharpdeclineinthepricesofstockshousesand
otherfinancialassetsindevelopedcountrieswasanimporshy
tantcatalystfortheCrisisThereisdisagreementhowever
aboutwhetherthispatterninpricesistheresultofrational
investorbehaviororldquoirrationalbubblesrdquo
SomearguethattherunshyupbeforetheCrisiswasdriven
by investorswhoknowingly acceptedunusually low exshy
pectedreturnsandtheyofferseveralpossiblereasonswhy
Firsttherewasasurgeofsavingsinemergingcountries
drivenbyacombinationofrapideconomicgrowthanddeshy
mographicsperhapsbecauseofadesiretoaccumulateforshy
eignreservesintheaftermathoftheasiacrisisof1997ndash98
muchof thiswealthwas invested indevelopedmarkets
Secondfinancialmarketswereunusually tranquilduring
200to200Withlowvolatilityinvestorsmayhavesettled
for a low risk premiumThird influenced by fears of a
Japaneseshystyledeflation resulting from themarketdownshy
turnof2000ndash2001andbyabeliefthattheyshouldnottry
to usemonetary policy to counteract rising asset prices
central bankers in the united States maintained a loose
monetarypolicythroughouttheperiod17andfromthisrashy
tionalviewofinvestorstheplungeinassetpricesthatacshy
companiedtheCrisiswascausedbybadnewsaboutfuture
cashflowsunexpectedincreasesinthereturnsrequiredby
investorsorboth
otherssuggestamoredirectexplanationThehighprices
before theCrisisweredrivenby an irrational belief that
prices would continue to rise and the collapse of asset
priceswastheinevitableresultofthismistakeWhatever
Copyrighted Material
28 bull CHapTer 1
theexplanationthesharpdropinassetpricesbothconshy
tributedtoandwasasymptomoftheCrisis
other commentators argue that the financial system
becamevulnerablebecausemanymarketparticipantsasshy
sessedrisksinaccuratelyduringtheperiodleadingupto
theWorldFinancialCrisisConsumersbanksandinvestors
ingeneralunderestimatedtheriskofhousepricedeclines
increasingthepricestheywerewillingtopayforrealesshy
tatethecredittheywerewillingtoextendandthevaluashy
tionsofbanksthatextendedsuchcreditBanksputmuch
weight on the recent pastwhen they estimated value at
riskwhichledthemtoconcludethatthelevelofriskwas
lowandthattherewaslittledownsidetohavinghighleshy
verageothermarketparticipantsdidnotfullyappreciate
thathighliquiditywassuppressingvolatilityandthatthe
processmightreversewithliquiditydecreasingandvolatilshy
ityincreasing
More generally the high level of financial innovation
driveninpartbythedecliningcostofinformationtechnolshy
ogymadeithardforriskassessmenttokeeppacewiththe
evolvingfinancialsystem18Thebenignenvironmentofthe
creditboomexacerbatedthisproblembytemptingfinanshy
cialinstitutionstounderinvestinriskmanagement
uSpolicymakersalsocontributedtotheseverityofthe
CrisisbypushingFannieMaeandFreddieMactoincrease
theavailabilityofmortgagefundingtoborrowerswithquesshy
tionableabilitytorepaytheirmortgagesasaresultofthis
pressure both agencies relaxed their standards for the
mortgages they purchased and guaranteedThe demand
Copyrighted Material
InTroDuCT Ion bull 29
forhomesbyborrowerswhoqualifiedformortgagesbeshy
causeoftheselowerstandardspusheduppricesandthe
defaultbymanyofthemduringtherecessioncontributed
tothedropinhomeprices
Thepanicandruninthefallof2008remainthecentral
distinguishingfeaturesoftheWorldFinancialCrisisasset
priceshave risenand fallenbeforeand theworldeconshy
omyhasbornelargefinancial lossesmanytimeswithout
suchasevereeconomicoutcomeConverselylossesfrom
completelydifferentunderlyingsourcesmdashcommercialreal
estateorperhapssovereigndefaultsmdashcouldcauseasimilar
catastrophe if theyagainprovoke tooshybigshytoshyfailchaosor
runs
Thisbookdoesnotseektoprovideacompletediagnosis
oftheWorldFinancialCrisisnordoesittakeastandonthe
relativeimportanceofthecontributingfactorslistedabove
ratherwebelieveourrecommendationswillhelpprevent
ormitigatefuturecriseseventhoughwedonotfullyundershy
standallthecausesofthelastone
CarmenreinhartandKennethrogoff amongothershave
pointedoutthatfinancialcriseshaveoccurredthroughout
thehistoryofcapitalismandthatthesecrisessharemany
commonpatterns19 Thelessonwedrawfromthisisthat
noacceptablesetofregulationscanpreventmarketparticishy
pantsfrommakingmistakesthatcreateeconomicinstability
ourpurposeinthisbookisinsteadtosuggestregulatory
reformsthatwillmakethesystemmorestabledespitethe
mistakesthataresuretocome
Copyrighted Material
InTroDuCT Ion bull 2
Wearguebelowthatthereisaneedforaspecialresolushy
tionprocedurethatcanbeappliedtolargeinsolventfinanshy
cialinstitutionsWealsoadvocateregulatorychangesthat
would push financial firms towardmore resilient capital
structures
Bank Runs
Classicbank runs inwhichdepositors race towithdraw
their funds before a bank failswere one of the central
contributors to theGreatDepressionDeposit insurance
whichwasintroducedaftertheDepressiontocounterthis
destructiveprocessmadedemanddepositsoneofthemost
stableformsofbankfinancingduringtheWorldFinancial
CrisisManyfinancialinstitutionshoweversufferedamodshy
ernversionofbankruns
Banksespeciallythosewithinvestmentbankingactivishy
tiestypicallyfinanceasignificantfractionoftheirbusiness
withovernightcommercialpaperreposandothershortshy
terminstrumentsInnormaltimesbanksrolloverthisdebt
asitmaturestakingnewloanstopayofftheoldInacrishy
sishoweveruncertaintyaboutwhetheratroubledinstitushy
tionwouldbeabletopayoffitscreditorstomorrowcauses
lenderstostopextendingcredittodayThusshortshytermfishy
nancingcanleadtoarunthatissimilartoaclassicrunon
deposits
even some secured creditors participated in runs durshy
ingtheWorldFinancialCrisisBanksoftenuserepurchase
agreements to borrow money securing the loan by givshy
ingthelenderafinancialassetsuchasaTreasurybond
Copyrighted Material
2 bull CHapTer 1
ascollateralBecausetheyareovershycollateralizedwithasshy
setsworthperhaps$105guaranteeingevery$100inloans
lendersviewldquoreposrdquoasasafewaytoextendcreditWhen
credit markets froze during the Crisis however lenders
worried that retrieving collateral and selling itwouldbe
difficultandnotworththesmallinterestonanovernight
loanasaresultatvarioustimesduringtheCrisismany
investmentbankshaddifficultyrollingovereventheirseshy
cured loanseven relatively healthy financial institutions
werehamperedbythetroubleintherepomarketafteraushy
gust2007asthemarketbecamemoreandmoreuncertain
about the prices securities would fetch in a forced sale
these institutions found they could borrow less and less
withthesamecollateral15
prime brokerage accounts also saw a runshylike withshy
drawalbycustomersManylargebankshaveprimebrokershy
agegroupsthatassisthedgefundsandotherinstitutionalinshy
vestorsbyprovidingfinancingsecuritieslendingclearing
custodial servicesandoperational supportInexchange
thefundspayfeesandcriticallypostcollateraltosecure
theirloansWithsomerestrictionsthatweexplaininChapshy
ter10theprimebrokercanthenusethecollateralinits
ownbusinessinsomecasescomminglingitwiththefirmrsquos
ownassetsDuringtheCrisishedgefundsmonitoredthe
financial wellshybeing of their prime brokers and like deshy
positorsintheDepressionfledwiththeircollateralatthe
firstsignoftroubleBearStearnsforexamplehadalarge
prime brokerage business according to press accounts
oneofthelargesthedgefundsthatusedBearStearnsasa
Copyrighted Material
InTroDuCT Ion bull 25
primebrokerrenaissanceTechnologieswithdrew$5bilshy
lionofcashintheweekthefirmfailedWithsuchoutflows
it is not surprising that Bear Stearns ran out of money
eventhoughithadmorethan$18billionincashaweek
earlier
Likeclassicbankrunsmodernbankrunsarebothdeshy
structiveandselfshyfulfillingConcernthatabankmightbe
in trouble spurs its creditors and counterparties towithshy
draworwithholdtheircapitalasaresultevenrumorsofa
problemmaybeenoughtodestroyaviableinstitutionThe
importanceofmodernbankrunsduringtheWorldFinanshy
cialCrisisisarecurringthemethroughoutthebookand
wemakeseveralproposalsthatareintendedtoreducethe
frequencyofsuchevents
The Inadequacy of the Regulatory Structure
TheWorldFinancialCrisismadeitclearthatfinancialinnoshy
vationhadoverwhelmedexistingfinancialregulationsnoshy
tableexamplesincludeaIGrsquosdecisiontosellanextremely
large amount of credit default swaps on subprime debt
tobanksintheunitedStatesandabroadtheholdingof
Lehmanpaperbymoneymarketfundsparticularlythereshy
serveprimaryFundthecomplexityofthederivativebooks
atLehmanandotherinvestmentbanksandthedifficultyof
simultaneouslyapplyingseveralcountriesrsquobankruptcycodes
tothesubsidiariesofmultinationalfinancialinstitutions1
Thereisatradeshyoffbetweenfinancialinnovationandstashy
bilityInnovationcanimprovethefinancialsystemrsquosability
Copyrighted Material
2 bull CHapTer 1
toallocateresourcestotheirhighestvaluedusebutitcan
alsoreducethestabilityofthesystemThechallengeisto
developregulationsthatimprovestabilitywithoutstifling
innovation In addition regulation often leads to innoshy
vations designed to evade the regulationswhich makes
thefinancialsystemmorefragileForexamplemanyofthe
specialshypurposevehiclesthatimplodedintheCrisiswere
createdtogetaroundcapitalrequirements
In many countries the response of regulators to the
World Financial Crisis was hampered by the fragmented
nature of their regulatory systems Financial regulations
are typically designed to ensure thehealth of individual
institutionsratherthanthefinancialsystemasawholeIn
thisbookwearguethatsystemicregulationisanimporshy
tantfunctionthatrequiresaspecialmandateandthatthe
central bank is particularly well equipped to fulfill this
function
Finallyeffectivefinancialregulationrequiresthatpolitishy
ciansandultimatelythepublichaveanadequateundershy
standing of the financial system The political turmoil
surroundingtheCrisissuggeststheimportanceofdissemishy
natingexpertknowledgeaboutfinancetoabroaderaudishy
enceThisisoneofourmotivationsforwritingthisbook
What Were the orIgIns oF the World FInancIal crIsIs
LiketheoriginsoftheFirstWorldWarthecausesofthe
Crisiswillbedebatedbyscholarsformanyyears
Copyrighted Material
InTroDuCT Ion bull 27
Most observers agree that the strong runshyup and subshy
sequentsharpdeclineinthepricesofstockshousesand
otherfinancialassetsindevelopedcountrieswasanimporshy
tantcatalystfortheCrisisThereisdisagreementhowever
aboutwhetherthispatterninpricesistheresultofrational
investorbehaviororldquoirrationalbubblesrdquo
SomearguethattherunshyupbeforetheCrisiswasdriven
by investorswhoknowingly acceptedunusually low exshy
pectedreturnsandtheyofferseveralpossiblereasonswhy
Firsttherewasasurgeofsavingsinemergingcountries
drivenbyacombinationofrapideconomicgrowthanddeshy
mographicsperhapsbecauseofadesiretoaccumulateforshy
eignreservesintheaftermathoftheasiacrisisof1997ndash98
muchof thiswealthwas invested indevelopedmarkets
Secondfinancialmarketswereunusually tranquilduring
200to200Withlowvolatilityinvestorsmayhavesettled
for a low risk premiumThird influenced by fears of a
Japaneseshystyledeflation resulting from themarketdownshy
turnof2000ndash2001andbyabeliefthattheyshouldnottry
to usemonetary policy to counteract rising asset prices
central bankers in the united States maintained a loose
monetarypolicythroughouttheperiod17andfromthisrashy
tionalviewofinvestorstheplungeinassetpricesthatacshy
companiedtheCrisiswascausedbybadnewsaboutfuture
cashflowsunexpectedincreasesinthereturnsrequiredby
investorsorboth
otherssuggestamoredirectexplanationThehighprices
before theCrisisweredrivenby an irrational belief that
prices would continue to rise and the collapse of asset
priceswastheinevitableresultofthismistakeWhatever
Copyrighted Material
28 bull CHapTer 1
theexplanationthesharpdropinassetpricesbothconshy
tributedtoandwasasymptomoftheCrisis
other commentators argue that the financial system
becamevulnerablebecausemanymarketparticipantsasshy
sessedrisksinaccuratelyduringtheperiodleadingupto
theWorldFinancialCrisisConsumersbanksandinvestors
ingeneralunderestimatedtheriskofhousepricedeclines
increasingthepricestheywerewillingtopayforrealesshy
tatethecredittheywerewillingtoextendandthevaluashy
tionsofbanksthatextendedsuchcreditBanksputmuch
weight on the recent pastwhen they estimated value at
riskwhichledthemtoconcludethatthelevelofriskwas
lowandthattherewaslittledownsidetohavinghighleshy
verageothermarketparticipantsdidnotfullyappreciate
thathighliquiditywassuppressingvolatilityandthatthe
processmightreversewithliquiditydecreasingandvolatilshy
ityincreasing
More generally the high level of financial innovation
driveninpartbythedecliningcostofinformationtechnolshy
ogymadeithardforriskassessmenttokeeppacewiththe
evolvingfinancialsystem18Thebenignenvironmentofthe
creditboomexacerbatedthisproblembytemptingfinanshy
cialinstitutionstounderinvestinriskmanagement
uSpolicymakersalsocontributedtotheseverityofthe
CrisisbypushingFannieMaeandFreddieMactoincrease
theavailabilityofmortgagefundingtoborrowerswithquesshy
tionableabilitytorepaytheirmortgagesasaresultofthis
pressure both agencies relaxed their standards for the
mortgages they purchased and guaranteedThe demand
Copyrighted Material
InTroDuCT Ion bull 29
forhomesbyborrowerswhoqualifiedformortgagesbeshy
causeoftheselowerstandardspusheduppricesandthe
defaultbymanyofthemduringtherecessioncontributed
tothedropinhomeprices
Thepanicandruninthefallof2008remainthecentral
distinguishingfeaturesoftheWorldFinancialCrisisasset
priceshave risenand fallenbeforeand theworldeconshy
omyhasbornelargefinancial lossesmanytimeswithout
suchasevereeconomicoutcomeConverselylossesfrom
completelydifferentunderlyingsourcesmdashcommercialreal
estateorperhapssovereigndefaultsmdashcouldcauseasimilar
catastrophe if theyagainprovoke tooshybigshytoshyfailchaosor
runs
Thisbookdoesnotseektoprovideacompletediagnosis
oftheWorldFinancialCrisisnordoesittakeastandonthe
relativeimportanceofthecontributingfactorslistedabove
ratherwebelieveourrecommendationswillhelpprevent
ormitigatefuturecriseseventhoughwedonotfullyundershy
standallthecausesofthelastone
CarmenreinhartandKennethrogoff amongothershave
pointedoutthatfinancialcriseshaveoccurredthroughout
thehistoryofcapitalismandthatthesecrisessharemany
commonpatterns19 Thelessonwedrawfromthisisthat
noacceptablesetofregulationscanpreventmarketparticishy
pantsfrommakingmistakesthatcreateeconomicinstability
ourpurposeinthisbookisinsteadtosuggestregulatory
reformsthatwillmakethesystemmorestabledespitethe
mistakesthataresuretocome
Copyrighted Material
2 bull CHapTer 1
ascollateralBecausetheyareovershycollateralizedwithasshy
setsworthperhaps$105guaranteeingevery$100inloans
lendersviewldquoreposrdquoasasafewaytoextendcreditWhen
credit markets froze during the Crisis however lenders
worried that retrieving collateral and selling itwouldbe
difficultandnotworththesmallinterestonanovernight
loanasaresultatvarioustimesduringtheCrisismany
investmentbankshaddifficultyrollingovereventheirseshy
cured loanseven relatively healthy financial institutions
werehamperedbythetroubleintherepomarketafteraushy
gust2007asthemarketbecamemoreandmoreuncertain
about the prices securities would fetch in a forced sale
these institutions found they could borrow less and less
withthesamecollateral15
prime brokerage accounts also saw a runshylike withshy
drawalbycustomersManylargebankshaveprimebrokershy
agegroupsthatassisthedgefundsandotherinstitutionalinshy
vestorsbyprovidingfinancingsecuritieslendingclearing
custodial servicesandoperational supportInexchange
thefundspayfeesandcriticallypostcollateraltosecure
theirloansWithsomerestrictionsthatweexplaininChapshy
ter10theprimebrokercanthenusethecollateralinits
ownbusinessinsomecasescomminglingitwiththefirmrsquos
ownassetsDuringtheCrisishedgefundsmonitoredthe
financial wellshybeing of their prime brokers and like deshy
positorsintheDepressionfledwiththeircollateralatthe
firstsignoftroubleBearStearnsforexamplehadalarge
prime brokerage business according to press accounts
oneofthelargesthedgefundsthatusedBearStearnsasa
Copyrighted Material
InTroDuCT Ion bull 25
primebrokerrenaissanceTechnologieswithdrew$5bilshy
lionofcashintheweekthefirmfailedWithsuchoutflows
it is not surprising that Bear Stearns ran out of money
eventhoughithadmorethan$18billionincashaweek
earlier
Likeclassicbankrunsmodernbankrunsarebothdeshy
structiveandselfshyfulfillingConcernthatabankmightbe
in trouble spurs its creditors and counterparties towithshy
draworwithholdtheircapitalasaresultevenrumorsofa
problemmaybeenoughtodestroyaviableinstitutionThe
importanceofmodernbankrunsduringtheWorldFinanshy
cialCrisisisarecurringthemethroughoutthebookand
wemakeseveralproposalsthatareintendedtoreducethe
frequencyofsuchevents
The Inadequacy of the Regulatory Structure
TheWorldFinancialCrisismadeitclearthatfinancialinnoshy
vationhadoverwhelmedexistingfinancialregulationsnoshy
tableexamplesincludeaIGrsquosdecisiontosellanextremely
large amount of credit default swaps on subprime debt
tobanksintheunitedStatesandabroadtheholdingof
Lehmanpaperbymoneymarketfundsparticularlythereshy
serveprimaryFundthecomplexityofthederivativebooks
atLehmanandotherinvestmentbanksandthedifficultyof
simultaneouslyapplyingseveralcountriesrsquobankruptcycodes
tothesubsidiariesofmultinationalfinancialinstitutions1
Thereisatradeshyoffbetweenfinancialinnovationandstashy
bilityInnovationcanimprovethefinancialsystemrsquosability
Copyrighted Material
2 bull CHapTer 1
toallocateresourcestotheirhighestvaluedusebutitcan
alsoreducethestabilityofthesystemThechallengeisto
developregulationsthatimprovestabilitywithoutstifling
innovation In addition regulation often leads to innoshy
vations designed to evade the regulationswhich makes
thefinancialsystemmorefragileForexamplemanyofthe
specialshypurposevehiclesthatimplodedintheCrisiswere
createdtogetaroundcapitalrequirements
In many countries the response of regulators to the
World Financial Crisis was hampered by the fragmented
nature of their regulatory systems Financial regulations
are typically designed to ensure thehealth of individual
institutionsratherthanthefinancialsystemasawholeIn
thisbookwearguethatsystemicregulationisanimporshy
tantfunctionthatrequiresaspecialmandateandthatthe
central bank is particularly well equipped to fulfill this
function
Finallyeffectivefinancialregulationrequiresthatpolitishy
ciansandultimatelythepublichaveanadequateundershy
standing of the financial system The political turmoil
surroundingtheCrisissuggeststheimportanceofdissemishy
natingexpertknowledgeaboutfinancetoabroaderaudishy
enceThisisoneofourmotivationsforwritingthisbook
What Were the orIgIns oF the World FInancIal crIsIs
LiketheoriginsoftheFirstWorldWarthecausesofthe
Crisiswillbedebatedbyscholarsformanyyears
Copyrighted Material
InTroDuCT Ion bull 27
Most observers agree that the strong runshyup and subshy
sequentsharpdeclineinthepricesofstockshousesand
otherfinancialassetsindevelopedcountrieswasanimporshy
tantcatalystfortheCrisisThereisdisagreementhowever
aboutwhetherthispatterninpricesistheresultofrational
investorbehaviororldquoirrationalbubblesrdquo
SomearguethattherunshyupbeforetheCrisiswasdriven
by investorswhoknowingly acceptedunusually low exshy
pectedreturnsandtheyofferseveralpossiblereasonswhy
Firsttherewasasurgeofsavingsinemergingcountries
drivenbyacombinationofrapideconomicgrowthanddeshy
mographicsperhapsbecauseofadesiretoaccumulateforshy
eignreservesintheaftermathoftheasiacrisisof1997ndash98
muchof thiswealthwas invested indevelopedmarkets
Secondfinancialmarketswereunusually tranquilduring
200to200Withlowvolatilityinvestorsmayhavesettled
for a low risk premiumThird influenced by fears of a
Japaneseshystyledeflation resulting from themarketdownshy
turnof2000ndash2001andbyabeliefthattheyshouldnottry
to usemonetary policy to counteract rising asset prices
central bankers in the united States maintained a loose
monetarypolicythroughouttheperiod17andfromthisrashy
tionalviewofinvestorstheplungeinassetpricesthatacshy
companiedtheCrisiswascausedbybadnewsaboutfuture
cashflowsunexpectedincreasesinthereturnsrequiredby
investorsorboth
otherssuggestamoredirectexplanationThehighprices
before theCrisisweredrivenby an irrational belief that
prices would continue to rise and the collapse of asset
priceswastheinevitableresultofthismistakeWhatever
Copyrighted Material
28 bull CHapTer 1
theexplanationthesharpdropinassetpricesbothconshy
tributedtoandwasasymptomoftheCrisis
other commentators argue that the financial system
becamevulnerablebecausemanymarketparticipantsasshy
sessedrisksinaccuratelyduringtheperiodleadingupto
theWorldFinancialCrisisConsumersbanksandinvestors
ingeneralunderestimatedtheriskofhousepricedeclines
increasingthepricestheywerewillingtopayforrealesshy
tatethecredittheywerewillingtoextendandthevaluashy
tionsofbanksthatextendedsuchcreditBanksputmuch
weight on the recent pastwhen they estimated value at
riskwhichledthemtoconcludethatthelevelofriskwas
lowandthattherewaslittledownsidetohavinghighleshy
verageothermarketparticipantsdidnotfullyappreciate
thathighliquiditywassuppressingvolatilityandthatthe
processmightreversewithliquiditydecreasingandvolatilshy
ityincreasing
More generally the high level of financial innovation
driveninpartbythedecliningcostofinformationtechnolshy
ogymadeithardforriskassessmenttokeeppacewiththe
evolvingfinancialsystem18Thebenignenvironmentofthe
creditboomexacerbatedthisproblembytemptingfinanshy
cialinstitutionstounderinvestinriskmanagement
uSpolicymakersalsocontributedtotheseverityofthe
CrisisbypushingFannieMaeandFreddieMactoincrease
theavailabilityofmortgagefundingtoborrowerswithquesshy
tionableabilitytorepaytheirmortgagesasaresultofthis
pressure both agencies relaxed their standards for the
mortgages they purchased and guaranteedThe demand
Copyrighted Material
InTroDuCT Ion bull 29
forhomesbyborrowerswhoqualifiedformortgagesbeshy
causeoftheselowerstandardspusheduppricesandthe
defaultbymanyofthemduringtherecessioncontributed
tothedropinhomeprices
Thepanicandruninthefallof2008remainthecentral
distinguishingfeaturesoftheWorldFinancialCrisisasset
priceshave risenand fallenbeforeand theworldeconshy
omyhasbornelargefinancial lossesmanytimeswithout
suchasevereeconomicoutcomeConverselylossesfrom
completelydifferentunderlyingsourcesmdashcommercialreal
estateorperhapssovereigndefaultsmdashcouldcauseasimilar
catastrophe if theyagainprovoke tooshybigshytoshyfailchaosor
runs
Thisbookdoesnotseektoprovideacompletediagnosis
oftheWorldFinancialCrisisnordoesittakeastandonthe
relativeimportanceofthecontributingfactorslistedabove
ratherwebelieveourrecommendationswillhelpprevent
ormitigatefuturecriseseventhoughwedonotfullyundershy
standallthecausesofthelastone
CarmenreinhartandKennethrogoff amongothershave
pointedoutthatfinancialcriseshaveoccurredthroughout
thehistoryofcapitalismandthatthesecrisessharemany
commonpatterns19 Thelessonwedrawfromthisisthat
noacceptablesetofregulationscanpreventmarketparticishy
pantsfrommakingmistakesthatcreateeconomicinstability
ourpurposeinthisbookisinsteadtosuggestregulatory
reformsthatwillmakethesystemmorestabledespitethe
mistakesthataresuretocome
Copyrighted Material
InTroDuCT Ion bull 25
primebrokerrenaissanceTechnologieswithdrew$5bilshy
lionofcashintheweekthefirmfailedWithsuchoutflows
it is not surprising that Bear Stearns ran out of money
eventhoughithadmorethan$18billionincashaweek
earlier
Likeclassicbankrunsmodernbankrunsarebothdeshy
structiveandselfshyfulfillingConcernthatabankmightbe
in trouble spurs its creditors and counterparties towithshy
draworwithholdtheircapitalasaresultevenrumorsofa
problemmaybeenoughtodestroyaviableinstitutionThe
importanceofmodernbankrunsduringtheWorldFinanshy
cialCrisisisarecurringthemethroughoutthebookand
wemakeseveralproposalsthatareintendedtoreducethe
frequencyofsuchevents
The Inadequacy of the Regulatory Structure
TheWorldFinancialCrisismadeitclearthatfinancialinnoshy
vationhadoverwhelmedexistingfinancialregulationsnoshy
tableexamplesincludeaIGrsquosdecisiontosellanextremely
large amount of credit default swaps on subprime debt
tobanksintheunitedStatesandabroadtheholdingof
Lehmanpaperbymoneymarketfundsparticularlythereshy
serveprimaryFundthecomplexityofthederivativebooks
atLehmanandotherinvestmentbanksandthedifficultyof
simultaneouslyapplyingseveralcountriesrsquobankruptcycodes
tothesubsidiariesofmultinationalfinancialinstitutions1
Thereisatradeshyoffbetweenfinancialinnovationandstashy
bilityInnovationcanimprovethefinancialsystemrsquosability
Copyrighted Material
2 bull CHapTer 1
toallocateresourcestotheirhighestvaluedusebutitcan
alsoreducethestabilityofthesystemThechallengeisto
developregulationsthatimprovestabilitywithoutstifling
innovation In addition regulation often leads to innoshy
vations designed to evade the regulationswhich makes
thefinancialsystemmorefragileForexamplemanyofthe
specialshypurposevehiclesthatimplodedintheCrisiswere
createdtogetaroundcapitalrequirements
In many countries the response of regulators to the
World Financial Crisis was hampered by the fragmented
nature of their regulatory systems Financial regulations
are typically designed to ensure thehealth of individual
institutionsratherthanthefinancialsystemasawholeIn
thisbookwearguethatsystemicregulationisanimporshy
tantfunctionthatrequiresaspecialmandateandthatthe
central bank is particularly well equipped to fulfill this
function
Finallyeffectivefinancialregulationrequiresthatpolitishy
ciansandultimatelythepublichaveanadequateundershy
standing of the financial system The political turmoil
surroundingtheCrisissuggeststheimportanceofdissemishy
natingexpertknowledgeaboutfinancetoabroaderaudishy
enceThisisoneofourmotivationsforwritingthisbook
What Were the orIgIns oF the World FInancIal crIsIs
LiketheoriginsoftheFirstWorldWarthecausesofthe
Crisiswillbedebatedbyscholarsformanyyears
Copyrighted Material
InTroDuCT Ion bull 27
Most observers agree that the strong runshyup and subshy
sequentsharpdeclineinthepricesofstockshousesand
otherfinancialassetsindevelopedcountrieswasanimporshy
tantcatalystfortheCrisisThereisdisagreementhowever
aboutwhetherthispatterninpricesistheresultofrational
investorbehaviororldquoirrationalbubblesrdquo
SomearguethattherunshyupbeforetheCrisiswasdriven
by investorswhoknowingly acceptedunusually low exshy
pectedreturnsandtheyofferseveralpossiblereasonswhy
Firsttherewasasurgeofsavingsinemergingcountries
drivenbyacombinationofrapideconomicgrowthanddeshy
mographicsperhapsbecauseofadesiretoaccumulateforshy
eignreservesintheaftermathoftheasiacrisisof1997ndash98
muchof thiswealthwas invested indevelopedmarkets
Secondfinancialmarketswereunusually tranquilduring
200to200Withlowvolatilityinvestorsmayhavesettled
for a low risk premiumThird influenced by fears of a
Japaneseshystyledeflation resulting from themarketdownshy
turnof2000ndash2001andbyabeliefthattheyshouldnottry
to usemonetary policy to counteract rising asset prices
central bankers in the united States maintained a loose
monetarypolicythroughouttheperiod17andfromthisrashy
tionalviewofinvestorstheplungeinassetpricesthatacshy
companiedtheCrisiswascausedbybadnewsaboutfuture
cashflowsunexpectedincreasesinthereturnsrequiredby
investorsorboth
otherssuggestamoredirectexplanationThehighprices
before theCrisisweredrivenby an irrational belief that
prices would continue to rise and the collapse of asset
priceswastheinevitableresultofthismistakeWhatever
Copyrighted Material
28 bull CHapTer 1
theexplanationthesharpdropinassetpricesbothconshy
tributedtoandwasasymptomoftheCrisis
other commentators argue that the financial system
becamevulnerablebecausemanymarketparticipantsasshy
sessedrisksinaccuratelyduringtheperiodleadingupto
theWorldFinancialCrisisConsumersbanksandinvestors
ingeneralunderestimatedtheriskofhousepricedeclines
increasingthepricestheywerewillingtopayforrealesshy
tatethecredittheywerewillingtoextendandthevaluashy
tionsofbanksthatextendedsuchcreditBanksputmuch
weight on the recent pastwhen they estimated value at
riskwhichledthemtoconcludethatthelevelofriskwas
lowandthattherewaslittledownsidetohavinghighleshy
verageothermarketparticipantsdidnotfullyappreciate
thathighliquiditywassuppressingvolatilityandthatthe
processmightreversewithliquiditydecreasingandvolatilshy
ityincreasing
More generally the high level of financial innovation
driveninpartbythedecliningcostofinformationtechnolshy
ogymadeithardforriskassessmenttokeeppacewiththe
evolvingfinancialsystem18Thebenignenvironmentofthe
creditboomexacerbatedthisproblembytemptingfinanshy
cialinstitutionstounderinvestinriskmanagement
uSpolicymakersalsocontributedtotheseverityofthe
CrisisbypushingFannieMaeandFreddieMactoincrease
theavailabilityofmortgagefundingtoborrowerswithquesshy
tionableabilitytorepaytheirmortgagesasaresultofthis
pressure both agencies relaxed their standards for the
mortgages they purchased and guaranteedThe demand
Copyrighted Material
InTroDuCT Ion bull 29
forhomesbyborrowerswhoqualifiedformortgagesbeshy
causeoftheselowerstandardspusheduppricesandthe
defaultbymanyofthemduringtherecessioncontributed
tothedropinhomeprices
Thepanicandruninthefallof2008remainthecentral
distinguishingfeaturesoftheWorldFinancialCrisisasset
priceshave risenand fallenbeforeand theworldeconshy
omyhasbornelargefinancial lossesmanytimeswithout
suchasevereeconomicoutcomeConverselylossesfrom
completelydifferentunderlyingsourcesmdashcommercialreal
estateorperhapssovereigndefaultsmdashcouldcauseasimilar
catastrophe if theyagainprovoke tooshybigshytoshyfailchaosor
runs
Thisbookdoesnotseektoprovideacompletediagnosis
oftheWorldFinancialCrisisnordoesittakeastandonthe
relativeimportanceofthecontributingfactorslistedabove
ratherwebelieveourrecommendationswillhelpprevent
ormitigatefuturecriseseventhoughwedonotfullyundershy
standallthecausesofthelastone
CarmenreinhartandKennethrogoff amongothershave
pointedoutthatfinancialcriseshaveoccurredthroughout
thehistoryofcapitalismandthatthesecrisessharemany
commonpatterns19 Thelessonwedrawfromthisisthat
noacceptablesetofregulationscanpreventmarketparticishy
pantsfrommakingmistakesthatcreateeconomicinstability
ourpurposeinthisbookisinsteadtosuggestregulatory
reformsthatwillmakethesystemmorestabledespitethe
mistakesthataresuretocome
Copyrighted Material
2 bull CHapTer 1
toallocateresourcestotheirhighestvaluedusebutitcan
alsoreducethestabilityofthesystemThechallengeisto
developregulationsthatimprovestabilitywithoutstifling
innovation In addition regulation often leads to innoshy
vations designed to evade the regulationswhich makes
thefinancialsystemmorefragileForexamplemanyofthe
specialshypurposevehiclesthatimplodedintheCrisiswere
createdtogetaroundcapitalrequirements
In many countries the response of regulators to the
World Financial Crisis was hampered by the fragmented
nature of their regulatory systems Financial regulations
are typically designed to ensure thehealth of individual
institutionsratherthanthefinancialsystemasawholeIn
thisbookwearguethatsystemicregulationisanimporshy
tantfunctionthatrequiresaspecialmandateandthatthe
central bank is particularly well equipped to fulfill this
function
Finallyeffectivefinancialregulationrequiresthatpolitishy
ciansandultimatelythepublichaveanadequateundershy
standing of the financial system The political turmoil
surroundingtheCrisissuggeststheimportanceofdissemishy
natingexpertknowledgeaboutfinancetoabroaderaudishy
enceThisisoneofourmotivationsforwritingthisbook
What Were the orIgIns oF the World FInancIal crIsIs
LiketheoriginsoftheFirstWorldWarthecausesofthe
Crisiswillbedebatedbyscholarsformanyyears
Copyrighted Material
InTroDuCT Ion bull 27
Most observers agree that the strong runshyup and subshy
sequentsharpdeclineinthepricesofstockshousesand
otherfinancialassetsindevelopedcountrieswasanimporshy
tantcatalystfortheCrisisThereisdisagreementhowever
aboutwhetherthispatterninpricesistheresultofrational
investorbehaviororldquoirrationalbubblesrdquo
SomearguethattherunshyupbeforetheCrisiswasdriven
by investorswhoknowingly acceptedunusually low exshy
pectedreturnsandtheyofferseveralpossiblereasonswhy
Firsttherewasasurgeofsavingsinemergingcountries
drivenbyacombinationofrapideconomicgrowthanddeshy
mographicsperhapsbecauseofadesiretoaccumulateforshy
eignreservesintheaftermathoftheasiacrisisof1997ndash98
muchof thiswealthwas invested indevelopedmarkets
Secondfinancialmarketswereunusually tranquilduring
200to200Withlowvolatilityinvestorsmayhavesettled
for a low risk premiumThird influenced by fears of a
Japaneseshystyledeflation resulting from themarketdownshy
turnof2000ndash2001andbyabeliefthattheyshouldnottry
to usemonetary policy to counteract rising asset prices
central bankers in the united States maintained a loose
monetarypolicythroughouttheperiod17andfromthisrashy
tionalviewofinvestorstheplungeinassetpricesthatacshy
companiedtheCrisiswascausedbybadnewsaboutfuture
cashflowsunexpectedincreasesinthereturnsrequiredby
investorsorboth
otherssuggestamoredirectexplanationThehighprices
before theCrisisweredrivenby an irrational belief that
prices would continue to rise and the collapse of asset
priceswastheinevitableresultofthismistakeWhatever
Copyrighted Material
28 bull CHapTer 1
theexplanationthesharpdropinassetpricesbothconshy
tributedtoandwasasymptomoftheCrisis
other commentators argue that the financial system
becamevulnerablebecausemanymarketparticipantsasshy
sessedrisksinaccuratelyduringtheperiodleadingupto
theWorldFinancialCrisisConsumersbanksandinvestors
ingeneralunderestimatedtheriskofhousepricedeclines
increasingthepricestheywerewillingtopayforrealesshy
tatethecredittheywerewillingtoextendandthevaluashy
tionsofbanksthatextendedsuchcreditBanksputmuch
weight on the recent pastwhen they estimated value at
riskwhichledthemtoconcludethatthelevelofriskwas
lowandthattherewaslittledownsidetohavinghighleshy
verageothermarketparticipantsdidnotfullyappreciate
thathighliquiditywassuppressingvolatilityandthatthe
processmightreversewithliquiditydecreasingandvolatilshy
ityincreasing
More generally the high level of financial innovation
driveninpartbythedecliningcostofinformationtechnolshy
ogymadeithardforriskassessmenttokeeppacewiththe
evolvingfinancialsystem18Thebenignenvironmentofthe
creditboomexacerbatedthisproblembytemptingfinanshy
cialinstitutionstounderinvestinriskmanagement
uSpolicymakersalsocontributedtotheseverityofthe
CrisisbypushingFannieMaeandFreddieMactoincrease
theavailabilityofmortgagefundingtoborrowerswithquesshy
tionableabilitytorepaytheirmortgagesasaresultofthis
pressure both agencies relaxed their standards for the
mortgages they purchased and guaranteedThe demand
Copyrighted Material
InTroDuCT Ion bull 29
forhomesbyborrowerswhoqualifiedformortgagesbeshy
causeoftheselowerstandardspusheduppricesandthe
defaultbymanyofthemduringtherecessioncontributed
tothedropinhomeprices
Thepanicandruninthefallof2008remainthecentral
distinguishingfeaturesoftheWorldFinancialCrisisasset
priceshave risenand fallenbeforeand theworldeconshy
omyhasbornelargefinancial lossesmanytimeswithout
suchasevereeconomicoutcomeConverselylossesfrom
completelydifferentunderlyingsourcesmdashcommercialreal
estateorperhapssovereigndefaultsmdashcouldcauseasimilar
catastrophe if theyagainprovoke tooshybigshytoshyfailchaosor
runs
Thisbookdoesnotseektoprovideacompletediagnosis
oftheWorldFinancialCrisisnordoesittakeastandonthe
relativeimportanceofthecontributingfactorslistedabove
ratherwebelieveourrecommendationswillhelpprevent
ormitigatefuturecriseseventhoughwedonotfullyundershy
standallthecausesofthelastone
CarmenreinhartandKennethrogoff amongothershave
pointedoutthatfinancialcriseshaveoccurredthroughout
thehistoryofcapitalismandthatthesecrisessharemany
commonpatterns19 Thelessonwedrawfromthisisthat
noacceptablesetofregulationscanpreventmarketparticishy
pantsfrommakingmistakesthatcreateeconomicinstability
ourpurposeinthisbookisinsteadtosuggestregulatory
reformsthatwillmakethesystemmorestabledespitethe
mistakesthataresuretocome
Copyrighted Material
InTroDuCT Ion bull 27
Most observers agree that the strong runshyup and subshy
sequentsharpdeclineinthepricesofstockshousesand
otherfinancialassetsindevelopedcountrieswasanimporshy
tantcatalystfortheCrisisThereisdisagreementhowever
aboutwhetherthispatterninpricesistheresultofrational
investorbehaviororldquoirrationalbubblesrdquo
SomearguethattherunshyupbeforetheCrisiswasdriven
by investorswhoknowingly acceptedunusually low exshy
pectedreturnsandtheyofferseveralpossiblereasonswhy
Firsttherewasasurgeofsavingsinemergingcountries
drivenbyacombinationofrapideconomicgrowthanddeshy
mographicsperhapsbecauseofadesiretoaccumulateforshy
eignreservesintheaftermathoftheasiacrisisof1997ndash98
muchof thiswealthwas invested indevelopedmarkets
Secondfinancialmarketswereunusually tranquilduring
200to200Withlowvolatilityinvestorsmayhavesettled
for a low risk premiumThird influenced by fears of a
Japaneseshystyledeflation resulting from themarketdownshy
turnof2000ndash2001andbyabeliefthattheyshouldnottry
to usemonetary policy to counteract rising asset prices
central bankers in the united States maintained a loose
monetarypolicythroughouttheperiod17andfromthisrashy
tionalviewofinvestorstheplungeinassetpricesthatacshy
companiedtheCrisiswascausedbybadnewsaboutfuture
cashflowsunexpectedincreasesinthereturnsrequiredby
investorsorboth
otherssuggestamoredirectexplanationThehighprices
before theCrisisweredrivenby an irrational belief that
prices would continue to rise and the collapse of asset
priceswastheinevitableresultofthismistakeWhatever
Copyrighted Material
28 bull CHapTer 1
theexplanationthesharpdropinassetpricesbothconshy
tributedtoandwasasymptomoftheCrisis
other commentators argue that the financial system
becamevulnerablebecausemanymarketparticipantsasshy
sessedrisksinaccuratelyduringtheperiodleadingupto
theWorldFinancialCrisisConsumersbanksandinvestors
ingeneralunderestimatedtheriskofhousepricedeclines
increasingthepricestheywerewillingtopayforrealesshy
tatethecredittheywerewillingtoextendandthevaluashy
tionsofbanksthatextendedsuchcreditBanksputmuch
weight on the recent pastwhen they estimated value at
riskwhichledthemtoconcludethatthelevelofriskwas
lowandthattherewaslittledownsidetohavinghighleshy
verageothermarketparticipantsdidnotfullyappreciate
thathighliquiditywassuppressingvolatilityandthatthe
processmightreversewithliquiditydecreasingandvolatilshy
ityincreasing
More generally the high level of financial innovation
driveninpartbythedecliningcostofinformationtechnolshy
ogymadeithardforriskassessmenttokeeppacewiththe
evolvingfinancialsystem18Thebenignenvironmentofthe
creditboomexacerbatedthisproblembytemptingfinanshy
cialinstitutionstounderinvestinriskmanagement
uSpolicymakersalsocontributedtotheseverityofthe
CrisisbypushingFannieMaeandFreddieMactoincrease
theavailabilityofmortgagefundingtoborrowerswithquesshy
tionableabilitytorepaytheirmortgagesasaresultofthis
pressure both agencies relaxed their standards for the
mortgages they purchased and guaranteedThe demand
Copyrighted Material
InTroDuCT Ion bull 29
forhomesbyborrowerswhoqualifiedformortgagesbeshy
causeoftheselowerstandardspusheduppricesandthe
defaultbymanyofthemduringtherecessioncontributed
tothedropinhomeprices
Thepanicandruninthefallof2008remainthecentral
distinguishingfeaturesoftheWorldFinancialCrisisasset
priceshave risenand fallenbeforeand theworldeconshy
omyhasbornelargefinancial lossesmanytimeswithout
suchasevereeconomicoutcomeConverselylossesfrom
completelydifferentunderlyingsourcesmdashcommercialreal
estateorperhapssovereigndefaultsmdashcouldcauseasimilar
catastrophe if theyagainprovoke tooshybigshytoshyfailchaosor
runs
Thisbookdoesnotseektoprovideacompletediagnosis
oftheWorldFinancialCrisisnordoesittakeastandonthe
relativeimportanceofthecontributingfactorslistedabove
ratherwebelieveourrecommendationswillhelpprevent
ormitigatefuturecriseseventhoughwedonotfullyundershy
standallthecausesofthelastone
CarmenreinhartandKennethrogoff amongothershave
pointedoutthatfinancialcriseshaveoccurredthroughout
thehistoryofcapitalismandthatthesecrisessharemany
commonpatterns19 Thelessonwedrawfromthisisthat
noacceptablesetofregulationscanpreventmarketparticishy
pantsfrommakingmistakesthatcreateeconomicinstability
ourpurposeinthisbookisinsteadtosuggestregulatory
reformsthatwillmakethesystemmorestabledespitethe
mistakesthataresuretocome
Copyrighted Material
28 bull CHapTer 1
theexplanationthesharpdropinassetpricesbothconshy
tributedtoandwasasymptomoftheCrisis
other commentators argue that the financial system
becamevulnerablebecausemanymarketparticipantsasshy
sessedrisksinaccuratelyduringtheperiodleadingupto
theWorldFinancialCrisisConsumersbanksandinvestors
ingeneralunderestimatedtheriskofhousepricedeclines
increasingthepricestheywerewillingtopayforrealesshy
tatethecredittheywerewillingtoextendandthevaluashy
tionsofbanksthatextendedsuchcreditBanksputmuch
weight on the recent pastwhen they estimated value at
riskwhichledthemtoconcludethatthelevelofriskwas
lowandthattherewaslittledownsidetohavinghighleshy
verageothermarketparticipantsdidnotfullyappreciate
thathighliquiditywassuppressingvolatilityandthatthe
processmightreversewithliquiditydecreasingandvolatilshy
ityincreasing
More generally the high level of financial innovation
driveninpartbythedecliningcostofinformationtechnolshy
ogymadeithardforriskassessmenttokeeppacewiththe
evolvingfinancialsystem18Thebenignenvironmentofthe
creditboomexacerbatedthisproblembytemptingfinanshy
cialinstitutionstounderinvestinriskmanagement
uSpolicymakersalsocontributedtotheseverityofthe
CrisisbypushingFannieMaeandFreddieMactoincrease
theavailabilityofmortgagefundingtoborrowerswithquesshy
tionableabilitytorepaytheirmortgagesasaresultofthis
pressure both agencies relaxed their standards for the
mortgages they purchased and guaranteedThe demand
Copyrighted Material
InTroDuCT Ion bull 29
forhomesbyborrowerswhoqualifiedformortgagesbeshy
causeoftheselowerstandardspusheduppricesandthe
defaultbymanyofthemduringtherecessioncontributed
tothedropinhomeprices
Thepanicandruninthefallof2008remainthecentral
distinguishingfeaturesoftheWorldFinancialCrisisasset
priceshave risenand fallenbeforeand theworldeconshy
omyhasbornelargefinancial lossesmanytimeswithout
suchasevereeconomicoutcomeConverselylossesfrom
completelydifferentunderlyingsourcesmdashcommercialreal
estateorperhapssovereigndefaultsmdashcouldcauseasimilar
catastrophe if theyagainprovoke tooshybigshytoshyfailchaosor
runs
Thisbookdoesnotseektoprovideacompletediagnosis
oftheWorldFinancialCrisisnordoesittakeastandonthe
relativeimportanceofthecontributingfactorslistedabove
ratherwebelieveourrecommendationswillhelpprevent
ormitigatefuturecriseseventhoughwedonotfullyundershy
standallthecausesofthelastone
CarmenreinhartandKennethrogoff amongothershave
pointedoutthatfinancialcriseshaveoccurredthroughout
thehistoryofcapitalismandthatthesecrisessharemany
commonpatterns19 Thelessonwedrawfromthisisthat
noacceptablesetofregulationscanpreventmarketparticishy
pantsfrommakingmistakesthatcreateeconomicinstability
ourpurposeinthisbookisinsteadtosuggestregulatory
reformsthatwillmakethesystemmorestabledespitethe
mistakesthataresuretocome
Copyrighted Material
InTroDuCT Ion bull 29
forhomesbyborrowerswhoqualifiedformortgagesbeshy
causeoftheselowerstandardspusheduppricesandthe
defaultbymanyofthemduringtherecessioncontributed
tothedropinhomeprices
Thepanicandruninthefallof2008remainthecentral
distinguishingfeaturesoftheWorldFinancialCrisisasset
priceshave risenand fallenbeforeand theworldeconshy
omyhasbornelargefinancial lossesmanytimeswithout
suchasevereeconomicoutcomeConverselylossesfrom
completelydifferentunderlyingsourcesmdashcommercialreal
estateorperhapssovereigndefaultsmdashcouldcauseasimilar
catastrophe if theyagainprovoke tooshybigshytoshyfailchaosor
runs
Thisbookdoesnotseektoprovideacompletediagnosis
oftheWorldFinancialCrisisnordoesittakeastandonthe
relativeimportanceofthecontributingfactorslistedabove
ratherwebelieveourrecommendationswillhelpprevent
ormitigatefuturecriseseventhoughwedonotfullyundershy
standallthecausesofthelastone
CarmenreinhartandKennethrogoff amongothershave
pointedoutthatfinancialcriseshaveoccurredthroughout
thehistoryofcapitalismandthatthesecrisessharemany
commonpatterns19 Thelessonwedrawfromthisisthat
noacceptablesetofregulationscanpreventmarketparticishy
pantsfrommakingmistakesthatcreateeconomicinstability
ourpurposeinthisbookisinsteadtosuggestregulatory
reformsthatwillmakethesystemmorestabledespitethe
mistakesthataresuretocome
