We are always better analysts with a 20/20 hindsight. Indeed, an ex post reading about events leading up to a crisis appears logical, and often leaves one with the question about why the evolution of the crisis could not be seen and corrected in time. Still, policy-makers know that such a review and understanding are important to learning from mistakes. Restoring Financial Stability (Wiley) acts as a catalyst to that understanding by offering a comprehensive sequencing of the causes and progression of the build-up of the financial strains that, following the Lehman bust in September 2008, evolved into a full-blown global financial crisis. It is a collection of thematic essays by the faculty of the Stern School of Business at New York University.
Finance today is full of acronyms and jargon, but the book attempts to offer the complicated details in a more readable manner, which, in turn, should appeal to a wide range of readers. The book comprises 18 papers covering the genesis of the problem, how it was transmitted, the regulatory failure, policy alternatives, international comparison, and a specific list of policy recommendations.
The authors suggest that the financial crisis was triggered in the first quarter of 2006 when the US housing market turned south. While that is true to some extent, it was actually Lehman’s fall that gave the US housing crisis a totally different flavour, including a more international one. Recall that the US economy was beginning to face the consequences of the housing bubble before September 2008. But it is quite likely that in the absence of Lehman debacle, the reverberations of the collapse of the US housing market would have been less vicious, both within the US and on other economies.
This has not been a traditional banking crisis. The authors put the blame for the spread of the financial crisis squarely on large, complex financial institutions (LCFIs), such as universal banks, investment banks, insurance companies and hedge funds, that dominate the financial industry. Ironically, LCFIs ignored their own business model of securitisation and chose not to transfer the credit risk to other investors. This lack of risk transfer — the leverage game that banks played — is the real reason offered for the collapse of the financial system.
I’m glad that the book emphasises that the benefits of derivatives outweigh the costs associated with misusing them, but also offers sensible advice that trading in OTC (over the counter) derivatives should be transparent and regulated like exchange-traded ones. Also, the authors agree that existing credit default swaps played an important role in exacerbating the current financial crisis because the OTC market they traded in is highly fragmented and opaque. Their suggestion to keep them from playing such a key role in the next crisis: move to centralised clearing with greater transparency.
The book also offers interesting insights into some international comparison. For example, in contrast to the financial rescue plan of the UK, the US one appears to be favourable to a small set of financial institutions. It also represents a significant transfer of funds from taxpayers to financial institutions, places no important restrictions on the institutions’ operations, and offers no clear path back to a market-based system.
Chapter Eight covers the thorny issue of compensation in financial firms. This is an interesting area, as the common person on the street often wonders how highly-paid bankers, especially the risk takers, could have precipitated the financial disaster, then got away by being bailed out by the taxpayer and, in some cases, still got rewarded handsomely! However, the key suggestion that compensation should have a multi-year structure through the cycle with bad performances subtracting from the bonus pool in the same way that good performances add to it appears impractical, I feel.
The global financial fallout triggered by the Lehman bust is the first modern global crisis of gigantic proportions that also made us realise that different economies and financial systems are more intricately connected than previously realised. In many ways, the different financial systems and economies are inter-connected like a teeter-totter. Consequently, policy gaffes in one country can be quickly transmitted to other “innocent” countries, and the volume of capital prowling for higher returns only amplifies the magnitude of the transmission.
The book also has indirect relevance for Indian policy-makers. While the broader financial regulatory environment in developed countries will be tightened — and might even become unduly restrictive in some ways — India still has to continue with more reforms and opening up of markets. The key lesson for India from the global crisis is not to enter a cocoon. Instead, India should move forward on financial sector reforms but also make sure they are in sync with the long overdue real sector reforms. Whether this happens gradually or rapidly is up to the government, not the Reserve Bank of India. But the government should stand warned that rapid financial opening up with a disappointing going-around-in-circles approach for the real economy is surely a recipe for a different disaster. Financial innovation almost always leads financial regulation, and the only thing certain about the next financial crisis is that it’ll catch us off-guard. The book is highly recommended even though bankers will remain bankers and will probably figure out ways to beat the new system.
The author is head of India and Asean economics at Macquarie Capital Securities, Singapore. The views expressed are personal
RESTORING FINANCIAL STABILITY
HOW TO REPAIR A FAILED SYSTEM
Viral V Acharya and Mathew Richardson
416 pages; $49.95