After perhaps the most tumultuous week in the financial markets in living memory, the question on everyone’s mind is whether this turn of events was inevitable. In order to answer this question fairly, one has to avoid making the common mistake of using 20-20 hindsight based on the facts that have come to light in the past 15 months or so.
Suppose we were back in 2002, looking at the architecture of the global financial system based on the knowledge of events until that point in time. We would have known about several crises of the previous two decades: the stock market crash of 1987; the Japanese financial meltdown that lasted through much of the 1990s; the Asian financial crisis of 1997 and the Russian default-LTCM crisis of 1998; and, of course, the dot-com collapse of 2002.
What lessons did the past crises teach us? What were the warning signs that were already evident at that time?
The declining savings rate and the looming trade and budget deficits.
This trend could only continue as long as U.S. deficits were being financed by issuing large quantities of financial claims to countries with large trade surpluses–principally China and Japan, but also many emerging economies. These transfers of financial claims–principally U.S. Treasury obligations–are substantial in relation to the overall size of the financial market. They will likely cause major disruptions to economic activity if there is even a hint that they may be interrupted.
Low interest rates and easy availability of credit.
Cheap credit exaggerated the returns from leveraged investments at both household and corporate levels. This easy-money policy encouraged speculation particularly in real estate, but also in assets, more generally. The global real estate boom and the rapid growth of the private equity industry are prominent examples of the institutionalization of such leveraged investments.
The backlash against regulation The failure of corporate governance in companies such as Enron and WorldCom led to greater regulation of corporations, principally through the passage of the Sarbanes-Oxley Act of 2002. The increased regulatory burden created a backlash against regulation in general. This sentiment was in tune with the prevailing political mood in Washington, which had lead to the repeal of the Gass-Steagall Act (which separated investment banking from commercial banking) in 1999.
“Too large to fail” and moral hazard. Although the argument about the systemic consequences of the failure of a single large financial entity has been used before, the most spectacular example of its use prior to the present crisis was the 1998 bailout coordinated by the Fed for the hedge fund Long Term Capital Management. This anchored in the minds of investors the notion that, at some point, large financial institutions carry such grave consequences for the entire market that the regulators have no option but to bail them out.
The asymmetry in the regulation of commercial and investment banks.
Both types of financial institutions offered increasingly similar products and services. Even the deposit-taking feature of commercial banks was mimicked by the ability of investment banks to issue short-term paper, albeit without insurance guarantees.
However, commercial banks were subject to more stringent regulations than investment banks, principally with regard to their capital adequacy under the Basle guidelines. Investment banks were subject to securities regulation, but not in terms of the risks they took or the amount of capital at their disposal. To stretch this point further, new entities–such as hedge funds, as well as more traditional financial arms of iconic manufacturing companies, such as General Electric (nyse: GE – news – people ) and General Motors (nyse: GM – news – people ), or insurance companies, such as AIG (nyse: AIG – news – people )–were indistinguishable in their practices and products from conventional financial institutions.
If the reason for regulation of commercial banks was the potential forsystemic risk, regulation would be just as valid for these other types of quasi-financial institutions. The question is whether it should focus on the form or the function of a financial product or service.
The exponential growth of the derivatives market. This growth was particularly noteworthy in the credit area, with the creation of more and more complex credit derivatives. Many of these products put a greater distance between the original credit transaction–say, a mortgage loan from a bank to a house buyer–and the ultimate owner of the claims, which were created by combining these loans and slicing and dicing them into various “tranches.” The incentive of the lender to monitor the capacity and ability of the borrower to repay the loan was blunted as a consequence, creating a huge moral hazard for the credit markets.
This growth was concentrated in the over-the-counter market.
Over-the-counter markets are more opaque than exchange-traded markets because the transactions are bilateral and the trades are not known to other market participants. The risks of default to the counterparties could be considerable, especially if there is no collateral posted. In contrast, exchanges publish their trades and use a clearing house for derivatives transactions: Prices and volumes are transparent to the whole market. Due to margins they impose on all traders, the risks to the counterparties are substantially mitigated. (A case in point is that no one today has a clear idea about the outstanding amounts of credit derivatives to the institutions that have recently failed or are likely to fail, causing the prices of credit default swaps to gyrate.)
The increased complexity of new financial products. These new products placed a greater burden on the accounting standards boards to ensure that the financial disclosures matched the underlying economic reality. This opacity was an important component in the spectacular collapse of Enron, which had created an unbelievably complex web of off-balance-sheet entities that no analyst could fathom. As financial products and markets became complex, the accounting was struggling to keep up.
The changing model of credit-rating agencies. Credit-rating agencies moved from assessing and rating credit risk to advising financial-product designers on modifying their products to obtain a more favorable rating. Since these entities–principally Moody’s (nyse: MCO – news – people ), Fitch and Standard & Poor’s–are the arbiters of credit quality, much depends on their judgment. Their conflicts of interest have pervasive effects on the whole financial system.
The above list indicates that many of the warning signs–some of them, admittedly, in their early stages–were there for the policymakers to see well before the present crisis. However, they were ignored, and–even worse–were dismissed as irrelevant. In particular, the lessons from the Japanese and later pan-Asian experience were dismissed as being peculiar to countries with ill-developed capital markets and unrelated to markets in Englishspeaking countries, principally the U.S. and the U.K.
In light of the above discussion, what could have been done to prevent or at least mitigate some of the systemic risk we face today? One can go through each one of the above trends, which could have been discerned many years ago, and state what corrective action could have been taken. It is clear that the excesses of the last five years resulted from a collective failure to learn from the past. After all, those who cannot learn from history are doomed to repeat it.