If you haven’t seen The Big Short, you should. The acting is superb and the story enlightening: a few brilliant outcasts each discover just how big the holes are that eventually bury the U.S. financial system in the crisis of 2007-2009. If you’re like most people we know, you’ll walk away delighted by the movie and disturbed by the reality it captures. [Full disclosure: one of us joined a panel organized by the film’s economic consultant to view and discuss it with the director.]
But we're not film critics, The movie—along with some misleading criticism—prompts us to clarify what we view as the prime causes of the financial crisis. The financial corruption depicted in the movie is deeply troubling (we've written about fraud and conflicts of interest in finance here and here). But what made the U.S. financial system so fragile a decade ago, and what made the crisis so deep, were practices that were completely legal. The scandal is that we still haven't addressed these properly....
On July 21, 2010, President Obama signed the Dodd-Frank Wall Street Reform and Consumer Protection Act (hereafter, DF), the most sweeping financial regulatory reform in the United States since the 1930s. DF explicitly aims to limit systemic risk, allow for the safe resolution of the largest intermediaries, submit risky nonbanks to greater scrutiny, and reform derivatives trading.
How to celebrate its fifth birthday? Well, if you are like us, it will be a sober affair, reflecting serious worries about the continued vulnerability of the financial system.
Let’s have a look at the most noteworthy accomplishments and the biggest failings so far. Starting with the successes, here are our top five: Read More
Walter Wriston, Citicorp’s chief for nearly two decades until 1984, used to argue that banks’ didn’t need much, if any, capital. The global financial crisis put that view to rest. Today, we know that if banks are going to be able to absorb large unforeseen losses that would otherwise threaten financial stability, they need to finance themselves with equity, not just debt.
But how much capital do banks need to have to ensure the financial system is safe? Even after the financial crisis, answers to this question range widely, making it the single most contentious source of debate among bankers, regulators, and academics... Read More
The SEC has finally acted. On July 23, the SEC issued 859 pages of new rules for the operation of some money market funds. (You can find a mercifully short description here.) To summarize our reaction: we are underwhelmed! It is hard to see how the new rules will reduce systemic risk in any meaningful way... Read More
Since the collapse of Lehman Brothers in September 2008, the Federal Reserve has stabilized the financial system and put the economy back on a path to sustainable growth. This task involved creating a colossal balance sheet, which now stands at $4.37 trillion, more than four times the pre-Lehman level ($940 billion). As textbooks (like ours) teach, along with this increase in Fed assets has come an increase in reserve liabilities (which represent deposits by banks at the Fed). Today, banks’ excess reserves (that is, the extra reserves beyond those that banks must hold at the Fed) are at $2.56 trillion, compared to virtually zero prior to the crisis.
Getting the money and banking system back to normal requires doing something to manage these excess reserves ... Read More
The Financial System Oversight Council (FSOC) is considering whether any asset managers should be designated as systemically important financial intermediaries (SIFIs), making them subject to supervision by the Federal Reserve. In the same vein, the Financial Stability Board recently proposed a framework for determining whether an asset manager is a global SIFI.
The question itself is highly controversial... Read More
Following the collapse of Lehman in 2008, a run on U.S. prime money market mutual funds (MMMFs) was halted only when the U.S. Treasury provided a blanket guarantee. (Prime MMMFs typically invest in corporate debt, including the debt of intermediaries.) Shortly thereafter, the Federal Reserve added emergency machinery (the “Asset-Backed Commercial Paper Money Market Mutual Fund Liquidity Facility”) to encourage depositories to acquire illiquid assets from MMMFs... Read More