Causes and Cures: Why Did the Financial Crisis Develop and How Can We Prevent Future Crises?

 

Donald Kohn, Vice Chairman of the Federal Reserve Board of Governors, gave a speech to the BIS Annual Conference on "Financial System and Macroeconomic Resilience Revisited" in Basel, Switzerland, that is definitely "economist-speak."  Nevertheless, if you can slog through it, it contains some insightful analysis.

In his comments on "Financial Intermediation and the Post-Crisis Financial System," Kohn addresses issues raised in articles by Hyun Shin.  Here are some of Kohn's thoughts:

Certain widespread practices within our financial system increased risk-taking and heightened the effects felt as institutions and individuals pulled back from risky positions, including: 

1. Too much leverage (borrowing) at all levels;
2. Lengthening of intermediation chains - meaning adding too many steps to the lending process: borrower to broker to lender to secondary market to securitizer to investors in securitized loans and derivatives; and

3. Reliance on short-term financing that could become unavailable when needed.

Two remedies going forward would be to keep debt levels lower even in good times and cut out some of the steps in the intermediation chain -- or at least make the risks more transparent at each stage and try to keep incentives appropriate to risk. 

Too much borrowing may have been a symptom as much as an underlying cause of the current crisis.  Kohn says that, in his opinion, "the root cause of the problems was the underpricing of risk as the financial sector interacted with the nonfinancial sectors." 

What does that mean?  Well, lenders did not charge high enough interest rates for the risk that their loan collateral (homes) would decline in value or that their borrowers would be unable to pay.  Individuals who held assets like mutual funds did not understand that shares in these funds could decline rapidly because of problems with their investments and that they would be unable to access their savings in mutual funds when needed.  When households and businesses tried to get money quickly to pay off their borrowings, they had to accept firesale prices.  Lenders were trying to pay off borrowings also and so either had less money to lend or were reluctant to lend, thinking to protect their liquidity in case it was needed and wanting to avoid making loans to borrowers who were having problems, or might have problems.  So when banks and individuals scrambled to reduce their debt ("deleveraging"), they generated problems for others in our economic system.

Uncertainty also made our economic problems worse.  Loans were not on the balance sheet at their true value, but what was their true value.  Kohn says, "Financial market participants didn't know the value of assets, the financial health of counterparties, or the likelihood that they themselves to unexpected hits to their capital or liquidity."

What should we do going forward? Kohn suggests:

1. Making financial products simpler to understand;
2. Requiring more accurate disclosure of value and risk involved in balance sheet assets from financial institutions, recognizing that determinig value and risk is no easy assignment;
3. Looking more closely at market aggregates to see buildup of risk;
4. Using central counterparties to focus risk information;
5. Holding large banks to higher capital, liquidity, and risk management standards;

6. Setting out clear authority to liquidate large financial institutions;

Kohn says we need to understand why unstable financial structures like excessive leverage, long intermediation chains, poor risk-pricing, and inadequate information developed so that we can how to prevent them in the future.

Link to Speech:  http://www.federalreserve.gov/newsevents/speech/kohn20090710a.htm

(ag) July 14, 2009, in Economy