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Engineering the Financial Crisis

Engineering the Financial Crisis: Systemic Risk and the Failure of Regulation

Jeffrey Friedman
Wladimir Kraus
Copyright Date: 2011
Pages: 224
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  • Book Info
    Engineering the Financial Crisis
    Book Description:

    The financial crisis has been blamed on reckless bankers, irrational exuberance, government support of mortgages for the poor, financial deregulation, and expansionary monetary policy. Specialists in banking, however, tell a story with less emotional resonance but a better correspondence to the evidence: the crisis was sparked by the international regulatory accords on bank capital levels, the Basel Accords.

    In one of the first studies critically to examine the Basel Accords,Engineering the Financial Crisisreveals the crucial role that bank capital requirements and other government regulations played in the recent financial crisis. Jeffrey Friedman and Wladimir Kraus argue that by encouraging banks to invest in highly rated mortgage-backed bonds, the Basel Accords created an overconcentration of risk in the banking industry. In addition, accounting regulations required banks to reduce lending if the temporary market value of these bonds declined, as they did in 2007 and 2008 during the panic over subprime mortgage defaults.

    The book begins by assessing leading theories about the crisis-deregulation, bank compensation practices, excessive leverage, "too big to fail," and Fannie Mae and Freddie Mac-and, through careful evidentiary scrutiny, debunks much of the conventional wisdom about what went wrong. It then discusses the Basel Accords and how they contributed to systemic risk. Finally, it presents an analysis of social-science expertise and the fallibility of economists and regulators. Engagingly written, theoretically inventive, yet empirically grounded,Engineering the Financial Crisisis a timely examination of the unintended-and sometimes disastrous-effects of regulation on complex economies.

    eISBN: 978-0-8122-0507-7
    Subjects: Business, Political Science

Table of Contents

  1. Front Matter
    (pp. i-iv)
  2. Table of Contents
    (pp. v-vi)
  3. List of Figures and Tables
    (pp. vii-viii)
  4. Glossary of Abbreviations and Acronyms
    (pp. ix-x)
    (pp. 1-4)

    This is not the ordinary book about the financial crisis. The product of a collaboration between an economist (Kraus) and a political theorist (Friedman), it is designed for readers who are interested not only in what caused the financial crisis, but in what those causes indicate about the nature of capitalism and of modern government. Along the way to considering these questions in Chapter 4, we discuss some of the methodological and logical conundrums of contemporary economics and of the modern political culture that shapes contemporary economics (Chapter 1). In Chapters 1, 3, and 4, and Appendix I, we criticize...

  6. 1 Bonuses, Irrationality, and Too-Bigness: The Conventional Wisdom About the Financial Crisis and Its Theoretical Implications
    (pp. 5-56)

    By the end of 2010, six elements of conventional wisdom about the causes of the financial crisis had taken root:

    1. The very low interest rates from 2001 to 2005 fueled a virtually unprecedented nationwide housing bubble in the United States.

    2. Fannie Mae and Freddie Mac, the two government-sponsored enterprises (GSEs), helped cause the crisis by loosening their lending standards.

    3. Deregulation of finance allowed the “shadow banking sector” to originate subprime loans and securitize them.

    4. The compensation systems used by banks, especially the payment of bonuses for revenue-generating transactions, encouraged bankers to bet huge amounts of borrowed...

  7. 2 Capital Adequacy Regulations and the Financial Crisis: Bankers’ and Regulators’ Errors
    (pp. 57-85)

    A bank’s “capital” is the security blanket it needs because of the fragile nature of banking. Any corporation’s capital boils down to its net worth, or “the residual after subtracting liabilities from assets” (Gilliam 2005, 293, emphasis added). “The greater a bank’s capital, the more it can absorb net losses before liabilities exceed assets”: capital serves as a buffer against bankruptcy, which occurs when a corporation’s assets dip below its liabilities. Capital is thus rightly seen as a “cushion” for any corporation, but it is especially important for banks. This is because of the unique nature of a (commercial) bank’s...

  8. 3 The Interaction of Regulations and the Great Recession: Fetishizing Market Prices
    (pp. 86-111)

    It is doubtful that the U.S. and international financial regulators who, in all three versions of the Basel regime (including the Recourse Rule), assigned a low risk weight to mortgages, anticipated the effect this might have on banks and on the world economy if a housing bubble were to occur—or that they anticipated that this action might have contributed to such a bubble. The same goes for the even lower risk weight that they assigned to securities issued by “public-sector entities” such as, in the United States, Fannie Mae and Freddie Mac; or the equally low risk weight that...

  9. 4 Capitalism and Regulation: Ignorance, Heterogeneity, and Systemic Risk
    (pp. 112-143)

    The modern democratic method of case-by-case social-problem solving, which Karl Popper (1961, 64–70) called the system of “piecemeal social engineering,” rarely rises to the conceptual level at which it can be labeled a “principle,” let alone a “system”; and “social engineering” has acquired totalitarian connotations that Popper did not intend. The engineer is not an architect of human behavior or the good society. She simply accomplishes mundane tasks: building a bridge where it is needed, producing a policy fix for reckless banking. Instead of a grand worldview, then, case-by-case “social engineering” is more like a tacit assumption that is...

    (pp. 144-156)

    Because our argument has covered a lot of ground, a summary is in order. We present it with its vulnerabilities (as we see them) exposed; after the summary, we briefly consider counterarguments directed at those vulnerabilities.

    We began in Chapter 1 with the fact that the mortgage-backed bonds on the balance sheets of U.S. commercial banks appear to have been either guaranteed by the GSEs or rated triple-A. This well-known fact poses serious problems for the two most prominent hypotheses about the cause of the crisis, both of which are “moral-hazard” stories.

    According to one of the moral-hazard stories, bankers...

  11. APPENDIX I. Scholarship About the Corporate-Compensation Hypothesis
    (pp. 157-162)
  12. APPENDIX II. The Basel Rules off the Balance Sheet
    (pp. 163-174)
  13. NOTES
    (pp. 175-188)
    (pp. 189-200)
  15. INDEX
    (pp. 201-210)
    (pp. 211-212)