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The purpose of this paper is to stress the role that several defective theories or views of
the world played in generating the subprime financial crisis.
Journal of Financial Economic Policy
The role of defective mental models in generating the global financial crisis
Thomas D. Willett
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Thomas D. Willett, (2012),"The role of defective mental models in generating the global financial crisis",
J ournal of Financial Economic Policy, Vol. 4 Iss 1 pp. 41 - 57
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The role of defective mental
models in generating the global
?nancial crisis
Thomas D. Willett
Department of Economics, Claremont Graduate University,
Claremont, California, USA
Abstract
Purpose – The purpose of this paper is to stress the role that several defective theories or views of
the world played in generating the subprime ?nancial crisis.
Design/methodology/approach – This is done by describing these views, showing that they were
widely held by relevant decision makers, and by analyzing the ?aws in these views. A considerable
amount of literature is surveyed in the process.
Findings – It was found that these defective views did play a major role in generating the crisis.
Research limitations/implications – Implications of the analysis for future research are discussed.
Practical implications – Implications of the analysis for reform of private and public sector
?nancial policies are discussed.
Originality/value – While most of the arguments in the paper are not new, no paper of which the
author is aware pulls them together with the same emphasis on how faulty mental models interacted
with dangerous incentive structures to play a prime role in generating the crisis. The paper also
references a muchwider range of literature on the crisis than anystudyof which the author is aware. The
paper should be of value to any one interested in the causes of the crisis and ways to make future crises
less likely.
Keywords Financial economics, International ?nancial institutions, Decision making, Financial policy,
Financial crisis, Mental models, Subprime, Defective theories, Future crisis
Paper type Viewpoint
1. Introduction
While the worst of the global ?nancial crisis has passed, debate still rages about the most
fundamental causes of the crisis and consequently about the nature of the reforms that
should be implemented to reduce the probabilities and magnitudes of future crises.
There is fairly widespread agreement that many factors contributed to the generation
and severity of the crisis. Davies (2010) has recently discussed over 30 factors that have
been suggested. Where there is still considerable disagreement is over what factors were
particularly important. This is re?ected in the failure of the US’ of?cial Financial Crisis
Inquiry Commission (2011) to produce a report that would be signed by both the
Democrats and Republicans on the Commission, thus leaving the huge volume produced
open to being described as over 400 pages and still no conclusion. The debates over
The current issue and full text archive of this journal is available at
www.emeraldinsight.com/1757-6385.htm
JEL classi?cation – A11, A1, A, A12, G01, G0, G
Earlier versions of this paper were presented at conferences and seminars at Cornell
University, Duke University, George Mason University, Seton Hall University and National
Chung-Hsing University. The author thanks the participants in these forums and in the
Claremont Crisis Workshop for many helpful suggestions.
Defective mental
models
41
Journal of Financial Economic Policy
Vol. 4 No. 1, 2012
pp. 41-57
qEmerald Group Publishing Limited
1757-6385
DOI 10.1108/17576381211206479
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the main causes are particularly strong in the political area where many on the right try
to force explanations into a framework of government being at fault, while many on the
left are equally insistent that deregulation and market excesses were the primary
culprits. The sharpness of such debate is given in an editorial in the Wall Street Journal
(“Rewriting Fannie Mae history”, 3 August 2010) which asserts that political defenses of
US housing ?nancial institutions, Fannie Mae and Freddie Mac, and the failure to date of
efforts to reform them, are “proof that the Washington establishment has learned
nothing from the 2008 ?nancial panic [. . .]” (p. A16).
Debate at the level of government versus the market is almost bound to be
unproductive. As the members of the Warwick Commission (2009, p. 2) on International
Financial Reformput it, “Our primary objective is not more regulation but more effective
regulation”. Careful analysis of the origins of the crisis clearly establish that
there were major failures on the parts of both government regulators (Levine, 2010) and
the private sector and that these interacted in ways that made the crisis much worse.
In terms of appropriate policy responses, it would be nice if it were true that the
problem was simply too much deregulation as some argue. If this were the case, then
we could simply re-regulate. It seems clear that some ?nancial deregulation did go too
far, but at the heart of the crisis were institutions over which governments still had
considerable regulatory authority. But the regulators in both Europe and the USAwere
simply not on top of the situation.
It seems clear that many regulators, especially in the USA, succumbed to the same
overoptimistic views as a majority of market participants – that “this time it’s different”
(Reinhart and Rogoff, 2009), and that high-asset prices re?ected fundamentals not
bubbles and that modern ?nancial engineering and risk management techniques have
made ?nancial systems much safer.
My argument in this paper is that such cognitive or intellectual capture of government
of?cials and the private sector alike played a major role in generating the crisis. These were
certainly not the only factor contributing importantly to the crisis, but correcting these
defective mental models, or views of the world, could play an important role in making our
?nancial systems safer. Althoughcorrectingsuchmistakenviews is onlya necessary, not a
suf?cient condition, for such improvements, but it is a necessary and an important one.
My criticisms of these defective mental models are not new. All had been raised by
some economists and ?nancial experts before the crisis, but these views were widely
ignored. These criticisms have also been made in many of the recent books and studies
on the crisis that have appeared. While some of the ?aws of the mental models that
contributed so much to generating the crisis have become widely acknowledged and this
has been incorporated into of?cial thinking and actions on ?nancial reform, as I review
in the concluding section, the deliberations of the G-20, the Financial Stability Board, the
Basel Committee on Banking Supervision, and the recently passed US ?nancial reform
bill still fail to take the dangers generated by these defective views suf?ciently into
account. This is similar to Mallaby’s (2010) recent discussion of the limited learning that
took place after the collapse of Long-term Capital Management (LTCM) in 1998. Thus,
I believe that it is useful for public debate (Thirkill-White, 2009) to pull these criticisms
together in one place and to discuss how they interacted with ?nancial innovations and
perverse incentives to contribute so importantly to the generation of the crisis.
Many economists andpolitical scientists have been skeptical about the roles that ideas
and ideology play in the formation of policy. Some argue that ideas and ideology are just
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used as masks for interests. And this is often true. But it surely cannot be the whole story,
for it is only through our mental models of the world that we perceive our interests.
I do not claim that the defective mental models discussed here provide a complete
explanation of the causes of the crisis. Recent studies have shown that a wide range of
factors contributed to the breadth and depth of the crisis[1]. De?cient mental models are
only part of the story. But they are an important part. I do not attempt to identify all the
faulty views that contributed to the crisis, but focus on three of the most important ones.
The ?rst is a simple one: the belief that house prices never fall. This false belief has
been largely shattered and almost certainly will not be the trigger for the next crisis.
It is worth beginning, however, by reviewing how this perception drove much of the
perverse behavior of the private sector.
Asecond faulty mental model was that market discipline would automatically lead to
self-regulation of the ?nancial markets, and as a result, little regulatory oversight was
needed. This viewwas most famously associated with Alan Greenspan, chairman of the
Federal Reserve. His golden reputation at the time of his position as Fed chairman gave
his views great weight with legislators and other regulators.
The third defective view was generated by over-con?dence in developments in the
mathematical modeling of risk that led to a revolution in the ?nancial engineering of
complex ?nancial instruments. This led to the viewthat these models would allowrisk to
be precisely measured and managed, and thus lead leading to a virtual conquering of
?nancial risk. This view became widely accepted by regulators as well as ?nancial
institutions. While these models were oftenexcellent for managingriskduringgoodtimes,
theywere generallypoorlyequipped to deal withthe badtimes. Byoffering a false sense of
security, these views facilitated the generation of excessive risk in the ?nancial system.
2. Myth 1: the whopper – house prices never fall
This was likely the false mental model that caused the most severe damage. Had the old
style structure of ?nancing, that the lender keeps the mortgage, still been predominant,
the damage would have been much less. Both the demand and supply for housing were
heavily in?uenced by this belief which became increasingly widespread as the housing
bubble grew. Of course, it is not surprising that real estate agents would strongly
disseminate this view, however, unfortunately of?cials, such as Alan Greenspan,
supported this viewas well. Post-war period housing prices in the USAhad never fallen
in nominal terms on a nationwide basis. Nor were housing bubbles limited to the USA.
The USA, however, was the primary source of the mortgage-backed securities (MBSs)
that were at the heart of the crisis, and almost half of these were sold to institutions in
other countries, especially Europe.
If housing prices were indeed bound to keep going up then there was much less need
for lenders to demand substantial down payments to ensure reasonable risk levels on
mortgages. As long as the owners could meet their payments for the ?rst fewyears, then
even with a zero down mortgage they would soon have considerable equity in their
home. Teaser rates could be justi?ed by beliefs that by the time the higher interest rates
kicked in, the owner would have enough equity to re?nance. And even if default
occurred, the value of the collateral would have likely appreciated enough to cover the
various costs of foreclosure. As Gorton (2010) argues, the problem was not so much
securitization per se, but the way that ?nancing was structured, making it highly
sensitive to a need for continued increases in housing prices.
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Clearly there were a number of cases where aggressive salesmanship and
speculative purchases went well beyond even the widest limits of appropriate behavior,
but such abuses appear to have been of lesser importance than the general frenzy of
buying and selling. It is fairly easy to see how real estate agents and relatively
uninformed buyers could get caught up in a mania of extrapolative expectations, but
such views also spread to many supposedly cool headed analysts as well. This belief
that at the national level housing prices could only go up became widespread. Many of
the models used by the ratings agencies and large ?nancial institutions had no
provisions for dealing with price declines, and such possibilities were not suf?ciently
included in stress testing.
While some hedge funds and analysts challenged such rosy scenarios (Lewis, 2010;
Mallaby, 2010), the possibility of a collapse of the real estate market was ignored by
most of the participants in the ?nancial markets that provided such a large share of
mortgage ?nancing through the purchase of MBSs. There were some exceptions.
Aprime example is Kerry K. Killinger, Chief Executive of Washington Mutual (WaMu).
In 2005, he wrote to his chief risk of?cer that he had never seen “such a high risk housing
market” (Norris, 2011). Unfortunately, he did not convert his views into actions to
reduce risk. This was due in large part to the fear of losing market share to competitors
as is discussed in Section 4 (WaMu’s failure also provides a prime example of the
regulatory failures discussed by Levine (2010)). It is not hard to see why originators
would substantially lower their standards since they collect their fees while passing
on the risks to purchasers of the MBSs. But then the question becomes why investors
would be willing to buy securities based on potentially toxic assets. Strong market
discipline by purchases of MBSs would have forced the originators to keep up their
standards.
Belief that such market discipline would be forthcoming, and that hence there would
be little need for strong regulatory oversight, is a second major mistaken belief or false
minded model that contributed importantly to the crisis, and to which we now turn.
3. Myth 2: ?nancial markets are self-regulating
A key problem with the self-regulation view most famously associated with
Alan Greenspan was that it was based more on faith in the market system than
careful analysis of the incentive structures needed for the market to provide effective
discipline over ?nancial behavior. Financial innovations had led to an enormous change
in incentive structures with respect to mortgage lending. With the development of the
widespread use of securitization and the originate and distribute model of mortgage
lending, the direct incentives for lenders to carefully monitor the quality of their loans
were sharply diminished.
This in itself might not have presented serious problems if the prospective
purchasers of the securities had been demanding about what they bought. Careful
attention to quality by purchasers would have forced continued discipline by lenders in
their originations in order to be able to distribute pro?tably. Unfortunately, buyers
showed little discrimination. They relied heavily on certi?cation by the ratings agencies
and the herding instincts of following the crowd of supposedly sophisticated big
investors.
The ratings agencies played a key role in the breakdown of market discipline by
offering disgracefully high ratings on a high proportion of sub-prime and other bad
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mortgages. What happened was that a potentially valuable innovation in ?nancial
engineering was taken and then drastically oversold. The good idea was that with
the bene?ts of diversi?cation and the slicing and dicing allowed by securitization, the
top proportion of a large group of sub-prime securities genuinely deserved AAAratings.
But while this might have appropriately applied to 10 or 20 percent of the total package,
the ratings agencies were convinced by mortgage securitizing clients to rate well over
half of many of these bundles as AAA.
To some extent, this re?ected the de?cient models of risk that will be discussed in
Section 4. But also important were the gross con?icts of interest generated by the
development of a market structure where the payments for ratings came from those
being rated. It does not require one to be an advanced student of economics to see the
con?ict of interest problemthat this generated. But the money was rolling in and neither
the players nor apparently the regulators wanted to rock the boat. The regulators and
politicians got what they wanted – increased home ownership by the poor with the
ratings agencies, real estate ?rms, and ?nancial institutions raking in huge pro?ts. The
problem was that this was a game that was not sustainable.
While the ratingagencies hadanoligopolistic structure favoredbygovernment-erected
barriers to entry, on both the supply and demand side the market for securitized
mortgages was highly competitive. The problem was that this is a market where
information costs are high and knowledge is quite asymmetric. While we can fault buyers
of these securities for being lazy and relying too much on the ratings agencies, a careful
look at the information structure in this market suggests why the ultimate purchasers did
not provide strong oversight. The information costs of doing so were quite high.
It may be true, as advocates of the new ?nancial alchemy argued, that securitization
allowed risk to be transferred to those in better positions to bear it – but in many cases
little attention was given to the problem of diminished incentives to obtain good
information. In the old hold-to-maturity model of mortgage lending, the institutions that
could most ef?ciently gather the relevant information and act on it had the incentives to
do so. With widespread securitization, the initial lenders’ incentives to obtain relevant
information about the borrower decreased drastically, while diversi?ed investors had
little access to direct information. These investors relied heavily on middleman
evaluations fromthe ratings agencies which turned out to be highly biased. As a result,
the level of effective information with which the systemoperated deteriorated markedly.
Often we can count on the market to turn up its nose at investment opportunities
about which there’s little knowledge. This would have forced discipline back onto the
lenders. But with the combination of misleadingly high ratings and fee-driven sales
pushes frommajor ?nancial institutions, MBSs became viewed as a smart thing to have
in one’s portfolio. The herd rushed in. Alargely similar phenomenon developed with the
booming market for credit default swaps. Little attention was paid to counterparty risks
and institutions were allowed to, in effect, offer insurance without being required to have
the reserves needed to meet potential obligations.
In many industries, a reasonable degree of competition is all that is needed for market
discipline to work well. However, where there are substantial differences between
private and social costs and bene?ts, competition is not enough. This is easy to see with
polluting industries, but in the banking sector the potentially important divergences
between private and social costs and bene?ts are not as readily apparent.
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Two major functions of a productive banking system are liquidity transformation,
and promotion of the effective allocation of investment. These two functions are
mutually reinforcing. Securing longer term sources of ?nancing are necessary for
real investments. However, for day-to-day operations, both ?rms and individuals also
have a need for liquidity, the quick availability of funds at lowcost. Bank deposits have
for centuries been a major source of such liquidity. Long ago, however, bankers
discovered that seldom, if ever, will all depositors want their money at the same time.
Thus, under normal circumstances bankers could safely lend out a substantial fraction
of their deposits longer term, thus facilitating real investment. This was one of the ?rst
major examples of ?nancial alchemy. This process substantially lowered the cost and
increased the availability of ?nancing for longer terminvestments in total. Furthermore,
the desire to be repaid gave the bankers strong incentives to monitor carefully their loans
and thus contribute to an ef?cient allocation of capital.
The Achilles heel of this system was that in panics the typical depositor could not
easily discover which banks were sound and which were not. Thus, there were strong
incentives among depositors for runs on all banks. Because of the characteristics of
liquidity transformation, even solidly solvent banks could not meet huge increases in
demands for liquidity by their depositors. By their very nature longer term investments
could only be liquidated quickly at huge discounts, if at all. As a result, most economists
concludedthat modern bankingsystems could not effectivelymanage themselves during
a crisis, and thus there was a strong case for governments to act as a lender of last resort.
This would allow the crucial function of liquidity transformation to continue to operate,
while reducing the risks of ?nancial crises. With the implementation of modern deposit
insurance, depositor runs on banks are now quite infrequent (the run on Northern rock
was a vivid exception). Nonetheless, the basic problem has not disappeared. With the
development of heavy reliance on short-term borrowing by many ?nancial institutions,
the most serious form of modern bank runs, namely the drying up of short-term
?nancing, can prove equally devastating as many investment and commercial banks
have discovered during the most recent global ?nancial crisis (Gorton, 2010).
As long as governments followed Bagehot’s advice to lend only to solvent
institutions, and only at penalty rates, no major problems of moral hazard were
generated by this increased role of government in the economy. Often, however,
solvency is not so easy to judge, and particularly with large institutions, governments
may have strong political incentives to bias their judgments in terms of solvency or even
to ignore this constraint all together. Hence the too big to fail moral hazard was
generated. As a counter, governments tended to adopt capital requirements to offset the
incentives for excessive risk taking generated bythis moral hazard. This moral hazard is
probably economists’ favorite explanation for excessive risk taking in ?nancial sectors,
and it has often been an important phenomena. It is not so clear, however, that this was
the dominant factor in the crisis of 2007-2008.
The combination of defective mental models – internal management problems
within ?nancial ?rms, changes in the structure of ?nancing, and perverse effects of
competitive pressures – was to cause most of the problems without any need to involve
moral hazard considerations generated by governments. The widespread bailouts and
guarantees offered by governments during the recent crisis, combined with the
increased size of many ?nancial institutions means that the too big to fail problem has
substantially increased since the crisis however. As partial evidence in support of this
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proposition, we can invoke the huge wealth losses that the crisis generated for most of
the top managers of the large ?nancial institutions. Although their creditors and
institutions were generally bailed out, most top managers had considerable portions
of their personal wealth tied up in the stock of their institutions, and these took huge hits.
The enormous golden parachutes that several ousted leaders received were the results of
private contracts, not government intervention.
Several accounts of the internal decision making within many of the large ?nancial
institutions that contributed to the crisis have nowbeen published (Cohan, 2009; Bamber
and Spencer, 2008; Gilbert, 2010; Faber, 2009; Lowenstein, 2010; Mallaby, 2010; McLean
and Nocera, 2010; McDonald and Robinson, 2009; Sorkin, 2009; Tett, 2009; Tibman,
2009). These accounts strongly suggest that over the period in which most of the risky
investments were made, many of the top management of the ?nancial institutions had
little conception of the true magnitude of the risks that were being taken. While many of
these top managers can certainly be faulted for failing to under due diligence, and in
some cases for being grossly out of touch with what was going on, many of themseemto
have been just as misled about the safety of asset-backed securities as the purchasers of
the exotic instruments that these created. Many managers appear to have believed as
strongly in the AAA ratings of MBSs as ordinary investors.
Within the ratings agencies themselves a strong case can be made that the risk
analyses performed was as much (or more) a mask for greed than a result of true beliefs
in defective mental models. Certainly a number of examples have come to light of
employees who had severe doubts about the adequacy of many of the risk assessments
being offered. For many analysts, their technical analysis was likely as much a recordfor
plausible deniability when things went than a source of genuine errors. Some analysts
did express concerns to higher ups, but perhaps blinded by all the money rolling in, top
management typically overlooked these concerns. Indeed a number of of?cials fromthe
ratings agencies have argued that they were marginalized, and in some cases, even ?red
for warning of dangers.
Even beyond the prospect of government bailouts, economists have analyzed
dilemmas in which managers who fear that their institutions may be insolvent could be
induced to gamble for redemption. However, as with the direct government-induced
moral hazard, this does not appear to have played a major role in generating the
sub-prime crisis[2]. Over the period in which most investments were made, no evidence
has surfaced of top-level internal concerns about solvency in any of the major ?nancial
institutions. By the time some insiders did begin to worry about this, it was likely
already too late. A number of warnings about excessive riskiness were given to top
management earlier on but these were generally ignored.
Astronger candidate for explanation is the competitive pressure in markets in which
short-run returns are accurately measured and longer run risks are not. When it comes to
decision making, there is a familiar tendency to over weigh what can be easily measured
versus what cannot. We also know that immediate effects tend to be weighed more
heavily than future ones. As analysts such as Taleb (2007) has emphasized, when what
is at issue is a perceived small probability of large future losses, short-run competitive
pressures are likely to generate insuf?cient attention to such risks and consequently
result in excessive risk taking. As a result, prudent investment managers who resist this
pressure and abstain from such activities will be outperformed in the short-run, losing
clients, substantial amounts of income and possibly their jobs.
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Frank (2008) argues that the phenomenon described above is actually a general
feature of situations in which performance is judged on a relative rather than absolute
basis[3]. Furthermore, this tendency is strengthened when the risk aspect of risk-return
tradeoffs cannot be adequately measured at the time of the decision making. Of course,
as will be discussed in the following section, when the standard risk evaluation methods
tend to understate the true risk, as the popular value-at-risk (VaR) method did, then the
problem becomes even more pronounced. Behavioral biases can also contribute to this
issue[4]. We often see what we want to see and overlook what we do not want to see.
Con?rmation bias seems to have played a strong role within major institutions with
many top executives not paying enough attention to warnings that high earnings were
coming from excessive risk taking.
Easy money also played a considerable role, both in facilitating ?nancing and in
changing the incentives facing many ?nancial decision makers. As rates of return fell in
response to the ?ood of global liquidity, many investment managers felt strong
competitive pressures to keep up returns. The easiest way to do this was to take on more
risk, and one of the easiest ways to take on more risk without this being immediately
apparent to one’s bosses or clients was to increase leverage. Such increases in leverage in
turn not only fueled the bubbles that resulted but also increased the damage to the
economic system when the crash came.
There are also important principal-agent problems in the ?nancial sector. Executive
compensation is a prime example. Many large ?rms, and not just ?nancial ones, have
generally had cozy arrangements between top executives and directors, with relatively
little effective oversight from the small number of outside directors and stockholders.
These ?rms have typically faced a number of institutional impediments to effective
oversight. Many analysts argue that this structure contributed importantly to high
salaries of executives. However, while there is a push for reformin this area, there is little
basis to believe that high salaries in themselves, as opposed to compensation structures
that gave too little weight to risk relative to return, contributed importantly to the
excessive risk taking[5]. Given the dif?culties of ascertaining “true” longer term risk
positions and the limited incentives for diversi?ed investors to invest their time and
resources in gathering and analyzing what information is publicly available, it seems
likely that the majority of shareholders would have penalized rather than rewarded
institutions that held back from increasing leverage and risk when others were
increasing it and hence producing greater short-term returns. From this perspective,
principal-agent problems between shareholders and the major ?nancial institutions
were likely not a major cause of the excessive risk these institutions undertook.
One indication that this is likely the case comes from the results of particular hedge
fund managers during the dot.com era. There were managers who believed correctly
that the rapid increases in the values of the dot.com companies were a bubble, and bet
against it in the early and middle stages. However, as the bubble continued they
underperformed in the short run and lost many investors who focused on chasing
returns. Some of these, like George Soros, took large losses and eventually gave up
(Mallaby, 2010). The lesson fromthese managers was that being right in the long run is
not always an effective short-run survival strategy in ?nancial markets.
In summary, competitive markets can provide productive discipline only when good
information is available and a suf?cient number of actors have the right incentives to
obtain, analyze, and act on this information. In the old days when banks kept their loans
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on their books and investment banks served in partnerships, these conditions were
reasonably approximated. As the new ?nancial structure based on widespread
securitization took hold, such discipline broke down. Ageneral faith in market discipline
was no substitute for a careful analysis of market structure and incentives. There was
little basis to believe that the ?nancial system would be self-disciplining under the new
conditions generated by ?nancial innovation. As long time Wall Street Economist
Kaufman (2009) puts it:
The structural changes in the ?nancial markets encouraged participants to become
short-term oriented [. . .] the fervor for pro?ts from securitization [. . .] ushered in a host of [. . .]
institutional shifts. Senior managers at a growing number of leading ?nancial institutions
either lost control of risk management or became its captives [. . .] every institution [. . .] felt
growing pressure to take risks in order to maintain market share (p. 203).
and “the glamour and pro?t of risk-taking ensured that the risk takers themselves
gained more and more power within the structure of ?nancial institutions” (p. 205).
Thus, neither internal disciplines from within the major ?nancial institutions nor
external disciplines from the ?nancial markets or from regulators were suf?cient to
counter these problems[6].
4. Ef?cient markets theory, ?nancial engineering, and the myth that risk
had been conquered
The rapid expansion of the use of complex ?nancial instruments, so many of which
eventually turned toxic, was made possible by a combination of advances in
mathematical ?nance andcomputational power. These advances likewise revolutionized
techniques of risk management[7]. As sophisticated as they were, however, such models
for pricing derivatives, discovering speculative opportunities, and managing risk, still
had to make a number of important simplifying assumptions in order to be computable.
These advances did bring a number of important bene?ts to society. Amuch greater
array of derivative products allowed ?rms to hedge more types of risks. But as was true
of the ?rst ?nancial derivative to become widely used, the forward contract in foreign
exchange, it was also true with these newinstruments, which could also be used to take
risks, i.e. to speculate. This is not necessarily bad, as speculators are often the source of
supply for the demands of hedgers and increase market liquidity.
Most of the innovations in the mathematical modeling of risk in recent decades were
based on the assumptions that markets were ef?cient, liquid, and subject to continuous
trading (of course mathematical models were also used to try to discover pro?t-making
inef?ciencies in markets). However, in crisis periods, these assumptions proved false.
In such cases standard risk models can generate spectacular failures of risk
management strategies. This was illustrated in the stock market crash of 1987. Many
investors had become sold on the bene?ts of so-called dynamic hedging, which under the
assumptions noted above, would allow investors to limit their losses from stock market
declines. These strategies were also based on the assumption that overall market
behavior would not be affected by the adoption of such strategies. This seemed
reasonable for a stock market in which each investor would normally be only a small
part of the market. However, what was overlooked was that if a large number of
investors started following similar strategies, this could begin to signi?cantly affect the
very behavior of the market. On Black Monday, 19 October 1987, when the market began
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to plunge, the dynamic insurance programs began to sell. This generated a sharp
discontinuity in the market with liquidity vanishing and prices plunging.
Despite this ?asco, other versions of pro?t seeking and risk management models
based on the same underlying assumptions continued their spread. Even the collapse
of LTCM due in large part to model failures in 1998 was not suf?cient to seriously
dampen the rise of widespread faith in these models. Anumber of economists, ?nancial
analysts, and Wall Street quants did point to serious problems with the reliability of
these models (Das, 2006; Taleb, 2007; Triana, 2009; Lindsey and Schachter, 2009; Willett
et al., 2005) but these individuals were in a distinct minority, both among ?nancial
market participants and regulators.
Such blind beliefs in ef?cient market theory and in the idea that innovations in risk
management had made ?nancial systems signi?cantly safer, contributed to the
tendency to focus primarily on the idiosyncratic risks of individual institutions in
isolation. Insuf?cient attention was being given to the danger of system wide shocks.
This, in turn, led regulators to pay insuf?cient attention to macro prudential issues, and
both public and private sector agents to pay insuf?cient attention to liquidity risks and
the liability side of ?nancial institutions’ balance sheets (these issues are discussed
further in the concluding section).
In general these new risk models and the derivative products based on them work
well during normal periods. A case in point is the VaR model which came to dominate
risk management strategies in large private ?nancial institutions. These were heartily
endorsed by many regulatory agencies. Part of their popularity was their collapsing of a
complex set of considerations into a single number. This number represented the largest
amount of money that could be lost on a portfolio over a relatively short period of time,
often a day to a month, with a certain degree of statistical con?dence (often 95 percent).
Usually such models worked quite well. Furthermore, they had the important advantage
of taking into account the risk reduction bene?ts of diversi?cation by incorporating
the correlations among different components of the portfolio. Unfortunately, however,
the precision of the calculations gave many traders and managers an exaggerated sense
of con?dence that risk was being adequately measured, and that with the bene?ts of
diversi?cation and the new array of hedging instruments, risk could be controlled to a
high degree. As the Financial Times Columnist Munchau (2009, p. 89) notes:
Some believed that innovation in the ?nancial markets had eliminated all risk for all time.
This, of course, was an erroneous belief, but it does give a clear picture of what people were
thinking at the time.
The key problems with the VaR models were not only that they ignored liquidity,
counterparty, and operational risks, but more importantly that they assumed ?nancial
market outcomes were normally distributed and that correlations over the recent past
would be a good guide to their behavior in the future. Both of these latter assumptions
were known to be invalid thanks to the results of massive amounts of empirical research.
It was well known to ?nancial economists and many ?nancial analysts that the
distributions of most ?nancial market outcomes had “fat tails”, i.e. that large positive
and negative changes occurred much more frequently than they would have if a normal
distribution were the case (Mandelbrot and Hudson, 2004).
In addition, many studies have shown that correlations among ?nancial variables
can vary a great deal over time. These measures are heavily in?uenced not only by
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structural relationships but also by patterns of shocks, which can vary considerably
over time. Thus, for example, if interest rates rise because monetary policy is tightened
we would expect the country’s currency to strengthen, but if interest rates rise because
of expectations of higher in?ation or perceptions of greater risk, we would expect the
currency to fall.
Furthermore, the VaR methods are essentially backward looking. They ignore many
types of warning signs that a crisis could be brewing. This was clearly the case in the
Asian crisis. Using the VaR model, risk was measured by past volatility. Since
the Thai baht had been basically pegged to the dollar for over a decade it had displayed
little variability. As a result, the VaR approach could not pick up the increased riskiness
of the baht as the crisis approached (Lindo, 2008).
All of these problems were well known to some academics and practitioners but were
nonetheless ignored by many others. Even the real world examples of these problems
such as the Asian and Russian-LTCMcrises did not succeed in convincing many market
participants of the dangers of believing that risk could now be precisely measured and
managed.
5. Concluding comments
In considering ?nancial reforms for both the public and private sectors, the global
?nancial crisis highlights a number of important lessons. The crisis tells a dismal tale
of greed, hubris, stupidity, false assumptions, defective mental models, and regulatory
inattention, fortunately we can end on a more positive note. If my analysis is correct,
many of the problems that led to this crisis can be substantially mitigated by taking a
more serious economic approach to ?nancial regulation and correcting the defective
mental models discussed above.
Of course, even with correct mental models con?icts of interest will remain and,
major ?nancial institutions and ratings agencies lobby for legislation that puts their
interests ahead of that of the overall economy. In general, however, the use of less
faulty mental models is likely to reduce some of these con?icts of interest, especially
those resulting from market actors taking on more risk than they realize. Likewise,
even without new legislation, more widespread recognition of the fact that housing
prices can fall as well as rise should promote more prudent behavior in the real estate
market.
While the ideology or mental model that the ?nancial sector needed little regulatory
oversight was a key factor in the cause of crisis, “cognitive capture” of regulators by
those being regulated also likely played a major role. This phenomenon will be dif?cult
to overcome, but efforts should be made.
From the standpoint of private risk management, the principal lesson is that the
behavioral relationships among different ?nancial assets and liabilities are not physical
constants such as those with which civil engineers deal. These relationships re?ect a
combination of direct economic and ?nancial interdependencies and the patterns of
shocks that hit the system. While most of the developments in mathematical modeling
and product innovations that can be categorized under the heading of ?nancial
engineering can have productive uses in ?nancial markets, they can lead to disaster
when combined with bad incentive structures and false beliefs in the stability of
historical correlations. It would be a shame to overreact and abolish all the recently
developed programs in ?nancial engineering. There is a strong need, however, for the
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risk management business to be re-engineered to put a stronger focus on ?nancial
economics, rather than just ?nancial mathematics.
This change will help both to de?ate hubris about the degree of predictability in
?nancial relationships and also to focus more attention both within private sector
institutions and regulatory agencies on incentive structures. One does not need to get
into a debate about whether greed is good or bad to recognize that it is a widespread
attribute of the human condition. While we can hope that most people would refuse to
engage in some of the most predatory of the practices that have been uncovered in
segments of the sub-prime mortgage industry, a central premise of the economic
approach is that we need to design incentive structures that minimize the need for people
to behave like saints. This should also be a central focus of regulatory reforms.
Critics of regulation such as Alan Greenspan put great stock in their judgments that
on average we cannot expect ?nancial regulators to match the resources and
sophistication of the institutions they are supposed to regulate. This is a judgment with
which I concur, but fromwhich I drawa quite different conclusion than Greenspan’s that
regulation should be virtually eliminated. While much has been made of the laissez-faire
attitude toward ?nancial regulation adopted by American regulators, the recent
?nancial crisis was far from just being an example of American free-market extremism.
The whole set of regulatory principles developed by the Basel group of international
regulators had deep ?aws. These principles relied heavily on the outsourcing of risk
analysis to ratings agencies andthe large banks’ internal models. Although these models
were indeed highly sophisticated, they were also deeply ?awed. Furthermore, regulators
largely overlooked the strong incentives to misuse such analyses to game the system to
reduce capital requirements and increase leverage. To discover these perverse incentives
one does not need a high-priced lawyer or a PhD in mathematics. Any run-of-the-mill
economist worth their salt would have spied many of these con?icts of interest
immediately, and others after some study.
The Securities and Exchange Commission in the USAis not unusual in being peopled
largely by lawyers who tend to give insuf?cient attention to basic economic analysis.
This situation could be easily improved if the political will is present. Of course it is not
suf?cient just to identify perverse incentives, they must also be corrected. Although in
many cases the discovery of optimal incentive structures is well beyond our current
capabilities, great gains can be made just by devising and implementing less bad ones.
We should also pay careful heed to the call of Bookstaber (2007) in his important book,
A Demon of Our Own Design, which predicted the current crisis as the outcome of
excessive complexity in our ?nancial structure. Bookstaber’s analysis offers a most
convincing warning of the danger of devising complex arrangements that optimize for a
particular environment but which may fail badly in others. He stresses the evolutionary
advantages of simpler but more robust arrangements which are optimal in no one
environment, but perform decently in a wide range of situations. As the current crisis
vividly – and painfully – illustrates, the ?nancial landscape can be quite variable. This
reality suggests that at least initially regulatory reform should focus on fairly simple
regulations such as limitations on leverage for different types of activities. This should
not require ?nancial wizards to implement and should not discourage the development
of useful ?nancial innovations. Furthermore, in lacking the look of sophistication it
would be much more dif?cult to game. However, this approach does require an
important ingredient that is often in short supply – political will.
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Unfortunately, despite the widespread recognitionof the problems withstandardrisk
modeling, it appears that the Basle Committee has been making little effort for reforms
on this front, focusing primarily instead on strengthening capital requirements and
tightening the de?nitions of what is counted as capital. While these go in the right
direction, there appears to have been little of?cial attention paid to the problems
associated with the standard methods of risk-weighting capital requirements that
contributed to allowing banks to engage in excessive leverage. Nor has much been done
to reduce the con?icts of interest faced by rating agencies[8].
Already as economies improve, we are seeing considerable of?cial backtracking from
positions taken in the depth of the crisis. One valuable proposal put forward in 2009 by
the Basel Committee was the use of a simple leverage ratio. While crude, this approach is
quite consistent with the lessons from Bookstaber’s analysis discussed above.
Unfortunately in the latest version of these proposals, the leverage ratio was extremely
weak. It is nowset at the extremely generous level of 3 percent while its implementation
is set to be delayed for a number of years.
One of the most signi?cant failures of the old Basel approach was its almost exclusive
focus on micro-prudential issues, i.e. the soundness of each institution in isolation. Not
enough focus was placed on macro prudential supervision of risks to the ?nancial
systems as a whole, especially with how?nancial institutions interact within the system
(Brunnermeier et al., 2009; Turner, 2009; Warwick Commission, 2009). Consequently, the
standard risk measures failed to account suf?ciently for the interconnectedness among
institutions and the potential for contagion across the overall system. Risk management
strategies that would be highly effective if adopted by one or a few institutions in
isolation can act to substantially worsen a crisis if adopted simultaneously by a large
number of institutions.
Since the standard risk measures were backwards looking they could be as much the
source of herd behavior as psychological panic. Thus, the Basel Committee’s risk
weighted capital requirements were pro cyclical. Instead of dampening the tendency of
the ?nancial systemto be subject to booms andbusts, this aspect of the regulatorysystem
helped contribute to the problem(Brunnermeier et al., 2009; Warwick Commission, 2009).
It appears that the need to make capital requirements counter cyclical has been generally
accepted. But again, in its latest proposal the Basel Committee has backed away, saying
the questionneeds more study. Nor has suf?cient progress beenmade ondealing withthe
international aspects of crisis prevention and management[9].
Thus, while some progress has been made on regulatory reformwe are still far short
of all that is needed. Mental models in?uence how actors see their interests.
Unfortunately public of?cials and the leaders of the major ?nancial institutions still
have more to learn than they seem to realize.
Notes
1. For book length studies by economists, see Barth et al. (2009), Dowd and Hutchinson (2010),
Gorton (2010), Johnson and Kwak (2010), Rajan (2010), Reinhart and Rogoff (2009), Roubini
and Mihm (2010), and Zandi (2009).
2. In the USA, several forms of government encouragement for lending to low income and
minority home buyers de?nitely contributed to the magnitude of the crisis, but much of the
bad lending was for higher priced houses. While the ?rst signs of the crisis showed up in the
sub-prime market, Munchau (2009) is right to argue that it is a misnomer to refer to this crisis
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as the sub-prime crisis. For more on the US housing aspects of the crisis, see Barth et al.
(2009), Gorton (2010), Shiller (2008), and Sowell (2009).
3. That competition can generate pressures for excessive risk-taking in modern ?nancial
systems is also a theme in Brunnermeier et al. (2009), French et al. (2010), Gibson (2010),
Rajan (2010), and Turner (2009).
4. The new sub?eld of behavioral and neuro ?nance focuses on such possible biases. See, for
example, Akerlof and Shiller (2009), Burnham (2005), Peterson (2007), Shefrin (2000), Shleifer
(2001), and Zweig (2007).
5. For discussion of proposals to reform compensation structures, see Acharya and Richardson
(2009), Brunnermeier et al. (2009), and French et al. (2010).
6. For discussion of proposals to improve market discipline by requiring the insurance of
subordinated debt, see Acharya and Richardson (2009), Brunnermeier et al. (2009), and
French et al. (2010).
7. For discussion of these revolutions, see Bernstein (2007), Best (2010), Fox (2009), Triana
(2009), and Lindsey and Schachter (2009).
8. On issues concerning the ratings agencies, see Acharya and Richardson (2009).
9. Of course there are some important spillover aspects of regulation but as several studies have
recently argued, concerns with level playing ?elds have been used in the past by multinational
?nancial institutions to gain favorable regulatory actions. Amove fromhome to host country
responsibility for regulation would have strong advantages fromthe standpoint of the public
as opposed to banking interests (Brunnermeier et al., 2009; Levinson, 2010; Persaud, 2010;
Warwick Commission, 2009). While there are of course gains from international
harmonization of regulations, there are also costs as a diversity of strategies is likely to
make a system less crisis prone (Bookstaber, 2007; Levinson, 2010).
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Further reading
Abdelal, R. (2009), “Constructivism as an approach to international political economy”,
in Blyth, M. (Ed.), Routledge Handbook of International Political Economy (IPE), Routledge,
Abingdon, pp. 62-76.
Mackenzie, D. (2008), An Engine, Not a Camera: How Financial Models Shape Markets, The MIT
Press, Cambridge, MA.
Montier, J. (2002), Behavioral Finance, Wiley, Hoboken, NJ.
Rebonato, R. (2007), Plight of the Fortune Tellers: Why We Need to Manage Financial Risk
Differently, Princeton University Press, Princeton, NJ.
Corresponding author
Thomas D. Willett can be contacted at: [email protected]
Defective mental
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57
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This article has been cited by:
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doc_526579490.pdf
The purpose of this paper is to stress the role that several defective theories or views of
the world played in generating the subprime financial crisis.
Journal of Financial Economic Policy
The role of defective mental models in generating the global financial crisis
Thomas D. Willett
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To cite this document:
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J ournal of Financial Economic Policy, Vol. 4 Iss 1 pp. 41 - 57
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The role of defective mental
models in generating the global
?nancial crisis
Thomas D. Willett
Department of Economics, Claremont Graduate University,
Claremont, California, USA
Abstract
Purpose – The purpose of this paper is to stress the role that several defective theories or views of
the world played in generating the subprime ?nancial crisis.
Design/methodology/approach – This is done by describing these views, showing that they were
widely held by relevant decision makers, and by analyzing the ?aws in these views. A considerable
amount of literature is surveyed in the process.
Findings – It was found that these defective views did play a major role in generating the crisis.
Research limitations/implications – Implications of the analysis for future research are discussed.
Practical implications – Implications of the analysis for reform of private and public sector
?nancial policies are discussed.
Originality/value – While most of the arguments in the paper are not new, no paper of which the
author is aware pulls them together with the same emphasis on how faulty mental models interacted
with dangerous incentive structures to play a prime role in generating the crisis. The paper also
references a muchwider range of literature on the crisis than anystudyof which the author is aware. The
paper should be of value to any one interested in the causes of the crisis and ways to make future crises
less likely.
Keywords Financial economics, International ?nancial institutions, Decision making, Financial policy,
Financial crisis, Mental models, Subprime, Defective theories, Future crisis
Paper type Viewpoint
1. Introduction
While the worst of the global ?nancial crisis has passed, debate still rages about the most
fundamental causes of the crisis and consequently about the nature of the reforms that
should be implemented to reduce the probabilities and magnitudes of future crises.
There is fairly widespread agreement that many factors contributed to the generation
and severity of the crisis. Davies (2010) has recently discussed over 30 factors that have
been suggested. Where there is still considerable disagreement is over what factors were
particularly important. This is re?ected in the failure of the US’ of?cial Financial Crisis
Inquiry Commission (2011) to produce a report that would be signed by both the
Democrats and Republicans on the Commission, thus leaving the huge volume produced
open to being described as over 400 pages and still no conclusion. The debates over
The current issue and full text archive of this journal is available at
www.emeraldinsight.com/1757-6385.htm
JEL classi?cation – A11, A1, A, A12, G01, G0, G
Earlier versions of this paper were presented at conferences and seminars at Cornell
University, Duke University, George Mason University, Seton Hall University and National
Chung-Hsing University. The author thanks the participants in these forums and in the
Claremont Crisis Workshop for many helpful suggestions.
Defective mental
models
41
Journal of Financial Economic Policy
Vol. 4 No. 1, 2012
pp. 41-57
qEmerald Group Publishing Limited
1757-6385
DOI 10.1108/17576381211206479
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the main causes are particularly strong in the political area where many on the right try
to force explanations into a framework of government being at fault, while many on the
left are equally insistent that deregulation and market excesses were the primary
culprits. The sharpness of such debate is given in an editorial in the Wall Street Journal
(“Rewriting Fannie Mae history”, 3 August 2010) which asserts that political defenses of
US housing ?nancial institutions, Fannie Mae and Freddie Mac, and the failure to date of
efforts to reform them, are “proof that the Washington establishment has learned
nothing from the 2008 ?nancial panic [. . .]” (p. A16).
Debate at the level of government versus the market is almost bound to be
unproductive. As the members of the Warwick Commission (2009, p. 2) on International
Financial Reformput it, “Our primary objective is not more regulation but more effective
regulation”. Careful analysis of the origins of the crisis clearly establish that
there were major failures on the parts of both government regulators (Levine, 2010) and
the private sector and that these interacted in ways that made the crisis much worse.
In terms of appropriate policy responses, it would be nice if it were true that the
problem was simply too much deregulation as some argue. If this were the case, then
we could simply re-regulate. It seems clear that some ?nancial deregulation did go too
far, but at the heart of the crisis were institutions over which governments still had
considerable regulatory authority. But the regulators in both Europe and the USAwere
simply not on top of the situation.
It seems clear that many regulators, especially in the USA, succumbed to the same
overoptimistic views as a majority of market participants – that “this time it’s different”
(Reinhart and Rogoff, 2009), and that high-asset prices re?ected fundamentals not
bubbles and that modern ?nancial engineering and risk management techniques have
made ?nancial systems much safer.
My argument in this paper is that such cognitive or intellectual capture of government
of?cials and the private sector alike played a major role in generating the crisis. These were
certainly not the only factor contributing importantly to the crisis, but correcting these
defective mental models, or views of the world, could play an important role in making our
?nancial systems safer. Althoughcorrectingsuchmistakenviews is onlya necessary, not a
suf?cient condition, for such improvements, but it is a necessary and an important one.
My criticisms of these defective mental models are not new. All had been raised by
some economists and ?nancial experts before the crisis, but these views were widely
ignored. These criticisms have also been made in many of the recent books and studies
on the crisis that have appeared. While some of the ?aws of the mental models that
contributed so much to generating the crisis have become widely acknowledged and this
has been incorporated into of?cial thinking and actions on ?nancial reform, as I review
in the concluding section, the deliberations of the G-20, the Financial Stability Board, the
Basel Committee on Banking Supervision, and the recently passed US ?nancial reform
bill still fail to take the dangers generated by these defective views suf?ciently into
account. This is similar to Mallaby’s (2010) recent discussion of the limited learning that
took place after the collapse of Long-term Capital Management (LTCM) in 1998. Thus,
I believe that it is useful for public debate (Thirkill-White, 2009) to pull these criticisms
together in one place and to discuss how they interacted with ?nancial innovations and
perverse incentives to contribute so importantly to the generation of the crisis.
Many economists andpolitical scientists have been skeptical about the roles that ideas
and ideology play in the formation of policy. Some argue that ideas and ideology are just
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used as masks for interests. And this is often true. But it surely cannot be the whole story,
for it is only through our mental models of the world that we perceive our interests.
I do not claim that the defective mental models discussed here provide a complete
explanation of the causes of the crisis. Recent studies have shown that a wide range of
factors contributed to the breadth and depth of the crisis[1]. De?cient mental models are
only part of the story. But they are an important part. I do not attempt to identify all the
faulty views that contributed to the crisis, but focus on three of the most important ones.
The ?rst is a simple one: the belief that house prices never fall. This false belief has
been largely shattered and almost certainly will not be the trigger for the next crisis.
It is worth beginning, however, by reviewing how this perception drove much of the
perverse behavior of the private sector.
Asecond faulty mental model was that market discipline would automatically lead to
self-regulation of the ?nancial markets, and as a result, little regulatory oversight was
needed. This viewwas most famously associated with Alan Greenspan, chairman of the
Federal Reserve. His golden reputation at the time of his position as Fed chairman gave
his views great weight with legislators and other regulators.
The third defective view was generated by over-con?dence in developments in the
mathematical modeling of risk that led to a revolution in the ?nancial engineering of
complex ?nancial instruments. This led to the viewthat these models would allowrisk to
be precisely measured and managed, and thus lead leading to a virtual conquering of
?nancial risk. This view became widely accepted by regulators as well as ?nancial
institutions. While these models were oftenexcellent for managingriskduringgoodtimes,
theywere generallypoorlyequipped to deal withthe badtimes. Byoffering a false sense of
security, these views facilitated the generation of excessive risk in the ?nancial system.
2. Myth 1: the whopper – house prices never fall
This was likely the false mental model that caused the most severe damage. Had the old
style structure of ?nancing, that the lender keeps the mortgage, still been predominant,
the damage would have been much less. Both the demand and supply for housing were
heavily in?uenced by this belief which became increasingly widespread as the housing
bubble grew. Of course, it is not surprising that real estate agents would strongly
disseminate this view, however, unfortunately of?cials, such as Alan Greenspan,
supported this viewas well. Post-war period housing prices in the USAhad never fallen
in nominal terms on a nationwide basis. Nor were housing bubbles limited to the USA.
The USA, however, was the primary source of the mortgage-backed securities (MBSs)
that were at the heart of the crisis, and almost half of these were sold to institutions in
other countries, especially Europe.
If housing prices were indeed bound to keep going up then there was much less need
for lenders to demand substantial down payments to ensure reasonable risk levels on
mortgages. As long as the owners could meet their payments for the ?rst fewyears, then
even with a zero down mortgage they would soon have considerable equity in their
home. Teaser rates could be justi?ed by beliefs that by the time the higher interest rates
kicked in, the owner would have enough equity to re?nance. And even if default
occurred, the value of the collateral would have likely appreciated enough to cover the
various costs of foreclosure. As Gorton (2010) argues, the problem was not so much
securitization per se, but the way that ?nancing was structured, making it highly
sensitive to a need for continued increases in housing prices.
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Clearly there were a number of cases where aggressive salesmanship and
speculative purchases went well beyond even the widest limits of appropriate behavior,
but such abuses appear to have been of lesser importance than the general frenzy of
buying and selling. It is fairly easy to see how real estate agents and relatively
uninformed buyers could get caught up in a mania of extrapolative expectations, but
such views also spread to many supposedly cool headed analysts as well. This belief
that at the national level housing prices could only go up became widespread. Many of
the models used by the ratings agencies and large ?nancial institutions had no
provisions for dealing with price declines, and such possibilities were not suf?ciently
included in stress testing.
While some hedge funds and analysts challenged such rosy scenarios (Lewis, 2010;
Mallaby, 2010), the possibility of a collapse of the real estate market was ignored by
most of the participants in the ?nancial markets that provided such a large share of
mortgage ?nancing through the purchase of MBSs. There were some exceptions.
Aprime example is Kerry K. Killinger, Chief Executive of Washington Mutual (WaMu).
In 2005, he wrote to his chief risk of?cer that he had never seen “such a high risk housing
market” (Norris, 2011). Unfortunately, he did not convert his views into actions to
reduce risk. This was due in large part to the fear of losing market share to competitors
as is discussed in Section 4 (WaMu’s failure also provides a prime example of the
regulatory failures discussed by Levine (2010)). It is not hard to see why originators
would substantially lower their standards since they collect their fees while passing
on the risks to purchasers of the MBSs. But then the question becomes why investors
would be willing to buy securities based on potentially toxic assets. Strong market
discipline by purchases of MBSs would have forced the originators to keep up their
standards.
Belief that such market discipline would be forthcoming, and that hence there would
be little need for strong regulatory oversight, is a second major mistaken belief or false
minded model that contributed importantly to the crisis, and to which we now turn.
3. Myth 2: ?nancial markets are self-regulating
A key problem with the self-regulation view most famously associated with
Alan Greenspan was that it was based more on faith in the market system than
careful analysis of the incentive structures needed for the market to provide effective
discipline over ?nancial behavior. Financial innovations had led to an enormous change
in incentive structures with respect to mortgage lending. With the development of the
widespread use of securitization and the originate and distribute model of mortgage
lending, the direct incentives for lenders to carefully monitor the quality of their loans
were sharply diminished.
This in itself might not have presented serious problems if the prospective
purchasers of the securities had been demanding about what they bought. Careful
attention to quality by purchasers would have forced continued discipline by lenders in
their originations in order to be able to distribute pro?tably. Unfortunately, buyers
showed little discrimination. They relied heavily on certi?cation by the ratings agencies
and the herding instincts of following the crowd of supposedly sophisticated big
investors.
The ratings agencies played a key role in the breakdown of market discipline by
offering disgracefully high ratings on a high proportion of sub-prime and other bad
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mortgages. What happened was that a potentially valuable innovation in ?nancial
engineering was taken and then drastically oversold. The good idea was that with
the bene?ts of diversi?cation and the slicing and dicing allowed by securitization, the
top proportion of a large group of sub-prime securities genuinely deserved AAAratings.
But while this might have appropriately applied to 10 or 20 percent of the total package,
the ratings agencies were convinced by mortgage securitizing clients to rate well over
half of many of these bundles as AAA.
To some extent, this re?ected the de?cient models of risk that will be discussed in
Section 4. But also important were the gross con?icts of interest generated by the
development of a market structure where the payments for ratings came from those
being rated. It does not require one to be an advanced student of economics to see the
con?ict of interest problemthat this generated. But the money was rolling in and neither
the players nor apparently the regulators wanted to rock the boat. The regulators and
politicians got what they wanted – increased home ownership by the poor with the
ratings agencies, real estate ?rms, and ?nancial institutions raking in huge pro?ts. The
problem was that this was a game that was not sustainable.
While the ratingagencies hadanoligopolistic structure favoredbygovernment-erected
barriers to entry, on both the supply and demand side the market for securitized
mortgages was highly competitive. The problem was that this is a market where
information costs are high and knowledge is quite asymmetric. While we can fault buyers
of these securities for being lazy and relying too much on the ratings agencies, a careful
look at the information structure in this market suggests why the ultimate purchasers did
not provide strong oversight. The information costs of doing so were quite high.
It may be true, as advocates of the new ?nancial alchemy argued, that securitization
allowed risk to be transferred to those in better positions to bear it – but in many cases
little attention was given to the problem of diminished incentives to obtain good
information. In the old hold-to-maturity model of mortgage lending, the institutions that
could most ef?ciently gather the relevant information and act on it had the incentives to
do so. With widespread securitization, the initial lenders’ incentives to obtain relevant
information about the borrower decreased drastically, while diversi?ed investors had
little access to direct information. These investors relied heavily on middleman
evaluations fromthe ratings agencies which turned out to be highly biased. As a result,
the level of effective information with which the systemoperated deteriorated markedly.
Often we can count on the market to turn up its nose at investment opportunities
about which there’s little knowledge. This would have forced discipline back onto the
lenders. But with the combination of misleadingly high ratings and fee-driven sales
pushes frommajor ?nancial institutions, MBSs became viewed as a smart thing to have
in one’s portfolio. The herd rushed in. Alargely similar phenomenon developed with the
booming market for credit default swaps. Little attention was paid to counterparty risks
and institutions were allowed to, in effect, offer insurance without being required to have
the reserves needed to meet potential obligations.
In many industries, a reasonable degree of competition is all that is needed for market
discipline to work well. However, where there are substantial differences between
private and social costs and bene?ts, competition is not enough. This is easy to see with
polluting industries, but in the banking sector the potentially important divergences
between private and social costs and bene?ts are not as readily apparent.
Defective mental
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Two major functions of a productive banking system are liquidity transformation,
and promotion of the effective allocation of investment. These two functions are
mutually reinforcing. Securing longer term sources of ?nancing are necessary for
real investments. However, for day-to-day operations, both ?rms and individuals also
have a need for liquidity, the quick availability of funds at lowcost. Bank deposits have
for centuries been a major source of such liquidity. Long ago, however, bankers
discovered that seldom, if ever, will all depositors want their money at the same time.
Thus, under normal circumstances bankers could safely lend out a substantial fraction
of their deposits longer term, thus facilitating real investment. This was one of the ?rst
major examples of ?nancial alchemy. This process substantially lowered the cost and
increased the availability of ?nancing for longer terminvestments in total. Furthermore,
the desire to be repaid gave the bankers strong incentives to monitor carefully their loans
and thus contribute to an ef?cient allocation of capital.
The Achilles heel of this system was that in panics the typical depositor could not
easily discover which banks were sound and which were not. Thus, there were strong
incentives among depositors for runs on all banks. Because of the characteristics of
liquidity transformation, even solidly solvent banks could not meet huge increases in
demands for liquidity by their depositors. By their very nature longer term investments
could only be liquidated quickly at huge discounts, if at all. As a result, most economists
concludedthat modern bankingsystems could not effectivelymanage themselves during
a crisis, and thus there was a strong case for governments to act as a lender of last resort.
This would allow the crucial function of liquidity transformation to continue to operate,
while reducing the risks of ?nancial crises. With the implementation of modern deposit
insurance, depositor runs on banks are now quite infrequent (the run on Northern rock
was a vivid exception). Nonetheless, the basic problem has not disappeared. With the
development of heavy reliance on short-term borrowing by many ?nancial institutions,
the most serious form of modern bank runs, namely the drying up of short-term
?nancing, can prove equally devastating as many investment and commercial banks
have discovered during the most recent global ?nancial crisis (Gorton, 2010).
As long as governments followed Bagehot’s advice to lend only to solvent
institutions, and only at penalty rates, no major problems of moral hazard were
generated by this increased role of government in the economy. Often, however,
solvency is not so easy to judge, and particularly with large institutions, governments
may have strong political incentives to bias their judgments in terms of solvency or even
to ignore this constraint all together. Hence the too big to fail moral hazard was
generated. As a counter, governments tended to adopt capital requirements to offset the
incentives for excessive risk taking generated bythis moral hazard. This moral hazard is
probably economists’ favorite explanation for excessive risk taking in ?nancial sectors,
and it has often been an important phenomena. It is not so clear, however, that this was
the dominant factor in the crisis of 2007-2008.
The combination of defective mental models – internal management problems
within ?nancial ?rms, changes in the structure of ?nancing, and perverse effects of
competitive pressures – was to cause most of the problems without any need to involve
moral hazard considerations generated by governments. The widespread bailouts and
guarantees offered by governments during the recent crisis, combined with the
increased size of many ?nancial institutions means that the too big to fail problem has
substantially increased since the crisis however. As partial evidence in support of this
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proposition, we can invoke the huge wealth losses that the crisis generated for most of
the top managers of the large ?nancial institutions. Although their creditors and
institutions were generally bailed out, most top managers had considerable portions
of their personal wealth tied up in the stock of their institutions, and these took huge hits.
The enormous golden parachutes that several ousted leaders received were the results of
private contracts, not government intervention.
Several accounts of the internal decision making within many of the large ?nancial
institutions that contributed to the crisis have nowbeen published (Cohan, 2009; Bamber
and Spencer, 2008; Gilbert, 2010; Faber, 2009; Lowenstein, 2010; Mallaby, 2010; McLean
and Nocera, 2010; McDonald and Robinson, 2009; Sorkin, 2009; Tett, 2009; Tibman,
2009). These accounts strongly suggest that over the period in which most of the risky
investments were made, many of the top management of the ?nancial institutions had
little conception of the true magnitude of the risks that were being taken. While many of
these top managers can certainly be faulted for failing to under due diligence, and in
some cases for being grossly out of touch with what was going on, many of themseemto
have been just as misled about the safety of asset-backed securities as the purchasers of
the exotic instruments that these created. Many managers appear to have believed as
strongly in the AAA ratings of MBSs as ordinary investors.
Within the ratings agencies themselves a strong case can be made that the risk
analyses performed was as much (or more) a mask for greed than a result of true beliefs
in defective mental models. Certainly a number of examples have come to light of
employees who had severe doubts about the adequacy of many of the risk assessments
being offered. For many analysts, their technical analysis was likely as much a recordfor
plausible deniability when things went than a source of genuine errors. Some analysts
did express concerns to higher ups, but perhaps blinded by all the money rolling in, top
management typically overlooked these concerns. Indeed a number of of?cials fromthe
ratings agencies have argued that they were marginalized, and in some cases, even ?red
for warning of dangers.
Even beyond the prospect of government bailouts, economists have analyzed
dilemmas in which managers who fear that their institutions may be insolvent could be
induced to gamble for redemption. However, as with the direct government-induced
moral hazard, this does not appear to have played a major role in generating the
sub-prime crisis[2]. Over the period in which most investments were made, no evidence
has surfaced of top-level internal concerns about solvency in any of the major ?nancial
institutions. By the time some insiders did begin to worry about this, it was likely
already too late. A number of warnings about excessive riskiness were given to top
management earlier on but these were generally ignored.
Astronger candidate for explanation is the competitive pressure in markets in which
short-run returns are accurately measured and longer run risks are not. When it comes to
decision making, there is a familiar tendency to over weigh what can be easily measured
versus what cannot. We also know that immediate effects tend to be weighed more
heavily than future ones. As analysts such as Taleb (2007) has emphasized, when what
is at issue is a perceived small probability of large future losses, short-run competitive
pressures are likely to generate insuf?cient attention to such risks and consequently
result in excessive risk taking. As a result, prudent investment managers who resist this
pressure and abstain from such activities will be outperformed in the short-run, losing
clients, substantial amounts of income and possibly their jobs.
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Frank (2008) argues that the phenomenon described above is actually a general
feature of situations in which performance is judged on a relative rather than absolute
basis[3]. Furthermore, this tendency is strengthened when the risk aspect of risk-return
tradeoffs cannot be adequately measured at the time of the decision making. Of course,
as will be discussed in the following section, when the standard risk evaluation methods
tend to understate the true risk, as the popular value-at-risk (VaR) method did, then the
problem becomes even more pronounced. Behavioral biases can also contribute to this
issue[4]. We often see what we want to see and overlook what we do not want to see.
Con?rmation bias seems to have played a strong role within major institutions with
many top executives not paying enough attention to warnings that high earnings were
coming from excessive risk taking.
Easy money also played a considerable role, both in facilitating ?nancing and in
changing the incentives facing many ?nancial decision makers. As rates of return fell in
response to the ?ood of global liquidity, many investment managers felt strong
competitive pressures to keep up returns. The easiest way to do this was to take on more
risk, and one of the easiest ways to take on more risk without this being immediately
apparent to one’s bosses or clients was to increase leverage. Such increases in leverage in
turn not only fueled the bubbles that resulted but also increased the damage to the
economic system when the crash came.
There are also important principal-agent problems in the ?nancial sector. Executive
compensation is a prime example. Many large ?rms, and not just ?nancial ones, have
generally had cozy arrangements between top executives and directors, with relatively
little effective oversight from the small number of outside directors and stockholders.
These ?rms have typically faced a number of institutional impediments to effective
oversight. Many analysts argue that this structure contributed importantly to high
salaries of executives. However, while there is a push for reformin this area, there is little
basis to believe that high salaries in themselves, as opposed to compensation structures
that gave too little weight to risk relative to return, contributed importantly to the
excessive risk taking[5]. Given the dif?culties of ascertaining “true” longer term risk
positions and the limited incentives for diversi?ed investors to invest their time and
resources in gathering and analyzing what information is publicly available, it seems
likely that the majority of shareholders would have penalized rather than rewarded
institutions that held back from increasing leverage and risk when others were
increasing it and hence producing greater short-term returns. From this perspective,
principal-agent problems between shareholders and the major ?nancial institutions
were likely not a major cause of the excessive risk these institutions undertook.
One indication that this is likely the case comes from the results of particular hedge
fund managers during the dot.com era. There were managers who believed correctly
that the rapid increases in the values of the dot.com companies were a bubble, and bet
against it in the early and middle stages. However, as the bubble continued they
underperformed in the short run and lost many investors who focused on chasing
returns. Some of these, like George Soros, took large losses and eventually gave up
(Mallaby, 2010). The lesson fromthese managers was that being right in the long run is
not always an effective short-run survival strategy in ?nancial markets.
In summary, competitive markets can provide productive discipline only when good
information is available and a suf?cient number of actors have the right incentives to
obtain, analyze, and act on this information. In the old days when banks kept their loans
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on their books and investment banks served in partnerships, these conditions were
reasonably approximated. As the new ?nancial structure based on widespread
securitization took hold, such discipline broke down. Ageneral faith in market discipline
was no substitute for a careful analysis of market structure and incentives. There was
little basis to believe that the ?nancial system would be self-disciplining under the new
conditions generated by ?nancial innovation. As long time Wall Street Economist
Kaufman (2009) puts it:
The structural changes in the ?nancial markets encouraged participants to become
short-term oriented [. . .] the fervor for pro?ts from securitization [. . .] ushered in a host of [. . .]
institutional shifts. Senior managers at a growing number of leading ?nancial institutions
either lost control of risk management or became its captives [. . .] every institution [. . .] felt
growing pressure to take risks in order to maintain market share (p. 203).
and “the glamour and pro?t of risk-taking ensured that the risk takers themselves
gained more and more power within the structure of ?nancial institutions” (p. 205).
Thus, neither internal disciplines from within the major ?nancial institutions nor
external disciplines from the ?nancial markets or from regulators were suf?cient to
counter these problems[6].
4. Ef?cient markets theory, ?nancial engineering, and the myth that risk
had been conquered
The rapid expansion of the use of complex ?nancial instruments, so many of which
eventually turned toxic, was made possible by a combination of advances in
mathematical ?nance andcomputational power. These advances likewise revolutionized
techniques of risk management[7]. As sophisticated as they were, however, such models
for pricing derivatives, discovering speculative opportunities, and managing risk, still
had to make a number of important simplifying assumptions in order to be computable.
These advances did bring a number of important bene?ts to society. Amuch greater
array of derivative products allowed ?rms to hedge more types of risks. But as was true
of the ?rst ?nancial derivative to become widely used, the forward contract in foreign
exchange, it was also true with these newinstruments, which could also be used to take
risks, i.e. to speculate. This is not necessarily bad, as speculators are often the source of
supply for the demands of hedgers and increase market liquidity.
Most of the innovations in the mathematical modeling of risk in recent decades were
based on the assumptions that markets were ef?cient, liquid, and subject to continuous
trading (of course mathematical models were also used to try to discover pro?t-making
inef?ciencies in markets). However, in crisis periods, these assumptions proved false.
In such cases standard risk models can generate spectacular failures of risk
management strategies. This was illustrated in the stock market crash of 1987. Many
investors had become sold on the bene?ts of so-called dynamic hedging, which under the
assumptions noted above, would allow investors to limit their losses from stock market
declines. These strategies were also based on the assumption that overall market
behavior would not be affected by the adoption of such strategies. This seemed
reasonable for a stock market in which each investor would normally be only a small
part of the market. However, what was overlooked was that if a large number of
investors started following similar strategies, this could begin to signi?cantly affect the
very behavior of the market. On Black Monday, 19 October 1987, when the market began
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to plunge, the dynamic insurance programs began to sell. This generated a sharp
discontinuity in the market with liquidity vanishing and prices plunging.
Despite this ?asco, other versions of pro?t seeking and risk management models
based on the same underlying assumptions continued their spread. Even the collapse
of LTCM due in large part to model failures in 1998 was not suf?cient to seriously
dampen the rise of widespread faith in these models. Anumber of economists, ?nancial
analysts, and Wall Street quants did point to serious problems with the reliability of
these models (Das, 2006; Taleb, 2007; Triana, 2009; Lindsey and Schachter, 2009; Willett
et al., 2005) but these individuals were in a distinct minority, both among ?nancial
market participants and regulators.
Such blind beliefs in ef?cient market theory and in the idea that innovations in risk
management had made ?nancial systems signi?cantly safer, contributed to the
tendency to focus primarily on the idiosyncratic risks of individual institutions in
isolation. Insuf?cient attention was being given to the danger of system wide shocks.
This, in turn, led regulators to pay insuf?cient attention to macro prudential issues, and
both public and private sector agents to pay insuf?cient attention to liquidity risks and
the liability side of ?nancial institutions’ balance sheets (these issues are discussed
further in the concluding section).
In general these new risk models and the derivative products based on them work
well during normal periods. A case in point is the VaR model which came to dominate
risk management strategies in large private ?nancial institutions. These were heartily
endorsed by many regulatory agencies. Part of their popularity was their collapsing of a
complex set of considerations into a single number. This number represented the largest
amount of money that could be lost on a portfolio over a relatively short period of time,
often a day to a month, with a certain degree of statistical con?dence (often 95 percent).
Usually such models worked quite well. Furthermore, they had the important advantage
of taking into account the risk reduction bene?ts of diversi?cation by incorporating
the correlations among different components of the portfolio. Unfortunately, however,
the precision of the calculations gave many traders and managers an exaggerated sense
of con?dence that risk was being adequately measured, and that with the bene?ts of
diversi?cation and the new array of hedging instruments, risk could be controlled to a
high degree. As the Financial Times Columnist Munchau (2009, p. 89) notes:
Some believed that innovation in the ?nancial markets had eliminated all risk for all time.
This, of course, was an erroneous belief, but it does give a clear picture of what people were
thinking at the time.
The key problems with the VaR models were not only that they ignored liquidity,
counterparty, and operational risks, but more importantly that they assumed ?nancial
market outcomes were normally distributed and that correlations over the recent past
would be a good guide to their behavior in the future. Both of these latter assumptions
were known to be invalid thanks to the results of massive amounts of empirical research.
It was well known to ?nancial economists and many ?nancial analysts that the
distributions of most ?nancial market outcomes had “fat tails”, i.e. that large positive
and negative changes occurred much more frequently than they would have if a normal
distribution were the case (Mandelbrot and Hudson, 2004).
In addition, many studies have shown that correlations among ?nancial variables
can vary a great deal over time. These measures are heavily in?uenced not only by
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structural relationships but also by patterns of shocks, which can vary considerably
over time. Thus, for example, if interest rates rise because monetary policy is tightened
we would expect the country’s currency to strengthen, but if interest rates rise because
of expectations of higher in?ation or perceptions of greater risk, we would expect the
currency to fall.
Furthermore, the VaR methods are essentially backward looking. They ignore many
types of warning signs that a crisis could be brewing. This was clearly the case in the
Asian crisis. Using the VaR model, risk was measured by past volatility. Since
the Thai baht had been basically pegged to the dollar for over a decade it had displayed
little variability. As a result, the VaR approach could not pick up the increased riskiness
of the baht as the crisis approached (Lindo, 2008).
All of these problems were well known to some academics and practitioners but were
nonetheless ignored by many others. Even the real world examples of these problems
such as the Asian and Russian-LTCMcrises did not succeed in convincing many market
participants of the dangers of believing that risk could now be precisely measured and
managed.
5. Concluding comments
In considering ?nancial reforms for both the public and private sectors, the global
?nancial crisis highlights a number of important lessons. The crisis tells a dismal tale
of greed, hubris, stupidity, false assumptions, defective mental models, and regulatory
inattention, fortunately we can end on a more positive note. If my analysis is correct,
many of the problems that led to this crisis can be substantially mitigated by taking a
more serious economic approach to ?nancial regulation and correcting the defective
mental models discussed above.
Of course, even with correct mental models con?icts of interest will remain and,
major ?nancial institutions and ratings agencies lobby for legislation that puts their
interests ahead of that of the overall economy. In general, however, the use of less
faulty mental models is likely to reduce some of these con?icts of interest, especially
those resulting from market actors taking on more risk than they realize. Likewise,
even without new legislation, more widespread recognition of the fact that housing
prices can fall as well as rise should promote more prudent behavior in the real estate
market.
While the ideology or mental model that the ?nancial sector needed little regulatory
oversight was a key factor in the cause of crisis, “cognitive capture” of regulators by
those being regulated also likely played a major role. This phenomenon will be dif?cult
to overcome, but efforts should be made.
From the standpoint of private risk management, the principal lesson is that the
behavioral relationships among different ?nancial assets and liabilities are not physical
constants such as those with which civil engineers deal. These relationships re?ect a
combination of direct economic and ?nancial interdependencies and the patterns of
shocks that hit the system. While most of the developments in mathematical modeling
and product innovations that can be categorized under the heading of ?nancial
engineering can have productive uses in ?nancial markets, they can lead to disaster
when combined with bad incentive structures and false beliefs in the stability of
historical correlations. It would be a shame to overreact and abolish all the recently
developed programs in ?nancial engineering. There is a strong need, however, for the
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risk management business to be re-engineered to put a stronger focus on ?nancial
economics, rather than just ?nancial mathematics.
This change will help both to de?ate hubris about the degree of predictability in
?nancial relationships and also to focus more attention both within private sector
institutions and regulatory agencies on incentive structures. One does not need to get
into a debate about whether greed is good or bad to recognize that it is a widespread
attribute of the human condition. While we can hope that most people would refuse to
engage in some of the most predatory of the practices that have been uncovered in
segments of the sub-prime mortgage industry, a central premise of the economic
approach is that we need to design incentive structures that minimize the need for people
to behave like saints. This should also be a central focus of regulatory reforms.
Critics of regulation such as Alan Greenspan put great stock in their judgments that
on average we cannot expect ?nancial regulators to match the resources and
sophistication of the institutions they are supposed to regulate. This is a judgment with
which I concur, but fromwhich I drawa quite different conclusion than Greenspan’s that
regulation should be virtually eliminated. While much has been made of the laissez-faire
attitude toward ?nancial regulation adopted by American regulators, the recent
?nancial crisis was far from just being an example of American free-market extremism.
The whole set of regulatory principles developed by the Basel group of international
regulators had deep ?aws. These principles relied heavily on the outsourcing of risk
analysis to ratings agencies andthe large banks’ internal models. Although these models
were indeed highly sophisticated, they were also deeply ?awed. Furthermore, regulators
largely overlooked the strong incentives to misuse such analyses to game the system to
reduce capital requirements and increase leverage. To discover these perverse incentives
one does not need a high-priced lawyer or a PhD in mathematics. Any run-of-the-mill
economist worth their salt would have spied many of these con?icts of interest
immediately, and others after some study.
The Securities and Exchange Commission in the USAis not unusual in being peopled
largely by lawyers who tend to give insuf?cient attention to basic economic analysis.
This situation could be easily improved if the political will is present. Of course it is not
suf?cient just to identify perverse incentives, they must also be corrected. Although in
many cases the discovery of optimal incentive structures is well beyond our current
capabilities, great gains can be made just by devising and implementing less bad ones.
We should also pay careful heed to the call of Bookstaber (2007) in his important book,
A Demon of Our Own Design, which predicted the current crisis as the outcome of
excessive complexity in our ?nancial structure. Bookstaber’s analysis offers a most
convincing warning of the danger of devising complex arrangements that optimize for a
particular environment but which may fail badly in others. He stresses the evolutionary
advantages of simpler but more robust arrangements which are optimal in no one
environment, but perform decently in a wide range of situations. As the current crisis
vividly – and painfully – illustrates, the ?nancial landscape can be quite variable. This
reality suggests that at least initially regulatory reform should focus on fairly simple
regulations such as limitations on leverage for different types of activities. This should
not require ?nancial wizards to implement and should not discourage the development
of useful ?nancial innovations. Furthermore, in lacking the look of sophistication it
would be much more dif?cult to game. However, this approach does require an
important ingredient that is often in short supply – political will.
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Unfortunately, despite the widespread recognitionof the problems withstandardrisk
modeling, it appears that the Basle Committee has been making little effort for reforms
on this front, focusing primarily instead on strengthening capital requirements and
tightening the de?nitions of what is counted as capital. While these go in the right
direction, there appears to have been little of?cial attention paid to the problems
associated with the standard methods of risk-weighting capital requirements that
contributed to allowing banks to engage in excessive leverage. Nor has much been done
to reduce the con?icts of interest faced by rating agencies[8].
Already as economies improve, we are seeing considerable of?cial backtracking from
positions taken in the depth of the crisis. One valuable proposal put forward in 2009 by
the Basel Committee was the use of a simple leverage ratio. While crude, this approach is
quite consistent with the lessons from Bookstaber’s analysis discussed above.
Unfortunately in the latest version of these proposals, the leverage ratio was extremely
weak. It is nowset at the extremely generous level of 3 percent while its implementation
is set to be delayed for a number of years.
One of the most signi?cant failures of the old Basel approach was its almost exclusive
focus on micro-prudential issues, i.e. the soundness of each institution in isolation. Not
enough focus was placed on macro prudential supervision of risks to the ?nancial
systems as a whole, especially with how?nancial institutions interact within the system
(Brunnermeier et al., 2009; Turner, 2009; Warwick Commission, 2009). Consequently, the
standard risk measures failed to account suf?ciently for the interconnectedness among
institutions and the potential for contagion across the overall system. Risk management
strategies that would be highly effective if adopted by one or a few institutions in
isolation can act to substantially worsen a crisis if adopted simultaneously by a large
number of institutions.
Since the standard risk measures were backwards looking they could be as much the
source of herd behavior as psychological panic. Thus, the Basel Committee’s risk
weighted capital requirements were pro cyclical. Instead of dampening the tendency of
the ?nancial systemto be subject to booms andbusts, this aspect of the regulatorysystem
helped contribute to the problem(Brunnermeier et al., 2009; Warwick Commission, 2009).
It appears that the need to make capital requirements counter cyclical has been generally
accepted. But again, in its latest proposal the Basel Committee has backed away, saying
the questionneeds more study. Nor has suf?cient progress beenmade ondealing withthe
international aspects of crisis prevention and management[9].
Thus, while some progress has been made on regulatory reformwe are still far short
of all that is needed. Mental models in?uence how actors see their interests.
Unfortunately public of?cials and the leaders of the major ?nancial institutions still
have more to learn than they seem to realize.
Notes
1. For book length studies by economists, see Barth et al. (2009), Dowd and Hutchinson (2010),
Gorton (2010), Johnson and Kwak (2010), Rajan (2010), Reinhart and Rogoff (2009), Roubini
and Mihm (2010), and Zandi (2009).
2. In the USA, several forms of government encouragement for lending to low income and
minority home buyers de?nitely contributed to the magnitude of the crisis, but much of the
bad lending was for higher priced houses. While the ?rst signs of the crisis showed up in the
sub-prime market, Munchau (2009) is right to argue that it is a misnomer to refer to this crisis
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as the sub-prime crisis. For more on the US housing aspects of the crisis, see Barth et al.
(2009), Gorton (2010), Shiller (2008), and Sowell (2009).
3. That competition can generate pressures for excessive risk-taking in modern ?nancial
systems is also a theme in Brunnermeier et al. (2009), French et al. (2010), Gibson (2010),
Rajan (2010), and Turner (2009).
4. The new sub?eld of behavioral and neuro ?nance focuses on such possible biases. See, for
example, Akerlof and Shiller (2009), Burnham (2005), Peterson (2007), Shefrin (2000), Shleifer
(2001), and Zweig (2007).
5. For discussion of proposals to reform compensation structures, see Acharya and Richardson
(2009), Brunnermeier et al. (2009), and French et al. (2010).
6. For discussion of proposals to improve market discipline by requiring the insurance of
subordinated debt, see Acharya and Richardson (2009), Brunnermeier et al. (2009), and
French et al. (2010).
7. For discussion of these revolutions, see Bernstein (2007), Best (2010), Fox (2009), Triana
(2009), and Lindsey and Schachter (2009).
8. On issues concerning the ratings agencies, see Acharya and Richardson (2009).
9. Of course there are some important spillover aspects of regulation but as several studies have
recently argued, concerns with level playing ?elds have been used in the past by multinational
?nancial institutions to gain favorable regulatory actions. Amove fromhome to host country
responsibility for regulation would have strong advantages fromthe standpoint of the public
as opposed to banking interests (Brunnermeier et al., 2009; Levinson, 2010; Persaud, 2010;
Warwick Commission, 2009). While there are of course gains from international
harmonization of regulations, there are also costs as a diversity of strategies is likely to
make a system less crisis prone (Bookstaber, 2007; Levinson, 2010).
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Further reading
Abdelal, R. (2009), “Constructivism as an approach to international political economy”,
in Blyth, M. (Ed.), Routledge Handbook of International Political Economy (IPE), Routledge,
Abingdon, pp. 62-76.
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Rebonato, R. (2007), Plight of the Fortune Tellers: Why We Need to Manage Financial Risk
Differently, Princeton University Press, Princeton, NJ.
Corresponding author
Thomas D. Willett can be contacted at: [email protected]
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