Book Review: Restoring Financial Stability. Edited by Viral V. Acharya and Matthew Richardson

This an excellent book. It is the first academic book to consider the crisis in depth and to propose policy responses and solutions. The faculty of New York University’s Stern School has provided a broad and deep overview of the crisis and made suggestions for how to minimize the chances of a recurrence going forward.

The book argues that the fundamental cause of the crisis is the credit boom and the housing bubble that it led to. The first section looks at the popular culprits for the crisis, namely the “originate to distribute” model of mortgages, the ratings agencies and excessive leverage by banks that was acquired through regulatory arbitrage. Here and throughout, the book provides essential institutional detail and makes sensible and often original suggestions for reform. The second section focuses on the role of financial institutions in the crisis. There is universal agreement that the government-sponsored enterprises, Fannie Mae and Freddie Mac, were a disaster waiting to happen. The solution suggested here is to have them operate within government agencies, similar to the successful Ginnie Mae programs. The more difficult problem is how to regulate large complex financial institutions (LCFIs). The proposal here is to have a dedicated regulator for these institutions that could ensure government guarantees to them are properly priced and that they are appropriately regulated. One of the important features of the current financial system is the existence of a shadow banking system consisting of investment banks, money market mutual funds, hedge funds, structured investment vehicles and so on that perform functions similar to banks but are largely unregulated. Here the suggestion is that such institutions should only be regulated to the extent they are large enough and/or interconnected enough to pose a systemic risk.

One important aspect of the current crisis is that the normal market mechanisms for controlling risk-taking within financial institutions appear to have performed poorly. These include the corporate governance of financial institutions, compensation of executives and traders, and the accounting system. The essential problem in the financial sector is that it is very easy for financial firms to alter their risk profile quickly and easily and it is difficult for outsiders such as board members to keep up with these changes. One of the interesting aspects of the crisis is that a number of CEOs, such as the heads of Bear Sterns and Lehman Brothers, lost sizable fortunes. Their extensive stakes in their firms did not prevent the firms from taking large risks. The argument made here is that although they themselves may have been incentivized appropriately, it may nevertheless have been very difficult to design good systems for others in the firm, such as traders. The moves in the industry towards longer horizons for compensation are all to the good. There has been an important debate on the merits of fair value accounting in times of crisis. While most people accept that in normal times, when markets are working efficiently, marking to market is desirable, there is an issue of what should be done in times of crisis when market values do not necessarily reflect fundamental values because of positive and negative bubbles in asset prices. Here the authors come out strongly in favor of fair value accounting but with the requirement that when models are used rather than market prices, there should be more disclosure of the assumptions behind such models.

One of the most important functions of a financial system is to allow the sharing of risk. The traditional view of many modern innovations such as credit default swaps and other derivatives that allow credit risk transfer is that they improve the ability of the financial system to do this. However, during the recent crisis, it seems that such innovations have caused significant problems because current trading systems for these instruments do not make clear counterparty credit risk. The authors endorse a standard way of controlling this credit risk, which is to trade through centralized clearing houses and exchanges. Short sales have also come under heavy criticism during the crisis, just as they did in the 1930’s, because of the possibility of bear raids. These are situations where short positions are taken and then bad rumors are spread in the hope that they will become self-fulfilling and cause the demise of the institution. Since confidence is so important for financial institutions, many believe that the possibility of such bear raids needs to be eliminated by short sale constraints. The suggestion in the book is that rather than using the blunt tools of short sale constraints, which have many disadvantages, such as limiting price discovery, market manipulations should be dealt with through investigation and prosecution of abuses.

Given the view that the basic cause of the crisis was a credit boom that drove a housing bubble, an important question to ask is why did the Federal Reserve do so little to prevent it. The book endorses this criticism. More importantly, it gives very interesting suggestions for trying to limit systemic risk, for example, by taxing institutions based on their contribution to such risk. It also points to the importance of structuring efficient lending facilities going forward.

The way in which financial institutions were bailed out comes under heavy criticism. It is argued that the government’s measures were too generous to the financial services industry and wasteful of taxpayers’ money. The basic problem is that the measures undertaken by the government have reinforced the notion that institutions taking risks will be bailed out, thus creating moral hazard and sowing the seeds of the next crisis. The modification of mortgages and interventions in the housing sector are also criticized and suggestions are made for improvements. Finally, it is argued that bailouts of other sectors of the economy such as the auto industry should only be undertaken if there is a clear market failure and intervention can help correct this. It is suggested that in the case of the auto industry bankruptcy should be allowed but the government should provide Debtor in Possession financing since this market has ceased to operate properly during the crisis.

The last section of the book looks at how international alignment of financial sector regulation can be achieved. While this is difficult, it is suggested it is not impossible, as the example at the end of the Second World War of the Bretton Woods Agreement, which led to the creation of the World Bank and International Monetary Fund, illustrates. More recent examples of such cooperation are provided by the Basel Agreements for bank regulation.

No book can cover all aspects of a problem. This one provides very little historical perspective on the crisis. The current crisis, despite its severity and its ample effects, is similar to past crises in many dimensions. In a recent paper, Reinhart and Rogoff (2009) document the effects of banking crises using an extensive data set of high- and middle-to-low income countries. They find that systemic banking crises are typically preceded by credit booms and asset price bubbles. In addition, Reinhart and Rogoff find that crises result, on average, in a 35% real drop in housing prices spread over a period of six years. Equity prices fall 55% over 3 ½ years. Output falls by 9% over two years, while unemployment rises 7% over a period of four years. Central government debt rises 86% compared to its pre-crisis level. Reinhart and Rogoff stress that the major episodes are sufficiently far apart that policymakers and investors typically believe that “this time is different.” An historical perspective of this kind is important because it illustrates that there is a limit to the importance of particular institutional details. The fact that crises have occurred historically for hundreds of years, and in many different circumstances, shows that it is important to focus on the big picture as well.

In a similar vein, the book focuses almost exclusively on the United States. Very little mention is made of other parts of the world such as Europe and Asia. One of the most interesting aspects of this current crisis is how badly these regions have been hit despite very different financial systems. For example, Spain has arguably one of the best regulated financial systems in the world. However, this has not prevented it from suffering very badly from a credit boom and housing bubble. South Korea is another interesting case. It has done much better this time around than during the 1997 financial crisis and an important question is how it has achieved this outcome. Finally, many people believe that global imbalances are an important cause of the crisis. These are mentioned but not discussed at great length.

One of the remarkable aspects of the book is the speed with which it was produced. Inevitably, though, since it was written before the end of the crisis, a number of important features are missing. In particular, the collapse in world trade is not discussed. The general conclusion from the 1930’s was that the collapse in trade was caused by protectionist measures. The current crisis shows that this is not the case. Protectionism no doubt makes things worse but is not the basic cause of the collapse. Understanding this piece of the puzzle is very important.

In conclusion, this book should be read by every serious observer of the crisis. It is an outstanding contribution.

Franklin Allen is the Nippon Life Professor of Finance at the Wharton School of the University of Pennsylvania.

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