Restoring Financial Stability: How to Repair a Failed System

by: John M. Mason

Restoring Financial Stability: How to Repair a Failed System (Viral V. Acharya and Matthew Richardson, eds; John Wiley & Sons, 2009) is a book composed of 18 different policy papers written by 33 faculty members of the New York University Stern School of Business. These faculty are from the fields of finance, economics, and accounting. They were charged with the task of examining the causes of the financial crisis that began in 2007 and with proposing “market-focused solutions” to the problems identified throughout the ensuing economic and financial collapse. The book is very comprehensive in scope and can be read piecemeal according to one’s tastes, or in whole as a relatively complete coverage of most of the areas in finance impacted by the crisis.

One of the best things about the book is the prologue, which presents “A Bird’s-Eye View” of the crisis of 2007-2009. This part of the book is as thorough and complete a history of the events of the past three years as I have seen to date and is very helpful in putting the happenings in some kind of order. In accomplishing this, the authors also present some of the policy issues that surface along the way, and this sets the stage for the chapters that are to follow that deal with many of them in more detail.

For those that might be interested, one of the authors of the prologue is Nouriel Roubini, who has achieved quite a bit of notoriety over the past year or so for his views on the weaknesses to be found in the United States economy and financial system.

The writers really don’t go very deeply into the causes of the financial crisis, stating only that there was a “credit boom” and an “asset bubble” that preceded the collapse. In essence, they get into their story by arguing that “the financial crisis was triggered in the first quarter of 2006 when the housing market turned.” From that point on the authors become very detailed in their examination of the events that followed. The prologue is well worth the read.

The rest of the book is divided up into seven parts that cover the most important issues relating to the financial collapse. Here's just a taste of the areas that are covered. Part One is the “Causes of the Financial Crisis of 2007-2009." The chapters included in this part may not exactly fit your description of “causes”, but they are very interesting components of the collapse. For example, Chapter 1 reviews the subject of mortgage origination and securitization. Chapter 2 examines how banks found ways to achieve extremely high levels of leverage in their operations. The role of the rating agencies in the credit boom is discussed in Chapter 3. I would argue that these developments related to the acceleration of the expansion of the credit and the asset bubble but were not causes.

Part Two is devoted to a discussion of financial institutions. But, again, the topics covered are not quite what you might expect. First, government sponsored enterprises (GSEs) are covered with a special focus on Fannie Mae and Freddie Mac. The question is asked, “What to do about them?” Second, the issue of “Too big to fail” is discussed. This part closes with a chapter on the role of hedge funds in the financial crisis. The emphasis is on the varying degrees of government guarantees that exist and how these should be addressed in the future. The basic conclusions reached in these studies are that “government guarantees, to the extent they are necessary, need to be priced accordingly” and “Systemic risk needs to be regulated and priced.”

Part Three covers the issues of governance, incentives and “fair value” accounting. The general approach taken in this part is that the origins of the crisis lie in the financial institutions themselves and result from the short-comings of corporate governance (Chapter 7) and from ill-designed executive incentive packages (Chapter 8). In Chapter 9 the issues of openness and transparency in presenting financial information are examined and the accounting for assets is looked at specifically.

The heart of the problems that some of the authors associate with the financial crisis are discussed in the next part of the book. These people see financial engineering and the use of derivatives and other financial innovations as the crux of the collapse. Thus, the question of the regulation of financial derivatives is discussed in one chapter while the need to have a more formal market structure along with a centralized clearing facility is discussed in another. It is argued that in the future, over-the-counter markets should just be used as a platform for financial innovation and that the incentive should be created to encourage migration of these products to a centralized registry and then to a clearing-house.

Parts Five, Six, and Seven discuss, respectively, the role of the Federal Reserve, the bailout, and international coordination. All of these parts look at how regulators and the government should organize and act to protect the financial (and economic) system from the risks to which the current crisis has exposed it. In terms of the Federal Reserve, the issues discussed are those of regulating “systemic risk” and responding to liquidity problems through the central bank’s role as a lender of last resort. In terms of the bailout, the concern is with how far the government should go in a crisis and when should it stop so as to not create the next crisis. In Part Seven of the book it is argued that there needs to be greater international involvement in handling financial crises, but that governments should aim to achieve greater coordination of national efforts to stem a crisis and not create a centralized international financial sector regulator.

The importance of this book is not so much what conclusions are reached by the authors of the various chapters. To me, it's important in that it systematically addresses related areas of the financial crisis and begins to provide a reasoned approach to dealing with the issues that are being identified.

The discussion and debate over what is to be done about the different segments of the financial markets, the different financial institutions that exist, the different regulatory bodies involved, and the different policymaking parts of the government is going to be a long and arduous process. Restoring Financial Stability helps us to identify the major issues we need to deal with and to start thinking about them in a relatively coherent manner. Hopefully, this will help us move on to solutions that will be more helpful than harmful.