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Liquidity Risk and the Ongoing Recession

The Global Economic System: How Liquidity Shocks Affect Financial Institutions and Lead to Economic Crises.  George Chacko, Carolyn L. Evans, Hans Gunawan, and Anders Sjöman.  FT Press 2011, pp.269, $34.99

            It has been nearly three years since Lehman Brothers filed for bankruptcy protection.  Unemployment nevertheless remains close to 10%, the housing market has not yet recovered, and recent college graduates find themselves underemployed and often living back home with their parents.  Despite the bailouts, deficit spending, and the Federal Reserve’s policy of quantitative easing, there has yet to be a recovery from the financial crisis of 2008.   Why is this the case?  Did the Obama Administration so completely fail to respond adequately to the faltering economy?  Was there too much federal government intervention or too little?   

            Although it does not attempt to answer these questions directly, The Global Economic System: How Liquidity Shocks Affect Financial Institutions and Lead to Economic Crises does provide a framework for understanding what exactly transpired in 2008.    It also helps explain, to some degree, why the anticipated recovery did not come to fruition as policy makers had planned.  Co-written by four experts in economics and finance, The Global Economic System is a monograph that would be inaccessible to readers without a prior knowledge of basic economics and recent financial history.  The authors themselves acknowledge that the book was “written assuming that the reader has some familiarity with finance and economics.”   That said, an advanced undergraduate business school student would be able to learn much from this recent work of scholarship.

            Chacko and Evans (both of Santa Clara University), Gunawan (Skyline Solar), and Sjöman (Voddler) draw upon the concept of a peso problem, referring to a hidden – and generally unobservable – risk factor in financial market data.  The authors argue that, during the period prior to the 2008-2009 economic crisis, there was “an extremely pervasive peso problem, touching our entire society.  It is present in every market (both financial and nonfinancial), it affects most financial institutions ranging from banks to hedge funds, it has always been there, and it will always continue to be there.  This latent risk factor is liquidity risk.”  

            The purpose of their work, in the authors’ formulation, “is to not only provide a detailed description of the concept of liquidity risk but also to lay out how this risk affects financial institutions and thereby gets transmitted into the global economic system.”  They attempt to do so through case studies of the Great Depression, Japan’s Lost Decade, and what the authors term The Great Recession (of 2008 to the present).   

            For those readers unfamiliar with liquidity, liquidity risk, liquidity shock, and other related concepts, Chapter 2 provides a comprehensive and readable overview.   The authors utilize graphs and discuss how an understanding of bid and ask curves helps to illuminate the concept of liquidity.   Liquidity risk, in their formulation, refers to “the risk of facing an illiquid market for a good or a financial security.”  The authors provide a useful, although perhaps a slightly too technical, definition, of liquidity shock as “a dramatic increase in the price volatility of a security and a dramatic decrease in trading volume with more sellers than buyers for the security, and it leads to a dramatic decrease in the price of the security.”  These are not easy concepts to define; the writers do an admirable job with difficult material. 

            Although tangential to the larger thesis, the authors’ discussion of how insurance companies utilize what they term liquidity-driven investing is worth consideration.  They define liquidity-driven investing (LdQI) as “an investment approach used by many institutional investors that have liability streams to capitalize on liquidity risk premiums in financial markets.”  More significantly, they demonstrate how an insurance company is able to use this approach.  The authors also discuss how such a company can, under certain circumstances, become a distressed seller.

            In Chapter 5, the authors employ a six-stage approach to demonstrate how, during the Great Recession, a liquidity shock spread from the financial sector to the nonfinancial sector.  The stages are as follows: an initial trigger; a change in the liquidity demanded throughout the economy; changes in bank balance sheets; how banks change their activities to bolster their balance sheets; fewer funds available for assets with low liquidity and increased investment in highly liquid assets; and real effects observed throughout the economy.  

            As they write in their Conclusion, “[t]he key to understanding how a liquidity shock spreads is the transmission process that occurs via the normal responses of banks to changes in their balance sheets and funding availability.”   In their formulation, during Great Recession, the initial liquidity shock was in the MBSs (mortgage backed securities) and the derivatives market.   The transmission of this liquidity shock from the financial sector to the nonfinancial sector resulted in a credit crunch.  

            Given that the authors spent well over two hundred pages discussing liquidity shocks, one would have thought they would have had more salient policy recommendations for how best to avoid, if not lessen, a liquidity shock.  The authors do rightly acknowledge that changing bank accounting rules to prevent banks from liquidating their assets in response to a sudden reduction of capital merely results in “zombie banks – banks that are in reality troubled, or even dead, but they are still seemingly healthy by accounting standards.”  They provide brief discussions of bank nationalization, debt guarantees, central bank lending, monetary policy, and fiscal spending. 

            While acknowledging that the approaches that could prevent liquidity crises also may, in turn, inhibit economic growth, the authors ultimately conclude “in the end, it may be the case that liquidity crises go hand-in-hand with an efficiently functioning economic system.”  Some readers will find this conclusion, while technically correct, less than satisfactory.   Others will recognize that the authors are just being realistic; liquidity shocks are, in a word, normal.   

            In conclusion, The Global Economic System is a comprehensive study of how liquidity risk helps to explain the financial crisis of 2008 and the ongoing recession.  Those working on the Hill on financial services reform would have a lot to gain from taking the authors’ thesis seriously.   

Jon Lewis (c) 2011

Fannie, Freddie, and the U.S. Covered Bond Act of 2011

The American Mortgage System: Crisis and Reform.  Edited by Susan M. Wachter and Marvin M. Smith.  University of Pennsylvania Press 2011, pp.392, $49.95

            There is a direct correlation between the housing bubble and the freezing up of the credit markets in 2008.   Indeed, many commentators have held the largely unregulated derivatives market – much of it based on securitized mortgages – responsible for nearly bringing down the entire financial system.  The Dodd-Frank Act has attempted to reform the derivatives market by imposing a clearing requirement on swaps.   That said, the ongoing challenge is how to reform the housing market itself so working Americans can afford to purchase homes.   A separate question, of course, is whether the federal government’s emphasis on homeownership for all (or as many as possible) during a time of exceedingly low interest rates was itself partially to blame for the financial crisis.

            With housing apparently now back on President Obama’s agenda, the release of The American Mortgage System: Crisis and Reform could not have come at a more opportune time.  Edited by Susan M. Wachter, from the Wharton School and PennDesign, and Marvin M. Smith, from the Federal Reserve Bank of Philadelphia, this volume contains a collection of fifteen essays on the housing crisis, its community impact, and ways to reevaluate and to reform housing and mortgage finance.  

            In their Introduction, Smith and Wachter premise their argument on the notion that, in order for the United States to have a sustainable mortgage system, it is necessary to remake that system, and that redesign is indeed possible.  They call for a separation of “innovations that increased – and sustained – homeownership from those that merely increased profits and risk.” 

           Although they acknowledge that the current system is broken, Smith and Wachter emphatically do not want to replace long-term fixed rate mortgage with an entirely new system.  Indeed, the authors argue that “[w]ith interest rates preparing to rise and sovereign debt at nosebleed levels, consumers need the long-term, fixed-rate mortgage now more than ever.”  They note that the focus of the collection is “[h]ow to create such a system and safeguard it from recurrences of the recent catastrophe.”   Smith and Wachtel are thus more interested in reforming, rather than fundamentally restructuring, housing finance.

            For readers interested in an accessible and brief introduction to Fannie Mae and Freddie Mac, Chapter 1 is worth particular consideration.  In “The Secondary Market for Housing Finance in the United States,” New York University faculty members Ingrid Gould Ellen, John Napier Tye, and Mark A. Willis, enumerate what they consider to be the strengths and weaknesses of the GSE (government-sponsored enterprise) model prior to the federal government’s putting Fannie Mae and Freddie Mac into conservatorship.     

           The authors are on the mark in citing the following as weaknesses: the implicit federal guarantee which made Fannie and Freddie susceptible to moral hazard; a favored regulatory status which created “a net bias toward investing in housing in the economy overall”; lack of proper oversight; duopoly power; a race to the bottom with lower underwriting standards; and their too-big-to-fail large size, which concentrated systemic risk.  

            It is notable that the authors point out how Fannie and Freddie’s structure created a net bias toward investment into the housing sector.   Although this is not necessarily an original point, it is nevertheless an important one.   The very existence of the GSEs (and indeed, the mortgage interest tax deduction) provides incentives for individuals to invest in housing, rather than in savings or in the money market.   

           Ellen, Tye, and Willis conclude with the observation that, while the GSEs should indeed be improved, “it would be a mistake to assume that simply reforming the GSEs, without making significant reforms to the private-label market would prevent another crisis.”  While technically correct, this misses the larger point; namely, that the GSEs, at least prior to their being placed into conservatorship, were very unique entities in which an implicit guarantee allowed gains to accrue to shareholders, with losses socialized and, hence, passed on to taxpayers.   

            In Chapter 13, “Improving U.S. Housing Finance Through Reform of Fannie Mae and Freddie Mac: A Framework for Evaluating Alternatives,” co-authors Ingrid Gould Ellen and Mark A. Willis list nine characteristics that, in their view, can be utilized to distinguish among the different approaches for reforming the secondary mortgage market: credit enhancement; regulation; securitization of non-favored products; market concentration; provision of credit to underserved markets; financing multi-family rental properties; allowing direct investments; methods of ownership; and transition issues.   The authors devote significant attention to the question of credit enhancement, which they consider “[a]rguably the most critical feature of any proposal.”   

           Free market advocates who would like to see the federal government exit the mortgage guarantee business entirely (something that is unlikely in the near term) would likely disagree with the authors on various points.  That said, their proposal for limiting federal guarantees to mortgage backed securities only – as opposed to corporate obligations and debt – should be given serious consideration.  They argue that “to limit moral hazard and taxpayer risk, the government should only guarantee MBS holders’ timely payment of interest and principal in the case of default rather than guaranteeing the corporate obligations of the issuer or even the underlying mortgage debt.”  Ellen and Willis should be commended for their acknowledgment of the correlation between the GSEs’ moral hazard problem and taxpayer risk.

            In light of the House Financial Services Committee’s recent vote in approval of H.R. 940, the United States Covered Bond Act of 2011, perhaps the most salient aspect of Ellen and Willis’ essay is to be found in their discussion of covered bonds in their Appendix B.   They argue that covered bonds differ from mortgage-backed securities (MBSs) in two ways: the covered bonds, unlike MBSs remain on a bank’s balance sheet and that bonds are usually regulated so as to be over-collateralized, with the mortgage pool exceeding the value of outstanding bonds.   

           Although the authors doubt the likelihood that covered bonds will replace the GSE MBS system of housing finance, they do suggest that “[I]n a more radical restructuring, the GSEs could be abolished, and the entire system could switch to covered bonds, or the GSEs could be reformed into covered bond issuers.”  This, in their view, “would seriously disrupt the housing finance system.” 

            Covered bonds do offer significant promise.  The Senate should take up similar legislation.  It should be noted, however, that George Soros’ proposal to eventually wind down the GSEs and to replace the current housing finance system with a Danish-style covered bond system based on the principle of balance would not be the best option for a dynamic American housing finance system.  What would be far more preferable would be to allow market forces to operate as freely as possible and to allow consumers and investors to have choices.   

            Indeed, as Ellen and Willis astutely note, covered bonds “could directly compete with the GSEs in the prime mortgage market.”  This may be the best option.  The goal should not be to replace the current American housing finance system with a model that has worked, until now at least, exceedingly well in a relatively geographically small and homogenous Nordic country and to expect that that model could be replicated in the United States.   Furthermore, Soros’ proposal that the GSEs should now begin to introduce securities based upon the Danish principle of balance should be rejected.  If this is to be done at all, it should be done by the private sector under a proper regulatory framework established by Congress, not by the GSEs. 

            In conclusion, bold thinking is needed to reform the American housing market.  Reforming the GSEs is a good idea.  Replacing them entirely and minimizing the federal government’s involvement in promoting the housing sector at the expense of other sectors of the economy, while still preserving opportunities for responsible homeownership, would be even better.  For those policymakers interested in a recent collection of essays on housing finance, The American Mortgage System: Crisis and Reform is worth ample consideration.
Jon Lewis (c) 2011

After the Bubble: Credit and Housing

Moving Forward: The Future of Consumer Credit and Mortgage Finance.  Edited by Nicolas P. Retsinas and Eric S. Belsky.  Brookings Institution Press 2011, pp. 264, $28.95

            Although there are indications that the housing market may be improving, particularly in rural states with large agricultural, energy, and industrial sectors, the housing market is unlikely to recover fully any time soon.  Adding to the uncertainty about the future of home purchases is the fact that a significant number of recent college graduates are returning home to live with their parents, likely delaying their path to homeownership.  Minority and low-income communities, where homeownership was always more of a challenge than for middle-class and affluent Americans, have been hurt the hardest by ongoing unemployment.  Although it is difficult to generalize about the national housing market, marked minority unemployment makes it less likely that members of these communities will be purchasing homes in the same numbers as they did in the mid-2000s when consumer credit was more readily accessible. 

            Moving Forward: The Future of Consumer Credit and Mortgage Finance is the product of a February 2010 conference held at the Harvard Business School.  Convened by the university’s Joint Center for Housing Studies, participants met “to explore the roots of the crisis that caused credit markets to seize up in late 2008 and more, important, to focus on the way forward.”   Edited by Nicholas P. Retsinas and Eric S. Belsky, both of Harvard, Moving Forward contains academic papers on such disparate topics as how best to serve the short-term credit needs of low-income consumers; a retrospective on the Home Mortgage Disclosure Act; and a case study of payday lending in the context of the regulation of consumer financial products.  The overall theme of the conference, as enunciated by Retsinas and Belsky in their Introduction, was how to “reopen the spigots of credit to low- and moderate-income Americans” in an efficient and fair manner.    

            Although each chapter provides a different perspective on the housing market, two stood out as particularly engaging.  In Chapter 1, “Rebuilding the Housing Finance System after the Boom and Bust in Nonprime Mortgage Lending,” Belsky and Nela Richardson, also from Harvard, present a fairly objective overview of the boom and bust cycle in the nonprime and nontraditional mortgage lending markets and provide their vision for better mortgage markets.   The authors identify four broad factors, which, in their opinion, were essential in the causation of the nonprime boom and subsequent bust: global liquidity and low interest rates; relaxed underwriting standards; financial engineering (i.e., derivatives such as credit-default swaps and synthetic CDOs); and regulatory and market failures.   These are all reasonable factors to cite; the authors, however, could have devoted more attention to the role played by monetary policy in fueling the initial housing boom, wherein the Federal Reserve kept the federal funds rate unnaturally low.  

            Although their historical analysis is largely dispassionate, Belsky and Richardson adamantly reject the notion that the Community Reinvestment Act had a major role in fostering the housing crisis. “But the problem was not, as some have argued, the Community Reinvestment Act (CRA) which places affirmative obligations on banks and thrifts to lend in low- and moderate-income communities.  CRA played a minor role at best.”   With regard to Fannie Mae and Freddie Mac (it should be noted that Freddie Mac provided funding for the conference and that the editors did rightly disclose this fact), the authors contend that the GSEs would have performed better had there been more regulation of financial institutions in the private-label securities market and the nonprime market, in general.  

            In their view, regulatory failure, rather than the structural problems inherent in the government-sponsored enterprises, is to blame. “If there is fault to be found with capital requirements and the goals of Fannie Mae and Freddie Mac, it is not with the effort to regulate capital standards or to impose goals for low- and moderate-income lending, but rather with the actual standards that were promulgated.”  This misses a larger point; namely, that the main problem with Fannie and Freddie was less about regulation, per se, and more systemic, wherein implicit government guarantees allowed the GSEs to issue agency debt that was perceived by investors as inherently less risky than corporate bonds.  

            Not surprisingly, the authors, in their discussion of how to improve the housing finance system do not call for winding down Fannie and Freddie in a reasonable and timely manner that protects taxpayers.  Nor do they seem to acknowledge the problem of the Federal Reserve having interest rate-sensitive GSE securities on its balance sheet.   To the contrary, they argue that, “it is clear that federal insurances and guarantees are vital to the stability of the mortgage finance system, the broader financial system, and the national economy.”   This point is highly debatable, as a subsequent chapter of the book makes clear.

            In “Alternative Forms of Mortgage Finance: What Can We Learn from Other Countries?,” Michael Lea takes a comparative approach to mortgage finance and demonstrates how very unique the American system actually is.  Lea, of San Diego State University, points out that, when compared with other industrialized countries, the United States “has the highest level of government involvement, the greatest use of securitization, and a product mix dominated by the long-term fixed rate mortgage.”  Indeed, readers would be interested to learn that “[t]he United States is unusual its use of all three types of government-supported mortgage institutions or guarantee programs: mortgage insurance, mortgage guarantees, and government-sponsored mortgage enterprises.”  

            In his discussion of what the United States could learn from other countries, Lea singles out Denmark for special treatment.  According to Lea, “Denmark is the only country in the world other than the United States in which the dominant product is the long-term fixed-rate mortgage that can be prepaid without penalty.”  What makes Denmark’s mortgage finance system different, however, is that it utilizes the principle of balance and also has its “funding through the issuance of covered bonds.”   Denmark’s system thus allows for borrowers to repay their mortgages through the bond market should rates rise and also keeps the credit risk on the lender’s balance sheet (as opposed to the American system wherein Fannie Mae securitizes mortgages into mortgage-backed securities that are then sold to investors).      

            Lea does a great service by providing this comparative perspective.   His discussion of Denmark, however, must be tempered with the very recent conflict between Moody’s, the credit rating agency, and Danish banks.   That said, Lea is on the mark in his observation that “[r]estricting the government role to guarantees without portfolio accumulation of mortgages would reduce the systemic risk of the U.S. housing finance system in line with the more targeted and stable Canadian system.”  Canada, as Lea notes, has a comparable rate of homeownership to that the United States, but does not have a government-sponsored enterprise such as Fannie and Freddie. 

            In conclusion, the housing market will likely not recover in the near term.  There are signs, however, that the market may be slightly improving.    In the meantime, it would be useful for policymakers to think critically about ways to improve mortgage finance.  Winding down Fannie and Freddie would be a good first start.   For those interested in recent academic literature on housing and consumer credit, Moving Forward is worth a read.

Jon Lewis (c) 2011           

           

Derivatives After Dodd-Frank

The New Financial Deal: Understanding The Dodd-Frank Act and Its (Unintended) Consequences.  David Skeel.  John Wiley & Sons, Inc. 2011, pp. 220, $34.95

            For those individuals who work in financial services, understanding the basic provisions of Dodd-Frank is a necessity.   Love it or hate it, no other legislation passed in recent years will have such an indelible impact on the regulation of America’s financial services industry.  In The New Financial Deal, David Skeel provides both an overview and a critique of the Dodd-Frank Act and suggests ways in which the legislation could be improved.  Skeel, a professor at the University of Pennsylvania Law School with an academic expertise in bankruptcy law, argues that two themes emerge from Dodd-Frank; namely, a corporatist European-style, partnership between the federal government and America’s largest, too-big-to-fail financial institutions and “a system of ad hoc interventions by regulators that are divorced from basic rule-of-law constraints.”  Among Skeel’s worries is his assessment that the legislation “invites the government to channel political policy through the big financial institutions by giving regulators sweeping discretion in the enforcement of nearly every aspect of the legislation.”   Indeed, government regulators will play an increasingly important role in the financial services industry in the years ahead.  

            Skeel argues that Dodd-Frank was falsely premised on what he calls “the Lehman myth,” the notion that Lehman Brothers’ bankruptcy caused the financial crisis and that, because of this, regulators needed more tools at their disposal to intervene when a large financial institution fell into distress.   Through a judicious use of charts (including one indicating the LIBOR-OIS spread reaction to the Fall 2008 crisis) and persuasive argumentation, he aptly demonstrates that Lehman’s bankruptcy did not precipitate the worst of the financial crisis of 2008.   Most significantly, however, is his discussion of the conditions under which Lehman filed for bankruptcy.  Skeel contends that, because CEO Richard Fuld and Lehman expected a government bailout, they did not prepare for bankruptcy proceedings.  “Given the expectation of a bailout, Fuld and Lehman had little reason to start making plans for an orderly bankruptcy, as they might be expected to do if they viewed bankruptcy as a plausible option.”  Skeel is generally correct that Lehman may have misperceived that it would be a recipient of a bailout.   Nevertheless, Lehman’s leadership – well paid executives, all – clearly dropped the ball.  His argument that, despite the dire circumstances, Lehman’s bankruptcy process has been a general success needs to be counterbalanced by the fact that Harvey R. Miller, the lead bankruptcy attorney for Lehman, wrote the book’s foreword.   Miller writes that Skeel’s work “is mandatory reading for all those interested in the financial markets and the global economy.”   A reader will have to make up his own mind as to whether Skeel’s analysis of Lehman’s bankruptcy process could have been more objective.

            While very critical of the corporatist aspect of Dodd-Frank, Skeel is not unthinkingly critical.  He acknowledges that Dodd-Frank has positive attributes.  One is in its treatment of derivatives, what he succinctly defines as “simply a contract between two parties whose value is based on changes in an interest rate, a currency, or almost anything else, or the occurrence of a specified event.”  Dodd-Frank institutes a framework wherein swaps are to be cleared and traded on an exchange.  According to Skeel, the most important innovation in Dodd-Frank with regard to derivatives regulation is the “new clearing requirement that gives the CFTC and SEC the power to require that any category of swaps be cleared.”  This means that a third party clearinghouse will “stand behind both parties, guaranteeing each party’s performance to the other.”  

            For those interested in how best to regulate financial institutions, Skeel’s discussion of how a clearinghouse could itself become a source of systemic risk merits particular attention.   Because a clearinghouse failure would be catastrophic, Dodd-Frank gives the Federal Reserve the power to lend to clearinghouses, making the largest clearinghouses entities that they themselves are too-big-to-fail.   This raises a significant question that policymakers will need to wrestle with in the years ahead; namely, should the United States allow financial institutions – be they bank holding companies, insurance companies, or clearinghouses – to become so big that their failure poses systemic risk to the national economy?  Although Dodd-Frank emphatically does not break up the largest financial institutions into smaller components, a future clearinghouse failure, in which taxpayers would be on the hook for billions or trillions, could reopen a debate on this subject that Dodd-Frank seems to have legislatively settled – for now.  

            Skeel, who has written a history of American bankruptcy law, not surprisingly, is biased in favor of the bankruptcy process as an alternative to the Dodd-Frank resolution regime.   Premising his argument on the notion that Dodd-Frank is here to stay and is unlikely to be legislatively repealed, Skeel makes the case for removing the protections that derivatives and other financial innovations are given in bankruptcy proceedings, wherein they are protected from the automatic stay.  He contends that “the special treatment of derivatives is a mistake” and that “[t]reating derivatives the same way as other contracts would give the managers of troubled financial institutions much greater incentives to make adequate preparation for insolvency proceedings, and to use bankruptcy rather than the Dodd-Frank resolution regime.”  This proposal, which has been opposed by the International Swaps and Derivatives Association, if implemented, would diminish “the bias towards derivatives-based and repo financing.”   It would also be a boon for the bankruptcy bar, particularly those attorneys who would then be able to bill hours for their efforts in winding down failing financial institutions through the court system.  

            In conclusion, The New Financial Deal is worth reading and ample consideration.   Students and those interested in bankruptcy law would particularly benefit from reading Skeel’s work.   The greatest weakness of the work is that, at times, the author seems too close to the events of 2008-2009 to be impartial to the personalities who were involved in both implementing the bailouts and drafting Dodd-Frank.  His reference to Paulson, Geithner, and Bernanke as “[t]he three musketeers of the financial crisis” seems gratuitous.   That said, Skeel has written an engaging study of Dodd-Frank and of the likely future of financial services regulation in the United States.
Jon Lewis (c) 2011

Too Much or Too Little Regulation?

New Directions in Financial Services Regulation.  Edited by Roger B. Porter, Robert R. Glauber, and Thomas J. Healey.  The MIT Press 2011, pp. 227, $35.00

           

            What caused the financial crisis of 2008?  Three years after the American financial system teetered on the brink of collapse, analysts and pundits have proffered differing theories as to how and why the United States just barely avoided a second Great Depression.  Fannie Mae and Freddie Mac, the Federal Reserve, and too-big-to-fail, highly leveraged banks have all been cited as bad actors.  Others have pointed to the Community Reinvestment Act and the federal government’s naive, albeit well intentioned, effort to support homeownership for individuals with poor credit histories.   One scholar has – quite convincingly – cited the impact that the Recourse Rule, an amendment to Basel II Accords, had on incentivizing banks to load up on mortgage-backed securities.    

            There is little doubt that the multiple causes of the financial crisis of 2008 will be debated for years to come.   In fifty years, there will almost certainly be historians who will present conference papers debating the issues that constitute our contemporary history.  That said, sometimes those closest to an historical event can provide extremely useful insights as to what precipitated the occurrence in question.  On October 15 and 16, 2009, a group of experts gathered at Harvard University’s Mossovar-Rahmani Center for Business and Government for a conference to debate and to discuss the recent financial crisis.   New Directions in Financial Services Regulation, edited by two Harvard faculty members and by a Senior Fellow at the Kennedy School, is the result of that conference.   The book is divided into roughly three parts; the origins of the crisis, appropriate regulatory modifications, and implementing a fitting regulatory structure.  The collection concludes with the text of a keynote speech delivered by Paul Volcker, the former chairman of the Federal Reserve best known for his unyielding – and successful – effort to curtail inflation during the early years of the Reagan Administration. 

            Although the work as a whole is highly recommended for those interested in exposure to myriad takes on the financial crisis, three essays stand out as particularly thought provoking.    In “Origins and Policy Implications of the Crisis,” John B. Taylor contends that his empirical approach to the financial crisis leads to the implication that “the federal government’s actions and interventions caused, prolonged, and worsened the financial crisis.”  Taylor, who is a professor at Stanford and was Under Secretary of the Treasury for International Affairs in the George W. Bush Administration, puts the blame on the government rather than on the markets.   He points to the role played by counterparty risk in the summer of 2007, when interest-rate spreads shot up precipitously.   One wishes, however, that he had provided slightly more data and analysis explaining why counterparty risk was the culprit in the unusual interest-rate spreads in the money markets.  

            Taylor’s main argument is that the federal government failed in its response to the crisis.  The government, in his view, failed to articulate a “clear and balanced plan.”  Furthermore, he states that, “we have convincing evidence that interventionist government policies have done harm.  The crisis did not occur because economy theory went wrong; rather, it occurred because policy went wrong, because policy makers stopped paying attention to sound economic principles.”  Given his diagnosis of the problem, it is not surprising that his policy prescription would focus “on proposals to stop systemically risky government actions.”   Taylor writes positively of new legislation that would ensure that a more accountable and transparent Federal Reserve focused “on the instruments of monetary policy.”   At a more general level, he advocates, “government should set clear rules, stop changing them during the game, and enforce them” and correctly posits that, “the rule of law is essential.”   Indeed, it can be argued that although government bailouts may have been necessary to prevent a wider economic collapse, they (the auto bailouts, in particular) may have also damaged the rule of law.    

            In “Underlying Causes of the Financial Crisis of 2008-2009,” Judge Richard A. Posner, of the Seventh Circuit Court of Appeals, argues that “[t]he financial crisis was at root a failure of monetary policy.”   He makes the case that low interest rates helped precipitate a housing bubble; however, he specifically does not place the blame on bankers and homebuyers for the banking sector’s collapse.  Posner contends that compensation practices, the derivatives market, structured finance, and the GSEs (government-sponsored enterprises) were secondary factors.  Significantly, his discussion of how changes in the federal funds rate affect other interest rates merits close attention.   What makes Posner’s somewhat lengthy essay stand out is his discussion of the collapse of the commercial paper market.  Far too few commentators have devoted adequate attention to this very important component within the broader narrative of the financial crisis; sadly, many would-be experts on the crisis probably have little notion as to what commercial paper actually is.   Many readers would disagree with Posner’s bold contention that the government’s failure to save Lehman Brothers was, in his words, “a critical error.”   That said, even skeptics of government bailouts would be well advised to read his contribution to New Directions in Financial Services Regulation.

            David A. Moss, in “An Ounce of Prevention: Financial Regulation, Moral Hazard, and the End of ‘Too Big to Fail’,” makes the case that deregulation and a crisis of too-big-to-fail institutions are to blame.  Moss, a professor at Harvard Business School, cites the moral hazard problem heightened by implicit federal guarantees of systemically important financial institutions.   His preferred solution to a clearly articulated problem, however, is not one that all free market advocates would accept as reasonable.  While he rightly acknowledges the problem of regulatory capture, Moss nevertheless advocates the creation of a new regulatory agency, a Systemic Risk Review Board.  It is not clear, however, why a new agency would succeed where others have clearly failed.   Nevertheless, he is correct to note that “implicit guarantees don’t disappear on their own and cannot be ignored or denied into oblivion.”   This point is particularly salient, one that policymakers in federal agencies and those on the Hill should take seriously.

            In conclusion, Taylor, Posner, and Moss each provide thoughtful, highly readable commentaries on the recent financial crisis, of which yet much remains to be written.   Indeed, it is unlikely that there will be a general consensus any time soon as to what caused the meltdown of the financial sector in 2008.   This is not necessarily a bad thing.  Furthermore, it appears that, as of this writing, the United States is facing a new type of financial crisis.  This time the crisis stems from sovereign debt and a huge deficit, rather than from the banking sector, per se.   Much will be written on this topic in the years ahead.  Those interested in banking crisis of the past few years, however, would benefit from a close read of the essays in New Directions in Financial Services.   For individuals unfamiliar with the commercial paper market, Posner’s essay is particularly illuminating.     

Jon Lewis (c) 2011            

EU Insurance Regulation -- Principles Instead of Rules

Executive’s Guide to Solvency II.   David Buckham, Jason Wahl, and Stuart Rose.  John Wiley & Sons 2011, pp.194, $95.00

            In the United States, the states, rather than the federal government, are primarily responsible for regulating the insurance industry and the business of insurance.    This is due to both longstanding custom and, most significantly, to Congress’ passage of the McCarren-Ferguson Act in 1945.   McCarren-Ferguson established a regulatory system in which, unless Congress specifically indicated otherwise, the states were to be the primary regulators of insurance companies.   This is why, to this day, each state and territory has its own insurance commissioner; unfortunately, there is no federal insurance regulatory agency in Washington D.C. to oversee and to regulate a national insurance market.    Indeed, for a modern economy with a large financial services industry, the American insurance market is quite decentralized.

            By way of contrast, the European Union (EU) is in the process of harmonizing its system of insurance regulation to prepare for the challenges of the 21^st-century economy.   Beginning January 1, 2013, the EU will implement Solvency II, an initiative designed to replace the Solvency I, a reform that the European Commission and European Council agreed to in 2002.  In Executive’s Guide to Solvency II, the authors argue that those cynical about this new phase in EU insurance regulation are wrong and that “Solvency II is a well-thought out directive, painstakingly developed over many years by collaboration between the European Commission, member states, and the insurance industry.”  Buckham and Wahl, of Monocle Solutions, and Rose, of SAS Institute, have written a comprehensive overview of the Solvency II Directive in a book that will most likely be a standard reference guide for years to come. 

            The authors begin their work with a cursory introduction to the role that insurance fills in mitigating and transferring risk.   For those unfamiliar with the historical development of insurance and its importance in market economies, Chapter 1 is particularly worth reading.   The authors rightly note that “the optimal goal” of Solvency II and similar regulations “is to promote a socially optimal balance between the profit motive of organizations and individuals’ rights” and cite Article 27 of the Solvency II Directive which emphasizes that “[t]he main objective of (re)insurance regulation and supervision is adequate policyholder protection.”  In Chapter 3, the authors argue, “the important role that insurance companies play in the financial system today makes it imperative that the industry should be regulated.”   

            As with any regulatory system for financial products, the question is where to strike the appropriate balance between consumer protection, managing systemic risk, and allowing companies to compete and to innovate.   (Indeed, the ongoing debate over the how best to write and to implement regulations for the recently enacted Dodd-Frank reform legislation highlights this tension).    Significantly, the authors state with clarity “that the production cycle in insurance is inverted; that is, insurers receive a premium up front but are obliged to pay out only if the risk materializes at some future date.”   Because an insurer bankruptcy would expose both policyholders and the beneficiaries of insurance contracts to losses, insurance regulation focuses on solvency.   That said, according to the authors,  insurer insolvency is not very frequent.   

            For those readers most interested in the nuts and bolts of Solvency II, Chapter 5 provides a useful overview of the Directive.    The authors point out that Solvency II, like the Basel II banking regulations, has a three-pillar structure and that its “primary objective is the protection of policyholders and beneficiaries.”  What makes Solvency II unique is that it is principles-based, rather than rules-based, and that “it explicitly states that capital is not the only (or necessarily the best) way to mitigate failure.”   In the United States, by way of contrast, the states utilize a    rules-based system for financial regulation, in which insurers have specific regulations with which they have to comply.  Within the Solvency II framework, EU (and Norwegian, Liechtensteinian, and Icelandic) insurance companies “will be required to meet regulatory principles rather than rules.”   Under the Solvency II regulations, good governance of insurance companies is emphasized and insurers are given wide latitude to develop internal modeling systems.    The new rules “will inevitably shift business attitude from a compliance-based culture to a risk management culture.”   What will be interesting to watch is how competitive EU insurance companies will likely be under this principles-based system. 

            Should Solvency II prove to be a successful regulatory framework for EU insurers, it would likely further expose the weaknesses of America’s current rules-based, compliance-oriented insurance regulation.   For those policymakers and legislative staffers interested in modernizing insurance regulation in the United States, Solvency II, as noted by insurance regulation scholars, Martin F. Grace and Robert W. Klein, “could be used as a template, but U.S. regulators need not mimic any particular system to create the best possible system.”    That said, for those interested in harmonizing and streamlining insurance regulation in the United States so as to make American insurers more competitive, the Solvency II Directive is worth ample consideration. 

            In conclusion, Executive’s Guide to Solvency II is not for the general reader, nor is it for readers without a serious interest in the economic and policy aspects of insurance regulation.  For individuals working in the EU insurance industry, this book will be invaluable; for Americans interested in bold thinking about how the United States might want to restructure insurance regulation after Dodd-Frank, as well as for those interested in an Optional Federal Charter, this book — and Chapter 5, in particular — is worth reading.   It may very well come to pass that by the end of 2013 EU insurers will be far more competitive globally than American insurers. 

Jon Lewis © 2011