Lessons from the North Atlantic financial crisis

The paper studies the causes of the current financial crisis and the policy responses by central banks and regulators. It also considers proposals for the prevention or mitigation of future crises. The crisis is the product of a ‘perfect storm’ bringing together a number of microeconomic/incentive pathologies, global macroeconomic developments and monetary policy errors. Among the microeconomic systemic failures were: wanton securitisation, fundamental flaws in the rating agencies’ business model, the procyclical behaviour of leverage in much of the financial system, of mark-to-market valuation and accounting and of the Basel capital adequacy requirements, privately rational but socially inefficient disintermediation, and competitive international de-regulation. Reduced incentives for collecting and disseminating information about counterparty risk were a pervasive feature of the new financial world of securitisation and off-balance sheet vehicles. So was lack of transparency about who owned what and about who owed what and to whom. In many ways, the crisis can be seen as a failure of the transactions-oriented model of financial capitalism favoured in the US and the UK. Proximate local drivers of the specific way in which these problems first manifested themselves were regulatory and supervisory failure in the US home loan market. The monetary policy errors that contributed to the crisis were excessive global liquidity creation by key central banks. Among the key global macroeconomic developments were an ex-ante global saving glut, brought about by the entry of a number of high-saving countries (notably China) into the global economy and the global redistribution of wealth and income towards commodity exporters that also had, at least in the short run, high propensities to save. Very low risk-free long-term real interest rates and unprecedently low credit risk spreads of all kinds together with the ‘Great Moderation’ – low and stable inflation and stable global GDP growth – prompted an increasingly frantic ‘search for yield’. In the UK, failures of the Tripartite financial stability arrangement between the Treasury, the Bank of England and the FSA, weaknesses in the Bank of England’s liquidity management, regulatory failure of the FSA, an inadequate deposit insurance arrangement and deficient insolvency laws for the banking sector contributed to the financial disarray and the failure of a medium-sized home-loan bank, Northern Rock. In the US, the balkanised and incoherent structure of regulation of financial institutions and financial markets, even at the Federal level, meant that too many regulators are involved, none of which is actually in charge or responsible. Despite this, because the excesses were confined mainly to the financial sector and (in the US and some European countries, the household sector), it should have been possible to limit the spillovers over from the crisis beyond the financial sector and the housing sector without macroeconomic heroics. Measures directly targeted at the liquidity crunch should have been sufficient. The macroeconomic response of the Fed to the crisis 325 basis point worth of cuts between September 2007 and May 2008 and a 75 basis point cut in the discount window penalty – therefore seem excessive and create doubt about the Fed’s commitment to price stability. The liquidity-enhancing policies of the Fed and its bailout of the investment bank Bear Stearns were effective in dealing with the immediate crisis. They also were, quite