The Narrative of the Financial Crisis

Ok, so the regulatory authorities did not say "don't stick your head in the bucket" and therefore its a failure of regulation?

Firms evaluate their business risk, even when they are subject to legal risk. If mandatory capital requirements were insufficient you might conclude that business risks exceeded legal risks, but so what? What is the purpose of banks if regulators must evaluate business risks. Market-to-market accounting was supposed to make the banks responsible for their own business risk in a world of shadow banking.

The essay in the American is excellent. However, it leaves unanswered one question which I would like to see addressed: How were banks allowed to keep mortgage securities (and other risky assets) off their balance sheets in SPVs and SIVs? Weighting assets by risk, although it seems to have had some unintended perverse consequences, at least has some logic behind it. I can see no logic to allowing banks not to report risky assets at all.

Seems that the biggest myth of all is that Diamond & Dybvig (1983) is no longer relevant. Their model, in a sentence: Borrowing short and lending long (or, “banking”) is inherently unstable.

D&D could only find government-based insurance of financial entities as an answer. That apparently was not good enough for the political climate of the nineties & naughties. Paulson got tarred for “bailing out” the (uninsured) Bear Stearns and so let Lehmann go down all the way to zero. This unremarkably supported D&D's main thesis, but between outrage at moral hazard and populist sentiment, the main point was missed.

So, here again:

Banking is inherently unstable. Shadow-banking, e.g., money market funds and hedge funds, without much of any regulation, is unstable. Non-Glass-Steagal banking is not only unstable, it borrows the appearance of stability by being affiliated with prescribed D&D support mechanism. FASB forebearance of off-balance-sheet obligations & rose-colored balance sheets shows we like the wild West where somebody getting a bit aggressive on Wall Street can give unwanted vacations to construction workers in Nevada.

Under the D&D model, the slightest rumor is enough to set off a run. Exhibit A: the $1.5Trillion, one afternoon attempted run when the Reserve Fund broke a buck last September. There is lots of wishful thinking that markets are self-equilibrating, and maybe in a micro sense they are, but we're buried in examples (currency crises in the US prior to the Fed; LTCM and many smaller market collapses; dozens of international crises) that financial markets fail.

Doesn't it come with its own moral hazards? Sure; see the S&L Crisis, ameliorated only by the greatly moderated level of systemic crisis. Counter to our desired political positions? Too bad. We're staring at the answer but refuse to see it.