The Six Root Causes of the Financial Crisis - CAPITAL INSTITUTE (2024)

“We conclude first and foremost that the crisis was avoidable,” declared Phil Angelides, chairman of the Financial Crisis Inquiry Commission. No act of God. Thanks Mr. Chairman.The report is weak and inconclusive, with no clear root causes. The FCIC is no Pecora Commission, the exhaustive, two year inquisition into the causes of the 1929 crash in which

Ferdinand Pecora, a tough assistant district attorney from New York, not a politician from California, personally grilled Charles Mitchell, Chairman of National City Bank, Richard Whitney, President of the New York Stock Exchange, J.P. Morgan Jr. and other leading bankers and speculators to much public fanfare at the time. The Pecora inquisition humiliated Wall Street and led to the Glass-Steagall Banking Act of 1933, four years after the Great Crash.Eighteen months of softball theater and political infighting reflective of Washington dysfunction, the Financial Crisis Inquiry Commission issued its 500-page reportafterDodd-Frank has been passed, and after the Basel III Agreement is largely set. So other than making for a nice history of the worst financial crash since the Great Depression, the report will have little impact.Actually, for the price of one, we get three versions of history, the majority (Democrat) version, the dissenting (Republican) version, and the “it’s all the US government’s fault” version of Commissioner Peter Wallison, a fellow at the conservative think tank American Enterprise Institute. I skimmed all three versions, and frankly they all contain truths. The criticism of the majority report that it is more a list of problems than a report on root causes is fair. Even the Wallison perspective, that HUD’s aggressive policy targeting home ownership holds some validity, although to single out the US government’s housing policy as the cause of the global financial crisis is patently absurd.Relying on judgment rather than an exhaustive investigation, let me try my best to suggest root causes and implied solutions. To identify root causes, it is essential to take a systems approach to the problem, which assumes human frailties, be they hubris, greed, or incompetence. It is of little use to say the crisis happened because human beings, bankers and regulators, were not perfect. It is the height of folly to suggest that a solution rests in improving human decision-making next time. Only systemic change will generate a different outcome.I suggest there aresix root causesof the financial crisis:

1. Leverage. Excess leverage is at the center of all banking crises, by definition. Leverage goes beyond balance sheets. Leverage is embedded in off-balance-sheet instruments such as derivatives. And dangerous hidden leverage is embedded in structured securities. We have no transparent accounting for leverage, so limiting it is complex and beyond the skill of legislators to efficiently write into law, and beyond the ability of regulators to manage as we have learned. The only solution is to impose radically higher capital requirements, intentional overkill, recognizing and accepting the consequences, which are far less harmful than the financial crisis we have just experienced. Then let the industry figure out how to improve accounting and transparency that will enable more efficient, yet still adequate, capital requirements. Invite such an industry and FASB joint initiative, but until robust solutions are developed, follow the precautionary principle. This does not mean 7% capital as is being floated by Basil III. It may not require 100% equity as suggested by Lawrence Kotlikoff, although his ideas are interesting to consider. But it probably means something like 20 to 25% equity to assets on balance sheets and similarly high buffers for margin (or capital allocation) on repos and derivatives. The bankers and certain highly leveraged hedge funds will squeal, reported profits will fall, volume of transactions will slow, the financial sector will shrink, and bonuses will follow. So be it. The system’s resiliency will markedly improve, and that’s the goal.
2. Liquidity. Similar to leverage, liquidity mismatches (lending long, borrowing short) must be dramatically curtailed. That Lehman was funding real estate holdings in the Repo and commercial paper markets was sheer folly, apparently understood as a joke even inside the firm. There is no reason for an investment bank to be speculating on buildings with the implicit backing of taxpayers. The Basel III liquidity ratios are an important battle to watch. Why there have been no fraud prosecutions at Lehman and other firms who mislead investors about their true liquidity position via accounting gimmicks as now well documented, away from the FCIC process, is impossible to understand.
3. Too Big To Fail. Common sense tells us we have now an industry filled with firms that are too big, complex, and “systemically important” to manage, govern, or allow fail. This demands an altered system architecture. The academic studies assessing economies of scale and scope are flawed and a distraction from the real issue. Even if one accepts that efficiencies improve indefinitely with scale (which I don’t), the point is that no sustainable system optimizes efficiency. All systems need to balance efficiency with resiliency as any systems scientist but few bankers or Treasury Secretaries understand. Resiliency is improved by immense diversity, decentralization, and maintenance of excess buffers. Continued aggregation of scale and risk suits management first who earns an effective “promote” off shareholders, shareholders second who benefit from a growing government subsidy providing an unfair competitive advantage, all coming at the expense of society who bare the catastrophic externalized cost of systems collapse as we know.
4. Conflicts of Interest. In no other profession are such blatant conflicts of interest tolerated. Even the asset management industry within finance is aghast, as are many “old school” bankers. Forcing the financial industry to pick a line of business and customer type to serve will solve the conflict problem while improving system resiliency due to the increased diversity of firms. Challenge the bankers to show exactly which customer “demands,” as Barclays CEO Bob Diamond suggests, that the banks offer both retail banking and equities underwriting for example. Such arguments are self-serving and patently false. And even if clients desire a bank to do certain things, this does not mean it is in the public interest to allow it to happen.
5. Taxes and Subsidies.Tax policy has a significant impact on the cost and flow of capital and the current tax code as it affects finance needs an overhaul. We need taxes such as a Financial Transaction Tax (see myApril 2010 press briefing) to discourage short-term speculation (harming system resiliency) and at the margin encourage longer term investment. We need a much more progressive capital gains tax that has the effect of encouraging real long-term investment over short-term speculation. The beneficial tax treatment of carried interest is absurd and yet legislators cower. We need to ensure that the subsidy provided to retail banks via FDIC insurance (which is a sensible public good) is recycled back into the real main street economy rather than used to subsidize speculation by Wall Street. We need to eliminate the subsidy on debt based financing, encouraging more debt when we have too much already.
6. Governance. We must recognize that the financial system has expanded and interconnected to the point that it is now effectively a “commons”, impacting all citizens. As with any commons (think a fishery, or the atmosphere), democratic governance becomes essential or the commons gets captured. The implications of this perspective run wide and deep as exemplified by the case of the stock exchanges. If the exchanges were understood to be, and governed as a commons, there is simply no way a democratic civil society would condone high frequency trading which benefits a few at the expense of reduced system resiliency. Again, even if one buys the logic of improved efficiency (ie, improved liquidity), which I do not as articulated in my call for a FTT, the point is that system resiliency is the more important objective.

Six root causes. Six directions for solutions. One page. Free. Not one root cause is linked to bad or corrupt decision-making by bankers, regulators, central bankers, rating agencies, or simply bad guys. We will always have such human failings and should plan for it. All six target system changes that build system resiliency at the expense of so called “efficiency” which has proved to be a mirage.The fair question: Will such changes still allow the banking system to direct capital to the real economy, producing jobs and long run prosperity? The short answer is yes. But that will require some additional and complex policy fixes since capital does not always flow naturally to the most productive uses within society as we now well understand. But only once we have restored system resiliency, can we take up this important challenge.