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Engineering the Financial Crisis: Systemic Risk and the Failure of Regulation
The financial crisis has been blamed on reckless bankers, irrational exuberance, government support of mortgages for the poor, financial deregulation, and expansionary monetary policy. Specialists in banking, however, tell a story with less emotional resonance but a better correspondence to the the crisis was sparked by the international regulatory accords on bank capital levels, the Basel Accords.
In one of the first studies critically to examine the Basel Accords, Engineering the Financial Crisis reveals the crucial role that bank capital requirements and other government regulations played in the recent financial crisis. Jeffrey Friedman and Wladimir Kraus argue that by encouraging banks to invest in highly rated mortgage-backed bonds, the Basel Accords created an overconcentration of risk in the banking industry. In addition, accounting regulations required banks to reduce lending if the temporary market value of these bonds declined, as they did in 2007 and 2008 during the panic over subprime mortgage defaults.
The book begins by assessing leading theories about the crisis—deregulation, bank compensation practices, excessive leverage, "too big to fail," and Fannie Mae and Freddie Mac—and, through careful evidentiary scrutiny, debunks much of the conventional wisdom about what went wrong. It then discusses the Basel Accords and how they contributed to systemic risk. Finally, it presents an analysis of social-science expertise and the fallibility of economists and regulators. Engagingly written, theoretically inventive, yet empirically grounded, Engineering the Financial Crisis is a timely examination of the unintended—and sometimes disastrous—effects of regulation on complex economies.
In one of the first studies critically to examine the Basel Accords, Engineering the Financial Crisis reveals the crucial role that bank capital requirements and other government regulations played in the recent financial crisis. Jeffrey Friedman and Wladimir Kraus argue that by encouraging banks to invest in highly rated mortgage-backed bonds, the Basel Accords created an overconcentration of risk in the banking industry. In addition, accounting regulations required banks to reduce lending if the temporary market value of these bonds declined, as they did in 2007 and 2008 during the panic over subprime mortgage defaults.
The book begins by assessing leading theories about the crisis—deregulation, bank compensation practices, excessive leverage, "too big to fail," and Fannie Mae and Freddie Mac—and, through careful evidentiary scrutiny, debunks much of the conventional wisdom about what went wrong. It then discusses the Basel Accords and how they contributed to systemic risk. Finally, it presents an analysis of social-science expertise and the fallibility of economists and regulators. Engagingly written, theoretically inventive, yet empirically grounded, Engineering the Financial Crisis is a timely examination of the unintended—and sometimes disastrous—effects of regulation on complex economies.
224 pages, Hardcover
First published September 1, 2011
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Displaying 1 - 6 of 6 reviews
February 18, 2013
I have read at least a dozen books on the causes of the 2008 Financial Crisis. This one is easily the best.
Friedman and Kraus eviscerate the six most popular explanations (Too Big Too Fail, Corporate Compensation, Greenspan ignoring the Taylor Rule, "Animal Spirits," Fannie & Freddie, "Deregulation" of "Shadow Banking"). Several financial regulations, each often disconnected from the others and with its own historical rationale, compounded together in a chain reaction. Public demands for security against the future unwittingly created a straitjacket constricting the options of otherwise healthy financial markets. Too many airbags during a car crash suffocated the driver, while their premature deployment obstructed his vision, causing novel accidents.
Even if you do not care to know why the Crisis happened, this book is valuable for the out-of-body experience it masterfully elicits. The political theorist of the duo, Jeffrey Friedman, induces a parable of human fallibility. Our societal conception and response to the Crisis illuminates the epistemological zeitgeist of our technocratic time. Disaster naturally progressed from our inescapable "radical ignorance," not just on a personal but systemic level, which the most efficacious bureaucracies and even markets cannot elude forever.
Each popular hypothesis about the Crisis assumed that at least some of the individuals involved foresaw the risks or pratfalls of the decisions they made. Much as we fear death less than we fear the uncertainty of what might come next, we dread the reality that capitalism or democracy cannot pre-empt the future whenever we retroactively concoct blameworthy motives onto past events in this manner.
The best path forward is analogous to the classic arcade game, Frogger. A particular space on the grid or pathway through the maze may be safe one moment and deadly the next. Regulations that restricted your movement through the maze would be disastrous. Even worse, add trucks and other debris that are completely invisible and unforeseeable, even if we were the best Frogger player alive. To add insult to injury, afterwards a consensus emerges that the Frog wanted to be squished by the car so he could take our quarters.
When our first response to an economic problem is to regulate ourselves perpetually out of harm's way, we deny the complexity of our surroundings. A world of "Unknown Unknowns" demands competition, aka continually evolving trial and error by multiple firms, backed by caveat emptor. This contrasts with regulation, the unilateral declaration that one method, often believed preferable to all others, is now mandatory.
The scariest takeaway from "Engineering the Financial Crisis," is that these Engineers remain at their desks, tightening the screws.
Friedman and Kraus eviscerate the six most popular explanations (Too Big Too Fail, Corporate Compensation, Greenspan ignoring the Taylor Rule, "Animal Spirits," Fannie & Freddie, "Deregulation" of "Shadow Banking"). Several financial regulations, each often disconnected from the others and with its own historical rationale, compounded together in a chain reaction. Public demands for security against the future unwittingly created a straitjacket constricting the options of otherwise healthy financial markets. Too many airbags during a car crash suffocated the driver, while their premature deployment obstructed his vision, causing novel accidents.
Even if you do not care to know why the Crisis happened, this book is valuable for the out-of-body experience it masterfully elicits. The political theorist of the duo, Jeffrey Friedman, induces a parable of human fallibility. Our societal conception and response to the Crisis illuminates the epistemological zeitgeist of our technocratic time. Disaster naturally progressed from our inescapable "radical ignorance," not just on a personal but systemic level, which the most efficacious bureaucracies and even markets cannot elude forever.
Each popular hypothesis about the Crisis assumed that at least some of the individuals involved foresaw the risks or pratfalls of the decisions they made. Much as we fear death less than we fear the uncertainty of what might come next, we dread the reality that capitalism or democracy cannot pre-empt the future whenever we retroactively concoct blameworthy motives onto past events in this manner.
The best path forward is analogous to the classic arcade game, Frogger. A particular space on the grid or pathway through the maze may be safe one moment and deadly the next. Regulations that restricted your movement through the maze would be disastrous. Even worse, add trucks and other debris that are completely invisible and unforeseeable, even if we were the best Frogger player alive. To add insult to injury, afterwards a consensus emerges that the Frog wanted to be squished by the car so he could take our quarters.
When our first response to an economic problem is to regulate ourselves perpetually out of harm's way, we deny the complexity of our surroundings. A world of "Unknown Unknowns" demands competition, aka continually evolving trial and error by multiple firms, backed by caveat emptor. This contrasts with regulation, the unilateral declaration that one method, often believed preferable to all others, is now mandatory.
The scariest takeaway from "Engineering the Financial Crisis," is that these Engineers remain at their desks, tightening the screws.
April 29, 2016
One of the more original books on the financial crisis of 2008, with a striking thesis backed-up by solid numbers.
The main argument of the book is that it was changing capital adequacy requirements (CARs) by bank regulators which lead to an explosion of mortgage-backed securities, and their consequent decline. The authors show that after the promulgation of the "Recourse Rule" in 2001, which allowed banks to buy triple-A rated asset-backed bonds using only 1/4 the capital required of business loans, there was a jump in the issuance such bonds, from $500 billion in 2000 to well over $2 trillion in 2006, mainly in mortgages, followed of course by a steep drop. Basically, the authors argue that while commercial banks were relatively well-capitalized in the U.S., at about 8-10% leverage, the "hard floor" of CAR requirements meant banks worked in the early 2000s to expand the amount of the "cushion" of CAR even while keeping their overall leverage stable, namely by expanding the amount of assets like those bonds that required lower CAR weights (sorry readers, it's is too complicated to go into depth here). So the leverage levels even dropped slightly in the 2000s, while the CAR based on risk-weights rose to about 14-15%. Combined with the new Mark-to-Market accounting rules, such as FAS 115 and 157 (don't worry about it), which suddenly depleted those capital cushions when fire-sales ensued to restore capital and asset prices dropped, this caused banks to ratchet back business lending by almost 80%, and thus start a recession which actually began in December 2007.
The authors do a great job of demolishing many other explanations for the crisis (Fannie's and Freddie's debt stayed pretty steady throughout the crisis, and Glass-Steagall had nothing to do with any of this). Importantly, the authors also show that bankers weren't merely feeding at the compensation trough or gorging on risk, they sincerely believed these bonds would pay off, as demonstrated by their concentration in only the most riskless versions of mortgage debt. Still the book left me with many questions. For one, the authors focus on the commercial banks as opposed to the investment banks where the September 2008 crisis was focused (although they do show that such investments banks held only about $250 billion in private mortgage-backed bonds, which are but a small part of the $2 trillion in private bonds)), and they don't explain how extremely low leverage ratios in those banks squared with the CAR requirements of commercial banks (they just mention they didn't apply). Overall, however, this book should help clarify and shape everyone's views on the crisis of 2008.
The main argument of the book is that it was changing capital adequacy requirements (CARs) by bank regulators which lead to an explosion of mortgage-backed securities, and their consequent decline. The authors show that after the promulgation of the "Recourse Rule" in 2001, which allowed banks to buy triple-A rated asset-backed bonds using only 1/4 the capital required of business loans, there was a jump in the issuance such bonds, from $500 billion in 2000 to well over $2 trillion in 2006, mainly in mortgages, followed of course by a steep drop. Basically, the authors argue that while commercial banks were relatively well-capitalized in the U.S., at about 8-10% leverage, the "hard floor" of CAR requirements meant banks worked in the early 2000s to expand the amount of the "cushion" of CAR even while keeping their overall leverage stable, namely by expanding the amount of assets like those bonds that required lower CAR weights (sorry readers, it's is too complicated to go into depth here). So the leverage levels even dropped slightly in the 2000s, while the CAR based on risk-weights rose to about 14-15%. Combined with the new Mark-to-Market accounting rules, such as FAS 115 and 157 (don't worry about it), which suddenly depleted those capital cushions when fire-sales ensued to restore capital and asset prices dropped, this caused banks to ratchet back business lending by almost 80%, and thus start a recession which actually began in December 2007.
The authors do a great job of demolishing many other explanations for the crisis (Fannie's and Freddie's debt stayed pretty steady throughout the crisis, and Glass-Steagall had nothing to do with any of this). Importantly, the authors also show that bankers weren't merely feeding at the compensation trough or gorging on risk, they sincerely believed these bonds would pay off, as demonstrated by their concentration in only the most riskless versions of mortgage debt. Still the book left me with many questions. For one, the authors focus on the commercial banks as opposed to the investment banks where the September 2008 crisis was focused (although they do show that such investments banks held only about $250 billion in private mortgage-backed bonds, which are but a small part of the $2 trillion in private bonds)), and they don't explain how extremely low leverage ratios in those banks squared with the CAR requirements of commercial banks (they just mention they didn't apply). Overall, however, this book should help clarify and shape everyone's views on the crisis of 2008.
August 28, 2012
Masterful! This book, co-authored by an economist and a political scientist, assesses the various theories of the cause of the economic crisis against the actual econometric data which might refute or corroborate those theories. They conclude that the major factor which allowed the burst of the housing bubble to become a financial crisis was capital adequacy regulation and accounting regulation. Also, they proffer a deeply considered theory of ignorance--inevitable in a world overflowing with data of conceivable importance--as being an ineluctable part of the problem. They conclude by urging a heterogeneous approach to the economy, the opposite of homogenizing regulation, to reduce aggregate risk in the economy. Highly recommended!
June 12, 2018
Great book IF your interests in the financial crisis go beyond the superficial. If you're vaguely interested in a quick, non-technical rundown of the crisis, this is not the book for you. It was helpful to have a background in finance and economics before reading, but is written in a way where I'd imagine an enthusiastic layperson wouldn't find it overly daunting.
April 25, 2016
By far the best book, and writing in general, I have read on the financial crisis. Kraus and Friedman bring a level of analysis that is unparalleled in revealing the myths and the (for now) known truths of the financial crisis, as well as a very compelling theory for its cause.
February 15, 2013
Friedman offers a more in-depth analysis on government policies that have contributed to the financial crisis more than any other books I've read.
Displaying 1 - 6 of 6 reviews