As each day in the latter half of 2008 brought forth stories of bank failures, and solutions seemed to be discarded almost as soon as they were proposed, a group of 33 academics at Stern School of Business, New York University, sat down to find the answers. These professors, led by dean Thomas Cooley and vice-dean Ingo Water, shaped 18 independent policy papers that proposed market-focused solutions to the problems within a common framework. In December, these copies were sent in great urgency to Washington. Compiled into a book called ?Restoring Financial Stability: How to Repair a Failed System?, it talks about the causes and possible reforms needed to bring the failed system back on track. Viral Acharya, one of the co-editors of the book and professor of finance at the school, shared with Fe?s Shweta Bhanot what he feels will be the last massive crisis the world witnessed. Excerpts:
How different is this book from any other written on financial crisis?
By the end of October last year, a number of us had already started commenting on the crisis independently. However, it was after the collapse of Lehman Brothers and its aftermath that we realised that there will be substantial reforms to regulate the financial sector. Hence, we thought that instead of academic writing on individual pieces, it would be better to collect everything and organise it on a set of common themes. The book is a collective effort of 33 academics at New York University Stern School of Business. The idea was to have an impact on the policy and write white papers, which will be quickly accessible to regulators. The book gives a holistic view of the crisis and identifies reasons of crisis, which in our opinion, is different than what has been written in popular media. It does not react to every single symptom of the underlying issue but goes after four key themes which need to be addressed by future financial regulations.
What are these four key themes?
One needs to first understand what really happened. There was a housing price boom across the board in US, UK, Ireland, Spain and other countries. But the unique thing about US and UK was that when housing prices crashed, the financial sector also collapsed. As per the popular explanation, the housing bubble was due to shift in the banking model from initial to originate and hold loans to originate and distribute loans model, where there is more of securitisation. The banks were making loans and then selling it as packages to investors.
If this was true, the risk should have hit the investors and not the banks. But what we have seen is that banks were bearing the brunt and so the popular explanation fails to tell the story. Instead, the deeper study shows that the banking sector had turned the model of securitisation to take bets. They all started taking tones of triple A-tranches, which is the safest tranche. The property of triple A-tranche in terms of risk return is that it will give more than risk-free rates or government security rates. But it is not completely risk free and the risk will materialise sometime. The risk is that triple A-tranche will get hit if there are a large number of defaults happening from the households in the economy all at once. This happens when there is housing price crash or a deep depression. A triple A-tranche yields 40-50 basis points over the financing cost and the banks started booking it as profits and carried it in the short term. It was this behaviour of the banking sector in the UK and USA of pocketing the carry-as-profits and paying it out cash bonus to traders and originators of securitisations that lead to the crisis. They had not left capital buffer to bear the shock if and when housing prices collapse. In my view, the financial crisis was triggered by a very small set of individuals less than 1000 in the entire banking system in this business who had put the bank capital at massive risk by simply scaling the portfolio these tranches.
The bankers were acting on short-term base and the tail risk of very aggregate nature that at some time the economy may collapse was not taken into account. Further, these institutions were simply too large to fail and the attitude was that the day risk materialises, it will be someone else?s problem. Hence, the proposals for future regulations are around four key themes including short termism, government guarantee, financial sector bets on aggregate risk and opacity of over the counter products and how to regulate them.
Are we really in the recovery path, globally?
We are out of the woods but we are still trying to figure out our direction into civilisation. Worst is over and probably recession might get over in the next two quarters. However, the critical point is how good does the financial sector looks now? Thanks to large amount of government bailouts, the banking sector looks all right but is not in a position of great strength and at extremely capitalised levels, one would want for a thriving economy. There is still an overhang of real estate assets on the banking sector and they will not be able to freely disburse loans towards corporate side. However, we expect lot more corporate bond issues and equity capital reliance for financing. But banks are crucial for day-to-day finance needs, working capital needs, lines of credit, for small borrowers and unrated borrowers, and these will find bank finances not coming easily. It is foreseen that it will take another 12-15 months for banks earnings to reach a level where they can start lending unconstrained to corporate and households. We are out of the recession but will see slow recovery.