A major new publication which challenges the myths and conventional wisdom regarding the recent banking crash.

SUMMARY
• To some degree, UK and US monetary policy was to blame for recent problems in financial markets, thus replicating previous boom and bust episodes both in the UK and overseas.

• US government policy, by encouraging banks to lend to people with poor credit records, was a contributory factor in undermining US banks’ balance sheets. This problem was exacerbated both by the presence of the securitisation agencies, Fannie Mae and Freddie Mac, and by dishonest behaviour by some US borrowers.

• International bank capital regulation did not reduce the risk of insolvency. It may have contributed to the crisis, however, by encouraging all banks to have similar risk models, by lulling banks’ counterparties into a false sense of security and by making banks accountable to regulators rather than to market participants.

• Both international and domestic regulation also encouraged banks to make their activities more opaque than would otherwise have been the case, thus contributing to the build-up of risk.

• The management of the crisis by the UK public authorities exacerbated the problems rather than eased them. Both the slow reaction of the Bank of England and the use of market-value accounting rules in inappropriate circumstances made liquidity problems in the wholesale banking market worse.

• Market monitoring of banks was less effective than it should have been. The presence of regulation was probably a contributory factor to this. Banks over-leveraged, however, in ways that, ex post, were clearly inappropriate.

• Short selling by hedge funds played no significant part in the crisis. The use by regulators of credit ratings to set regulatory capital has undermined their integrity. As such, attempts to regulate ratings agencies and hedge funds further are likely to be damaging.

• While regulators might now understand how to prevent the crash of 2008 from happening again, they have demonstrated that they have no special gifts of foresight that justify confidence in the view that regulation would be effective in preventing future problems in financial markets. In general, the public authorities welcomed the innovations in financial markets that many commentators suggest are at the root of the problems we face now.

• Public choice economics suggests that financial market regulation should be based on very clear principles, with regulators being given specific objectives. This involves a complete reversal of recent trends in financial regulation.

• The most important specific objective that should be given to bank regulators is the protection of the payments system. Regulation should also ensure that those who provide capital to a bank should not be sheltered from the risks.

• Specific legal mechanisms should be brought in to achieve these goals. A variety of approaches is possible, and these would not involve detailed regulation of the activities of banks.

• Such an approach to regulation would ensure that the risk of failure fell squarely on a bank’s shareholders and counterparties rather than on taxpayers.

Visit Verdict on the Crash: Causes and Policy Implications Download Page

You can download full publication in PDF format.

First published in Great Britain in 2009 by
The Institute of Economic Affairs
www.iea.org.uk  
2 Lord North Street
Westminster

The mission of the Institute of Economic Affairs is to improve public understanding of the fundamental institutions of a free society, by analysing and expounding the role of markets in solving economic and social problems.

FORWARD
The typical view of the financial market crash of 2008 is that it resulted from the unrestrained misbehaviour of bankers arising from the absence of proper regulatory constraints. While bankers may not have behaved as prudently as we would have hoped, we need to ask ‘why not?’ Lack of regulation cannot be the main answer as there have clearly been times when financial markets have been regulated much more lightly. If we do not look for the underlying, as opposed to the popularly assumed, causes of the financial crash then we will conclude, as our prime minister has, that regulatory oversight must be tightened. ...

EDITOR'S PREFACE
In popular folklore, the causes of the crash of 2008 are pretty clear. Unregulated financial markets were allowed to run wild, creating new products that nobody understood; short-term profits were put ahead of the importance of ensuring a long-term return; and incentive structures were such that huge bonuses were paid to bankers while they destroyed the value of their companies, thus putting the whole economy at risk.

This may or may not be true as a partial explanation, but folklore has also gone on to suggest that these problems demonstrate that what is needed is more intrusive systems of financial regulation. There has been no better manifestation of this than the comments by the Archbishop of Canterbury and the Archbishop of York, who made these very points, in one case in rather colourful language. ...

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