Restoring Financial Stability: Book review

Charles Goodhart 24 April 2009

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The production of this book has been a remarkable and praiseworthy enterprise. At the end of 2008, following an initiative by Tom Cooley and Ingo Walter, the Dean and Vice-Dean, its main authors and organisers, Viral Acharya and Matthew Richardson, realised that the faculty of the Stern School of Business at New York University were optimally placed to comment on and analyse the many facets of the on-going financial crisis. They got 33 colleagues to contribute to the 18 chapters, from Acharya to Zemel, in record time, (I wonder if any promised contributions had to be scratched because of lateness), and then had Wiley’s, to whom praise is also due, publish it within a couple of months – with no shortfall in quality – by the end of March.

So the book represents a comprehensive and up-to-date account of almost all the main features of the crisis, despite the latter’s rapid evolution and metamorphoses. Only in the instance of Chapter 15, on “The Financial Sector Bailout”, did I feel that events had moved on significantly since the authors had stopped writing. Moreover, despite the speed of the exercise, the quality was generally very high.

This book is the best available on this extraordinary and fascinating subject. Indeed, I would rank the Prologue, on ‘The Financial Crisis of 2007-8: Causes and Remedies’, (which is the longest chapter in the book, pp 1-56), as the best single paper yet written on the background and development of the crisis. The book is worth buying for this one chapter alone.

For the rest, the book is divided into seven parts, generally starting with a brief introductory and summary note, followed by some two, or three, somewhat longer chapters developing the themes involved. These cover:

  • Causes, with chapters on securitisation, leverage, and rating agencies (Chapters 1-3).
  • Institutions, with chapters on government-sponsored enterprises, large complex financial institutions, and hedge funds (Chapters 4-6).
  • Governance and Structure, with chapters on corporate governance, remuneration, and fair value accounting (Chapters 7-9).
  • Derivatives, with chapters on derivatives, centralised clearing, and short selling (Chapters 10-12).
  • The Role of the Fed, with chapters on regulating systemic risk and lenders of last resort (Chapters 13, 14).
  • The Bailout, with chapters on bailout mechanisms, the housing market, and General Motors (Chapters 15-17).
  • International, with a single chapter (18) on international regulation.

Given that the authors are from a School of Business and Finance, the best Sections were those that focussed on their professional expertise, Sections 1-4 and 6, which I heartily recommend.

There are, however, two huge gaps.

First, outside the housing market, there is really nothing on the macroeconomy, nothing on the move of the USA and the rest of the world into deep recession, nor on the official responses to this in the shape of interest rate cuts, quantitative easing, and fiscal policy. The introductory note on “The Role of the Federal System” was insufficient and did not cover the ground properly.

Second, this is an almost entirely US-focussed book. There is little or no mention of events abroad; thus, Northern Rock, IKB, Iceland and Ireland do not appear in the index. Again the one chapter on international regulation was also insufficient and did not cover the subject matter adequately. It is a US-centric book – anyone wanting a more global perspective will have to look elsewhere. Even in the regulatory arena, there was hardly anything on the crucial issue of the balance between “home” and “host” supervisory authority responsibilities.

The authors are not shy about coming out with their own proposals for remedying and restoring the financial system. For the most part, I found their suggestions attractive, for example on securitisation, hedge funds, remuneration, centralising clearing, short selling, mortgage reorganisation, and support for GM. The authors rather hedged their bets on ratings agencies. Views on Fair Value Accounting (FAS 157) tend to be polarised; the author here (Stephen Ryan) is one of the supporters. It is all too rare to get a balanced view.

Perhaps because I have a personal position myself on many of the issues involved in financial regulation, I found several of their proposals in the field misguided. These are:

  • Have a separate regulator/supervisor for large complex financial institutions (Chapter 5).

But US financial regulation/supervision is already too Balkanised into separate fiefdoms. The US needs consolidation along the lines of the Paulson plan instead.

  • Make lending of last resort conditional on previous good behaviour (Chapter 14).

As is surely obvious from the current crisis, the threat of denial of liquidity assistance in a crisis is just not credible, and rightly so. We need to devise sanctions that penalise banks misbehaving in normal (good) times, not deny liquidity assistance when the crisis hits.

  • Have a joint public/private insurance scheme to guard against systemic risk (Chapter 18).

I should, however, add both that much of the chapter on the need to guard against, and to measure, systemic risk is excellently done, (although there is no discussion about trying to introduce counter-cyclical regulatory measures), and that their proposed scheme in this respect is much better thought out, and superior to, most other proposals along these lines.

That said it still suffers from the defects – pointed out by behavioural economists – that people and markets suffer from disaster myopia in good times, and excessive aversion just after disaster strikes. The authors, like most US economists, believe that markets are always better at pricing risk than the authorities. When it comes to an assessment of tail risk, I am not in that camp, but in this case I admit that there is a fair argument to be made and that the authors have made the best case to date for a partially private insurance scheme.

So I do have a few niggles here and there, but overall the book was a brilliant idea, superbly executed, and has first-class content. Buy it.

References

Viral Acharya and Matthew Richardson (eds), New York University Stern School of Business (2009) Restoring Financial Stability: How to Repair a Failed System, Wiley, March

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Topics:  Financial markets Global crisis

Tags:  financial crisis, NYU Stern, world financial system

Emeritus Professor in the Financial Markets Group, London School of Economics

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