Below are papers, presentations and reports documenting how the Global Financial Crisis happened and what might be done to prevent a crisis of similar severity occurring in Australia, New Zealand or the rest of the world in the future.
Research papers and presentations
Journal of Economic Perspectives, Winter 2009
The GFC has made Brunnemeier's reputation, with Fed chairman Ben Bernanke citing this as one of four things to read on the crisis and its aftermath. The paper gives detailed treatment of the repo market, a market for secured lending which became the centre of the 2008 run on the US financial system.
"What is new about this crisis is the extent of securitization, which led to an opaque web of interconnected obligations."
Brunnemeier is a professor of economics at Princeton specialising in financial crises and mispricing.
US Federal Reserve Staff Working Paper
The basis of Fed chairman Ben Bernanke's important
January 2010 speech Monetary Policy and the Housing Bubble, this paper is notable for two points. It cogently rejects the claim that loose monetary policy created the US housing bubble, setting out how bubbles developed at other times and in other places with a wide variety of monetary settings, and arguing that it is impossible to believe that a mechanism such as a "Taylor Rule" would have prevented the US bubble from developing. And it embraces (after years of Fed neglect) the view that asset prices matter for the real economy, and that they are subject to feedback cycles in the manner long ago set out by Hyman Minsky in his "financial instability hypothesis".
"The rise in the popularity of nontraditional mortgage features may have merely been a symptom of an underlying bubble mentality. While such mortgages allow borrowers to buy more-expensive houses, they do not necessarily make borrowers more willing to pay inflated prices. Rather, these products may have instead provided some support to house prices as they became unsustainable."
The authors were staff economists at the US Federal Reserve.
Paper for the Federal Reserve Bank of Kansas City
The first great paper of the crisis, by one of the people who created it, and published just before the events of September 2008. Gorton showed that the events of 2007 were essentially a traditional "run", but occurring amongst financiers in the "shadow" banking sector of investment banks (rather than amongst everyday people queuing at bank counters). He also sets out how the complexities of the US mortgage securitisation process actually destroyed information.
"The sell-side of the market (dealer banks, CDO and SIV managers) understands the complexity of the sub-prime chain, while the buy-side (institutional investors) does not. Neither group knows where the risks are located, nor does either group know the value of every link in the chain. The chain made valuation opaque; information was lost as risk moved through the chain."
Gorton worked as a key consultant to AIG, and at times wildly underestimated the group's exposure to the sub-prime mortgages which eventually brought down the organisation - a development that threatened the entire world financial system.
Paper for the Max Planck Institute for Research on Collective Goods
Basel III makes marginal changes; Hellwig, one of Germany's leading economists, wants a thorough overhaul, moving away from risk calibration and raising capital requirements very substantially.
"Over the past two decades, this [Basel] system has been developed and ever more refined with an enormous investment of effort and sophistication. Why then could major banking institutions manage their risks and their equity in a way that materially contributed to the crisis? Why was bank capital so low that, shortly after the onset of the crisis, there were doubts about bank solvency, and interbank markets were destroyed by mistrust?"
Federal Reserve Bank of New York staff report, September 2008
A landmark attempt to measure the size of risks stemming from the interconnectedness of the financial system. CoVar is a measure of the value at risk (VaR) of the financial system conditional on institutions being under distress. The paper was influential in the push for "macroprudential" regulation seen in the Basel III framework. This was the second Brunnemeier paper cited by Ben Bernanke as important to understanding the crisis.
"Complementing individual institution Ãs risk monitoring with systemic risk monitoring shifts the focus of supervision from the individual institution to overall financial sector risk and to the potential externalities that actions of individual institutions might impose on the financial system as a whole."
Tobias Adrian runs research into capital markets for the Federal Reserve Bank of New York, specialising in asset pricing and financial intermediation. For Brunnemeier, see above.
Journal of Economic Perspectives, November 2009
While helping smooth their incomes, the financial innovations of the past two decades also encouraged consumers to accumulate even bigger debt loads and hence increased their financial risk:
"The expansion of credit card lending … home equity … lines of credit and cash-out refinancing …mean[s] that more households should be able to smooth their consumption across time… [But it] … exposed many of them to greater risk [of] significantly greater indebtedness, much higher debt payments relative to income, and substantially greater exposure to swings in housing and equity prices."
Dynan, a former US Fed staffer, is vice president and co-ddirector of economic studies at the Brookings Institution.
Sixth Boyer Lecture, 2006
A rare central banker with a deep interest in asset pricing and markets, Macfarlane gives a spookily prescient exposition of looming problems in the world financial system.
"No-one ... has a clear mandate at the moment to deal with the threat of major financial instability associated with an asset price boom and bust. Yet I cannot help but feel that the threat from that source is greater than the threat from inflation, deflation, the balance of payments and the other familiar economic variables that we have confronted in the past."
Ian Macfarlane was governor of the Reserve Bank of Australia from 1996 to 2006. As head of the RBA's research department from 1988, he researched asset price bubbles.
Video of a 13 October 2009 presentation to the New America Foundation
A passionate exposition of the dangers of letting an "equity culture" run finance, the perverse incentives created by the Basel II framework and the comparative success of Australia's financial system.
"We've allowed some monsters to emerge in the world of banking, and I just don't know what to do about it."
Blundell-Wignall is OECD Special Advisor on Financial Markets and a former RBA head of research who has also worked for Citigroup and Bankers Trust.
ECB Working Paper No 1272
Suggests that government guarantees of bank debt create substantial moral hazard effects. The conclusions are based on a natural experiment created when a lawsuit forced the removal of government guarantees from the German Landesbanken. When the guarantees were removed, the banks rapidly reduced credit risk, cut off their riskiest borrowers, increased rates for the remaining borrowers and cut their average loan size. Other German banks, by contrast, were increasing their credit risk at the same time. Note that the Landesbanken then decided to load up on US sub-prime debt, requiring their ultimate rescue by the German government, guarantee or no.
"The results suggest that a credible removal of guarantees will be essential in reducing the risk of potential future financial instability. They also support recent initiatives to impose capital surcharges on the largest banking institutions, which may benefit either from an explicit or an implicit guarantee."
The authors are from the EBS Business School at Wiesbaden and the University of Texas at Austin.
Speech to the Cato Institute, 18 November 2010
Argues that central banks cannot readily recognize bubbles, at least not in time to act pre-emptively. A central bank must be able to do three things: discern bubbles in real time, affect asset prices dependably with monetary policy, and ensure lost output and volatility do not exceeed the benefits of bubble-bursting.
"The bestiary of booms and busts is a far more diverse collection than is usually acknowledged ... This seems like the kind of macroeconomic policy fine-tuning chasing after a shock has passed that Milton Friedman warned against."
Paper for the Centre for the Study of Financial Innovation, 15 September 2009
A "narrow banking" proposal:
"A much needed restructuring of the financial services industry would establish a retail sector focussed on the needs of consumers, rather than on the promotion of products and the remuneration of producers. We could look forward to an industry in which new technologies are used, not just to reduce costs, but to deliver better services."
Draft paper, 4 March 2010
Survey of possible and actual responses, in a useful framework:
"A major policy challenge lies in finding a regulatory structure which generates financial stability, adequate competition and value adding financial innovation."
Davis is research director at the Melbourne Centre for Financial Studies.
Reserve Bank of Australia conference volume, 2008
Improvements in the financial infrastructure - including arrangements for
disclosure and post-trade processing - can help to limit the sharp rise in information asymmetries that can occur during financial crises. Governments can also usefully supply liquidity services to the private sector when asset-market liquidity dries up. But in doing so, arrangements must not encourage financial institutions to take on greater risk than is warranted. Macroprudential supervision may help.
Australian official inquiries into the financial system
The Wallis Inquiry, 1997
Final report Senate Inquiry on bank guarantees, 2009
Final report Australian opinions
Long blog post (or short book chapter draft) on what is needed to make a better system:
"It is crucial to maintain sharp boundaries between publicly guaranteed institutions and unprotected financial institutions such as hedge funds, finance companies, stockbroking firms and mutual funds. Institutions in the latter category must not be allowed to present a threat of systemic failure that might precipitate a public sector rescue, whether direct (as in the recent crisis) or indirect (as in the 1998 bailout of Long Term Capital Management)."
Argues for government to offer lenders mortgage insurance:
"Given the inevitability of the government's role in vouchsafing the financial system, the most efficient, transparent and fair way of doing so would be to sell lenders' mortgage default insurance (LMI) to lenders at a market price."
A similar proposition to the Gruen paper above:
"We propose that the Commonwealth Government sponsor an enterprise - 'AussieMac' - that would leverage the Government's AAA-rating to issue low-cost bonds and acquire high-quality mortgage-backed securities from Australian lenders just as Fannie Mae and Freddie Mac have done in the United States (and the CMHC in Canada) … It would restore stability and long-term confidence to both the primary and secondary mortgage markets in Australia and ensure that the vigorous level of competition that has characterised the housing finance industry will continue into the future."