Was it the Lehman Brothers Crash? Here's What Really Caused the Great Recession

Pundit Brenton Smith recently wrote a piece on the role of credit default swaps (CDS) in the 2008 financial crisis. He argued that the “naked” CDS (in which investors can bet that certain institutions will default without having an offsetting interest in the success of the company) was a major cause of the crisis, both because of conflicts of interest and also because issuers of credit default swaps, like AIG, were required to only hold collateral and not liquid reserves to fund potential claims.

While I agree that credit default swaps were a major pain point during the crisis, they were symptomatic of deeper issues within the financial sector, and neither outlawing nor somehow better regulating them would have prevented the crisis. Bad loans would still have been issued, securitized, and sold to investors gauging their risk with faulty ratings.

To be fair, some of the author’s criticisms of the “naked” CDS are valid. More stringent reserve requirements might have buttressed AIG from total collapse and in a more perfect world, the upper echelon of Goldman Sachs would be on the chopping block for gross conflicts of interest.

But the real problems lie deeper.

Twelve megabanks — only .21% of the overall number of banks in the U.S. — control about 69% of the financial system’s assets. The failure of any one of these firms is guaranteed to send shock waves throughout the economy. Many of the biggest banks are also ridiculously over-leveraged. Even under Basel III, banks are allowed to fund up to 97% of their assets with borrowed money. Financing investments via debt amplifies both the upside and downside for these institutions, which is fine for them as they remain protected from catastrophic failure by the public purse. This public guarantee both encourages debt financing and facilitates it, as lenders are willing to extend credit at lower rates to institutions with understood government backing.  

While there are some positive regulatory moves on the table — such as increasing capital requirements — the overall effect of regulation has been largely negative.

The barriers associated with breaking into the financial sector are daunting and the enormous costs of regulatory compliance ensure that the financial system is dominated by a handful of big players. The biggest banks are better able to absorb the overhead that comes with compliance and are largely insulated from upstart newcomers via a regulatory moat. Paypal faced these hurdles as it was taking off and bitcoin-based payment processors are feeling the same kind of pushback today. For the most part, potential innovators are kept out.

Regulation will have to accomplish a few key things to prevent another banking meltdown.

It will have to embrace innovation. If barriers to entry prevent new people from trying new things, the financial sector we have in a century will look much the same as the one we have today. It will also have to reduce compliance costs. Massive overhead naturally selects for massive firms that threaten the economy when they fail. Finally, it will have to force banks to bear the full extent of their losses. Guaranteeing banks from failure both encourages them to take on more risk, and allows them to use greater leverage through the public underwriting of their obligations.

How to actually arrive at any of these goals is another discussion altogether and whether our political system is willing or able to take us there is yet another debate. But for this stage in the conversation, we have to recognize that there are some fundamentally broken pieces of our financial system that need to be reordered completely. Piecemeal regulation isn’t going to cut it, and in fact might make it worse. If we put out every little brush fire, we’re only guaranteeing the entire forest will one day go up in smoke.


Related Reading: A Crisis of Politics, Not Economics: Complexity, Ignorance and Policy Failure, Jeffrey Friedman

Related Listening: Anat Admati discussing capital requirements and financial sector reform on Econtalk.

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Jeff Fong

Jeff covers the intersection of politics, economics, and technology. He currently lives in the SF Bay Area where he works at a start up focused on urban transportation.

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