The University of Pennsylvania Press has concluded the peer review of "Capitalism and the Crisis: Regulation, Competition, and Systemic Risk," by Jeffrey Friedman and Wladimir Kraus. The book will be published on September 1, 2011.
This book takes up the "Basel thesis" laid out in Critical Review's special issue on the crisis by Viral Acharya and Matthew Richardson ("Causes of the Financial Crisis") and by Juliusz Jablecki and Mateusz Machaj ("The Regulated Meltdown of 2008"): capital-adequacy regulations promulgated in the Basel I accords (1988), the U.S. financial regulators' Recourse Rule (2001), and Basel II (2004) significantly contributed to the financial crisis by inadvertently encouraging banks to purchase triple-A-rated mortgage-backed securities.
Chapter 1 rebuts various myths about the crisis, including the notion that the "too big to fail doctrine" and the performance incentives used by banks encouraged deliberately reckless risk-taking; that the crisis was caused by "irrational exuberance"; and that it was caused by deregulation.
Chapter 2 briefly reviews the rationale for capital-adequacy regulation and the provisions of Basel I, the Recourse Rule, and Basel II. The chapter also shows that U.S. commercial banks invested three times the proportion of their portfolios in mortgage bonds as did other U.S. investors, yet that banks preferred the safest mortgage bonds, those issued by GSEs, at a 2:1 ratio to privately issued mortgage bonds; and that all of the privately issued mortgage bonds bought by banks appear to have been relatively low-yielding, less-risky triple-A bonds. These facts suggest that capital arbitrage was a major motive. Yet under the Recourse Rule and Basel II, the same capital relief could have been achieved by buying higher-yielding, riskier double-A bonds, suggesting that banks were being prudent while operating within the Basel/Recourse Rule framework. Finally, the chapter discusses the paradox that capital arbitrage did not--contrary to the conventional wisdom--increase banks' leverage overall. Why, then, did banks want capital relief? The chapter answers by distinguishing between regulatory capital cushions and actual capital cushions. Regulatory capital cushions entail legal penalties if they are used, and thus are as good as worthless to banks. Real capital cushions, in contrast, offer security against future losses. By purchasing assets such as triple-A and GSE mortgage bonds that required less regulatory capital, banks were able to increase their real capital cushions.
Chapter 3 discusses the interaction of the Basel rules with fair-value (mark-to-market) accounting regulations that translated market unease (and eventually panic) about the value of mortgage-backed bonds into dollar-for-dollar subtractions from banks' regulatory (and real) capital cushions, dramatically reducing banks' lending capacity from the summer of 2007 through 2008. It also discusses the interaction of the Basel rules with the SEC's regulatory protection of the incumbent rating agencies--Moody's, S&P, and Fitch--whose ratings were given legal status by capital-adequacy regulations.
Chapter 4 considers the reasons for these regulatory errors and the implications for capitalism and regulation. The basic conclusion is that the regulators, like the bankers, were ignorant of the unintended consequences of their actions, but that the regulations had the inadvertent effect of making the entire economic system more fragile by homogenizing banks' asset purchases in pursuit of regulatory capital relief.
This book was written and edited for adoption in courses on the financial crisis, modern government, and related subjects in courses offered by American Studies, economics, history, political science, and sociology departments. It is accessible to educated laymen and nonspecialists.
--Jeffrey Friedman and Wladimir Kraus