The Global Financial Crisis

The Global Financial Crisis, recently published by Foundation Press, describes the basic causes of the financial crisis; analyzes the regulatory, political and market responses to it; and discusses the merits of various recent reform proposals. Written by Hal S. Scott, the Nomura Professor and Director of the Program on International Financial Systems at Harvard Law School, the book represents perhaps the most learned and succinct account of the financial crisis to date. Its careful focus on the terms of regulation – existing and proposed, U.S. and international – and its clear explanation and analysis of scholarly studies set it apart from many other recent offerings on this topic. The author offers rich, forthright insights and skillfully situates events in their historical and regulatory context. The book will likely hold strong appeal for scholars and policy makers and for others with an interest in rigorous, concise analysis of perplexing policy questions.

The book is structured as follows:

• Chapter 1 – causes and severity of the financial crisis
• Chapter 2 – measures taken throughout the crisis to stabilize the financial system
• Chapter 3 – problems afflicting the housing market and proposed solutions
• Chapter 4 – proposals for reforming regulatory rules
• Chapter 5 – proposals for reforming U.S. regulatory structure
• Chapter 6 – international responses to the crisis

Each chapter is further divided and sub-divided into topics, each of which is just a page or two in length. This structured approach aids understanding without compromising the book’s readability. In this brief post I touch on some of the material covered in the book. I cannot convey the depth of the author’s analysis or reproduce his succinct and engaging literary style.

Chapter 1 describes the causes of the financial crisis and assesses is likely severity. The author describes the transition from subprime crisis to financial crisis and the further transition to an economic crisis and deep recession, outlining the causes and presenting numerous economic indicators of the evolving crisis. “Suffice it to say,” Professor Scott writes, “there is enough blame to go around.” The chapter traces the path of economic events, from the surge in subprime loans until 2006 to the rise in serious delinquencies as the housing market deflated. Homeowners with negative equity, a situation in which one’s mortgage exceeds the home value, are concentrated in a small number of states, with Nevada (48% of mortgages) and Michigan (39%) of most concern. The chapter concludes with an expression of measured optimism, commenting on the appearance of “green shoots” with “unclear implications.”

Chapter 2, perhaps the most compelling chapter in the book, discusses the nature of systemic risk as well as the efforts from late 2007 through 2009 to stabilize the financial system, through emergency acquisitions, monetary policy, and public capital injections.

The author assesses in detail the role of systemic risk in the financial crisis. Systemic risk refers both to a financial shock that simultaneously affects numerous financial institutions and markets as well as to the risk of a chain reaction – or contagion – which occurs where the failure of one financial institution harms others. The two meanings are interrelated because a major shock can trigger a chain reaction among institutions, Professor Scott explains. Other factors may also contribute to chain reactions, such as the interconnectedness among financial institutions. For example, defaults by one institution on its counterparty obligations – on, say, a credit default swap (CDS), a type of standardized derivative contract – may bring down its counterparties. Chain reactions may also arise from “imitative runs,” in which customers attribute the financial problems of another financial institution to their own.

In assessing the role of systemic risk in the financial crisis, Professor Scott focuses on the risks associated with the failure of banks and hedge funds and on the potential impact of CDS defaults on counterparties. As the author notes, a major concern of the Lehman Brothers bankruptcy and a reason for the AIG rescue was the potential impact of CDS defaults on counterparties and the resulting risks to the financial system. The chapter’s approach is to raise issues – such as whether hedge funds pose significant systemic risk to the financial system and by what mechanisms any such risk would be transmitted – and to marshal the available evidence, explaining it and discussing its limitations. Unavoidably, the conclusions are cautious, measured and qualified.

The discussion of efforts to stabilize the financial system is particularly absorbing. The author analyzes each of the Federal Reserve’s and FDIC’s major initiatives as the crisis heightened, beginning with changes to the Fed’s discount window lending in late 2007. The author shows how the programs have transformed the Federal Reserve’s balance sheet and expresses concern about the substantial credit risks it now faces. It should no longer engage in insufficiently collateralized lending, Professor Scott recommends. Furthermore, according to the Committee on Capital Markets Regulation (of which Professor Scott is Director), any existing loans to the private sector that are uncollateralized or insufficiently collateralized should be transferred to the balance sheet of the federal government and thereby accounted for as part of the federal budget. The credit and other risks facing the Federal Reserve increase the likelihood of diminished independence, the author cautions, and the possibility of increased dependence on the Treasury and vulnerability to political pressures, among other dangers. As new financial legislation currently wends its way through Congress, these warnings appear to be borne out.

The chapter also considers the receiverships of AIG and government-sponsored enterprises (principally Fannie Mae and Freddie Mac), the engineering-assisted transactions (including JP Morgan’s acquisition of Bear Stearns and Bank of America’s purchase of Merrill Lynch), as well as other measures adopted to stabilize troubled financial institutions. In doing so, the author discusses the conduct of the major regulators, including the Securities and Exchange Commission (SEC), which he does not spare from criticism. Professor Scott refers to the Congressional testimony of Chairman Cox, just days before Bear Stearns’ collapse, that Bear had “high quality collateral” and to the distinction Chairman Cox later drew – apparently to deflect criticism of his testimony – between Bear’s adequate capital and its inadequate liquidity. But the SEC was also responsible for supervising liquidity, Professor Scott writes. Moreover, the SEC had just 25 professional staff, mostly lawyers, to regulate the major investment banks as consolidated supervised entities. In all, the chapter is wide-ranging, makes extensive use of current empirical studies and links many issues arising in the context of stabilization efforts, such as who should supervise investment banks, with those now actively being debated by Congress.

Chapter 3 offers a more detailed discussion than the first chapter of problems associated with the depressed housing market. It also analyses the regulatory responses to them. We learn that delinquencies were not concentrated in subprime loans; over 50% of all foreclosures have been on prime loans. The regulatory responses, such as initiatives to modify mortgage terms, appear meager relative to those adopted to stabilize the financial system, although Professor Scott cautions that doing too much to rehabilitate the housing market may add significant cost to mortgage borrowing and subject banks to increased risk of liability.

Attention is given in the chapter to modifying mortgages, including to the legal obstacles that arise from contracts related to the securitization of mortgages. In particular, servicers – parties that are contractually required to collect mortgage payments underlying securities – face potential liability and incentive problems in modifying loans. The chapter also includes analysis of several innovative suggestions by prominent economists for stabilizing home prices.

Chapter 4 discusses options for reform in the following areas: capital adequacy rules; regulatory coverage of institutions (including the merits of regulating hedge funds and sovereign wealth funds); product coverage (focusing on credit default swaps); the securitization process; accounting rules concerning fair value and consolidation; executive compensation; and liability. At some 70 pages in length, it is the longest chapter in the book.

In each enumerated area, the author weighs competing approaches to tackling identified problems, presenting the relevant historical and regulatory context and providing empirical evidence. His analysis is characteristically forthright. For example, in the area of capital adequacy rules, Professor Scott considers the Basel rules as adopted in the US, noting regulators’ insistence on US-specific modifications to Basel I. These modifications included revised capital floors and an added minimum current leverage ratio (which was not a requirement under Basel). Without the leverage ratio, Professor Scott observes, banks’ leverage and losses would have been even greater. But this does not excuse departure from the Basel methodology: either it is correct or it is not. “If it is not correct, it should probably be abandoned.” The author also suggests that the application of SEC-modified Basel II rules to investment banks – with disastrous consequences – should be considered in determining the application of Basel II rules to banks in the US.

In the discussion of the regulatory coverage of institutions, Professor Scott tackles structural questions, including whether investment banks (now subsidiaries of bank-holding companies, in the case of Goldman Sachs and Morgan Stanley) should run hedge funds and proprietary trading desks. The answers depend on whether affiliating these activities with investment banking activities magnify the institution’s systemic risk as well as the risk of market manipulation. These are issues inviting further research. All things being equal, Professor Scott writes, “internal hedge funds and proprietary trading desks are likely to have a much higher degree of ‘connectivity’ and be located closer to the heart of the financial system,” possibly justifying restrictions on the activities of investment banks. A related question, also considered, concerns the merits of re-imposing Glass-Steagall legislation to separate investment banking and commercial banking. Drawing on research of the Committee on Capital Markets Regulation (CCMR), Professor Scott explains why he would oppose such a restriction on banking activities.

The chapter also considers reforms of the securitization process, noting several important features of the process. Determining risks in a pool of (securitized) assets is fundamentally different than doing so for a corporate bond issue, the book notes. For securitized assets, the correlation of risks on the underlying assets (such as home mortgages) is crucial; a pool of assets whose risks are highly correlated, such as because of their location (in the same neighborhood, say), would pose greater risks than one that is more diversified. Furthermore, even slight changes in underwriting parameters (in the case of home mortgages) can significantly impact risk. Granular disclosure of the composition of the pool of assets is thus fundamentally important for investors to properly value their investments. Disclosure must also be accurate. In this regard, however, Professor Scott notes that no clarity exists on how due diligence really operates in the securitization context. For example, the author asks, must the underwriter sample particular loans for the accuracy of the information?

Chapter 5 discusses the existing, highly fragmented U.S. financial regulatory structure and identifies several major weaknesses with it. These include difficulties in implementing overall policy direction, unintended gaps in product regulation, and a lack of effective coordination among regulators and with counterpart agencies internationally. The chapter discusses proposals for reform, including those of the CCMR. The CCMR’s proposals, available here , relied on the article by Professor Howell Jackson of Harvard Law School entitled “A Pragmatic Approach to the Phased Consolidation of Financial Regulation in the United States” (2008), which was profiled on the Harvard Law School Forum on Corporate Governance and Financial Regulation here. The extensive proposals envisage a unitary regulator in the mould of the UK Financial Services Authority, operating in conjunction with Federal Reserve as central bank. The chapter concludes with Professor Scott expressing fears that the already broken regulatory structure “may get worse,” a risk he attributes “not to the failures of the Obama Administration but the deep forces at work against regulatory structural change.” These views were expressed several months ago.

Chapter 6, the final chapter, briefly outlines international responses to the financial crisis from the Financial Stability Board (formerly the Financial Stability Forum), the G-7 Finance Ministers and the G-20. Professor Scott suggests that nations should strive for compatible – rather than fully harmonized – rules in the short run and predicts some form of global regulation in the long run for the global financial system. He believes, however, that regulatory enforcement will remain a domestic matter for the foreseeable future.

Professor Scott’s book reflects his vast knowledge of international financial systems, gained over the past 35 years of teaching at Harvard Law School. The book draws extensively on current scholarly studies, which are clearly explained. It also reflects the pragmatic concerns of a policy maker and corporate director – roles that Professor Scott has played as a former Governor of the American Stock Exchange and current independent director of Lazard, Ltd. The book is written in a forthright, highly engaging style. Its material is current and its depth of analysis ensures it will remain so whatever legislative reforms are eventually adopted. The book will reward anyone interested in the global financial crisis, in the analysis of difficult policy questions, and in the confluence of political, commercial and other forces that operate in the domain of high finance.