Basel Accords, Not Fan, Fred or Bonuses, Caused the Crisis

The financial crisis of late 2008 has been attributed to any number of causes. But we don't want complex stories, we want simple ones that allow us to affix blame. So most investigations into the financial crisis involve determining of whom it can be said: if they didn't behave the way they did, everything would have been just fine.

For many conservatives, the people to blame were executives at the government-sponsored enterprises Fannie Mae and Freddie Mac, whom they believe recklessly purchased mortgage-backed securities (MBS) by the billions because the government would intervene if things went south. Many liberals theorized that outsized Wall Street bonuses led bankers to put short-term profits ahead of long-term security, while deregulation of the financial sector allowed them to get away with it.

Jeffrey Friedman and Wladimir Kraus, in their new work Engineering the Financial Crisis, seek to elevate empiricism in the debate. They ultimately don't buy either popular explanation, but they do claim to have found the true culprit. The financial crisis would not have happened, they argue, if developed countries had not adopted something that you've probably never heard of called the Basel Accords. Their assessment has the potential to shape the debate about the causes of the 2008 financial crash going forward.

Friedman and Kraus, respectively a political scientist and an economics doctoral student, are not whom you might first turn to as authorities on the economic downturn. Their approach is straightforward: they simply gathered all the preeminent explanations of the crash, and then assessed them one-by-one, looking for confirming or discrediting evidence. Friedman first brought together many credible accounts of the collapse in the 2010 book What Caused the Financial Crisis, which featured chapters by many prominent economists and finance experts, including the Nobel Prize winner Joseph Stiglitz from the left and Stanford economist John Taylor from the right.

In Engineering the Financial Crisis, Friedman and Kraus examine the most convincing arguments presented by our more prominent economists. They dispense with the case, presented by Stiglitz and others, that Wall Street compensation schemes led to excessive risk-taking by pointing out that there's almost no evidence whatsoever to support that view. They can find only one study that even purports to connect bank compensation schemes to overinvestment in risky securities.

Similarly, Friedman and Kraus brush off the Fannie/Freddie thesis. They acknowledge that the two GSEs played a significant role in inflating the housing bubble, pointing out that they "funded 45 percent percent of all mortgages outstanding as of the second quarter of 2008." Nevertheless, they show that the market never actually perceived the GSEs' problems as a crisis.

The price of Treasury debt never spiked above that of GSE debt in the way that it did for private banks, signaling that investors were never concerned that the government wouldn't step in and guarantee GSE debt. In other words, the market always knew that Fannie and Freddie's had government backing, and as a result never panicked about their safety. Based on yield spreads, "investors were about three times as concerned about the default risk of the banks as they were about the default risk of Fannie and Freddie."

The one explanation that Friedman and Kraus believe has supporting evidence is the theory that bad incentives created by the Basel I and II international financial regulations. These were rules first developed and signed on to by G-10 nations in Basel, Switzerland, in 1988, that established reserve requirements for banks.

The idea is simple: the rules included different minimum reserve requirements for different asset classes, and mandated too-low reserves for mortgage-backed securities (which both regulators and ratings agencies regarded as safe at the time). The more MBSs banks had on their books, the less cash they had to keep in the vault to meet regulatory requirements, leaving them with more capital with which to seek out profits.

The result was that commercial banks took on more MBSs than they would have without the regulations, only to find out once the bubble burst that their "safest" assets were in fact the most risky. This story not only describes a plausible mechanism by which banks wound up with far too many risky asset-backed securities in the fall of '08, but it also helps explain why the financial crisis struck so many developed countries simultaneously.

Friedman and Kraus provide a few key datapoints to back up their thesis. Although the U.S. never implemented Basel II, the second round of regulations for how private banks must weigh risks, it did adopt something very close to this rule, called the Recourse Rule. The Recourse Rule encouraged banks to hold highly-rated asset-backed securities and penalized them for holding other assets. Crucially, the Recourse Rule went into effect in 2001, and its introduction was immediately followed by an explosion of private-sector MBS growth. Non-commercial bank investors, not subject to the rule, purchased far fewer MBSs, suggesting the regulations were the driving force.

Why did the experts who agreed to the Basel Accords miss the dangers of MBSs? Friedman and Kraus argue that they did so out of ideology -- not political ideology, but a commitment to technocratic activism. Regulators believe they can solve the market's imperfections. These regulators were no exception.

The original imperfection was the frequency of runs on banks became during the Great Depression; market failure, at least according to some theorists. The solution was depositors' insurance, which in turn created a new problem, namely moral hazard.

If bankers knew the government would step in if they lost money, they might respond by taking on additional risk. The Basel Accords were designed to correct this problem by using reserve requirements to regulate and manipulate banks' risk-taking activities. The regulators failed to appreciate that in doing so, they took on the role of risk managers themselves. Their actions introduced the possibility that they, not the bankers, could cause banks to take on too much risk.