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Slapped by the Invisible Hand: The Panic of 2007
TL;DR: Gorton's "The Panic of 2007" garnered enormous attention and is considered by many to be the most convincing take on the recent economic meltdown as mentioned in this paper. But as any banking system, it was vulnerable to a panic, and the events starting in August 2007 can best be understood as a wholesale panic, rather than a retail panic-involving financial firms "running" on other financial firms, resulting in the system becoming insolvent.
Abstract: Originally written for a conference of the Federal Reserve, Gary Gorton's "The Panic of 2007" garnered enormous attention and is considered by many to be the most convincing take on the recent economic meltdown. Now, in Slapped by the Invisible Hand, Gorton builds upon this seminal work, explaining how the securitized banking system, the nexus of financial markets and instruments unknown to most people, stands at the heart of the financial crisis. The securitized banking system is, in fact, a real banking system, allowing institutional investors and firms to make large, short-term deposits. But, as any banking system, it was vulnerable to a panic. Indeed the events starting in August 2007 can best be understood as a panic-a wholesale panic, rather than a retail panic-involving financial firms "running" on other financial firms, resulting in the system becoming insolvent. As the financial crisis unfolded, Gorton was working inside an institution that played a central role in the collapse; thus this book presents the unparalleled perspective of a top scholar who was also a central insider.
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TL;DR: In this article, the authors provide a framework for studying the relationship between the financial network architecture and the likelihood of systemic failures due to contagion of counterparty risk, and show that financial contagion exhibits a form of phase transition as interbank connections increase.
Abstract: We provide a framework for studying the relationship between the financial network architecture and the likelihood of systemic failures due to contagion of counterparty risk. We show that financial contagion exhibits a form of phase transition as interbank connections increase: as long as the magnitude and the number of negative shocks affecting financial institutions are sufficiently small, more "complete" interbank claims enhance the stability of the system. However, beyond a certain point, such interconnections start to serve as a mechanism for propagation of shocks and lead to a more fragile financial system. We also show that, under natural contracting assumptions, financial networks that emerge in equilibrium may be socially inefficient due to the presence of a network externality: even though banks take the effects of their lending, risk-taking and failure on their immediate creditors into account, they do not internalize the consequences of their actions on the rest of the network.
1,187 citations
TL;DR: In this article, the authors argue that the extent of financial contagion exhibits a form of phase transition: as long as the magnitude of negative shocks affecting financial institutions are sufficiently small, a more densely connected financial network (corresponding to a more diversified pattern of interbank liabilities) enhances financial stability.
Abstract: This paper argues that the extent of financial contagion exhibits a form of phase transition: as long as the magnitude of negative shocks affecting financial institutions are sufficiently small, a more densely connected financial network (corresponding to a more diversified pattern of interbank liabilities) enhances financial stability. However, beyond a certain point, dense interconnections serve as a mechanism for the propagation of shocks, leading to a more fragile financial system. Our results thus highlight that the same factors that contribute to resilience under certain conditions may function as significant sources of systemic risk under others. (JEL D85, E44, G21, G28, L14)
898 citations
TL;DR: In the aftermath of the 2008 financial crisis, there seems to be agreement among both academics and policymakers that financial regulation needs to move in a macro-prudential direction as discussed by the authors.
Abstract: Many observers have argued the regulatory framework in place prior to the global financial crisis was deficient because it was largely “microprudential” in nature (Crockett, 2000; Borio, Furfine, and Lowe, 2001; Borio, 2003; Kashyap and Stein, 2004; Kashyap, Rajan, and Stein, 2008; Brunnermeier et al., 2009; Bank of England, 2009; French et al., 2010). A microprudential approach is one in which regulation is partial-equilibrium in its conception, and aimed at preventing the costly failure of individual financial institutions. By contrast, a “macroprudential” approach recognizes the importance of general-equilibrium effects, and seeks to safeguard the financial system as a whole. In the aftermath of the crisis, there seems to be agreement among both academics and policymakers that financial regulation needs to move in a macroprudential direction. According to Federal Reserve Chairman Ben Bernanke (2008): Going forward, a critical question for regulators and supervisors is what their appropriate "field of vision" should be. Under our current system of safety-and-soundness regulation, supervisors often focus on the financial conditions of individual institutions in isolation. An alternative approach, which has been called systemwide or macroprudential oversight, would broaden the mandate of regulators and supervisors to encompass consideration of potential systemic risks and weaknesses as well.
874 citations
TL;DR: In this article, the authors develop a model that speaks to the goals and methods of financial stability policies, and show how in a simple economy where commercial banks are the only lenders, conventional monetary-policy tools such as open-market operations can be used to regulate this externality, while in more advanced economies it may be helpful to supplement monetary policy with other measures.
Abstract: This paper develops a model that speaks to the goals and methods of financialstability policies. There are three main points. First, from a normative perspective, the model defines the fundamental market failure to be addressed, namely that unregulated private money creation can lead to an externality in which intermediaries issue too much short-term debt and leave the system excessively vulnerable to costly financial crises. Second, it shows how in a simple economy where commercial banks are the only lenders, conventional monetary-policy tools such as open-market operations can be used to regulate this externality, while in more advanced economies it may be helpful to supplement monetary policy with other measures. Third, from a positive perspective, the model provides an account of how monetary policy can influence bank lending and real activity, even in a world where prices adjust frictionlessly and there are other transactions media besides bank-created money that are outside the control of the central bank.
755 citations
TL;DR: This article investigated whether risk management-related corporate governance mechanisms, such as the presence of a chief risk officer (CRO) in a bank's executive board and whether the CRO reports to the CEO or directly to the board of directors, are associated with a better bank performance during the financial crisis of 2007/2008.
Abstract: The recent financial crisis has raised several questions with respect to the corporate governance of financial institutions. This paper investigates whether risk management-related corporate governance mechanisms, such as for example the presence of a chief risk officer (CRO) in a bank’s executive board and whether the CRO reports to the CEO or directly to the board of directors, are associated with a better bank performance during the financial crisis of 2007/2008. We measure bank performance by buy-and-hold returns and ROE and we control for standard corporate governance variables such as CEO ownership, board size, and board independence. Most importantly, our results indicate that banks, in which the CRO directly reports to the board of directors and not to the CEO (or other corporate entities), exhibit significantly higher (i.e., less negative) stock returns and ROE during the crisis. In contrast, standard corporate governance variables are mostly insignificantly or even negatively related to the banks’ performance during the crisis.
751 citations