Capital Standards, Regulatory Ignorance and the Financial Crisis of 2008
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In their new book, “Engineering the Financial Crisis: Systemic Risk and the Failure of Regulation” (University of Pennsylvania Press, 2011), Jeffrey Friedman and Wladimir Kraus argue that the primary cause of the financial crisis of 2008 was minimum capital standards intended to steer banks toward safer investments. Regulators adopted these standards with little understanding of how they related to other rules—especially those requiring mark-to-market accounting and those sanctioning ratings bureaus as the arbiters of investment risk. The result was a dangerous concentration of risky mortgage-backed securities at leading financial institutions. But Friedman and Kraus argue that the ultimate culprit is not a single policy decision, but rather the idea that systemic risk can be managed by the decisions of regulators—whose knowledge of the future is necessarily as limited and partial as the knowledge of those being regulated. In the face of uncertainty, the best protection against catastrophic failures like the collapse of 2008 is to permit multiple competing approaches toward financial risk, rather than imposing any single, uniform approach. At this AEI book forum, Friedman will present his book’s arguments, followed by comments from AEI’s Peter Wallison and Alex Pollock and a general discussion.

Purchase the book here

Agenda
2:45 PM
Registration

3:00 PM
Introduction:
CHRISTOPHER DEMUTH, AEI

Presentation:
JEFFREY FRIEDMAN, University of Texas, Austin, and Critical Review

3:40 PM
Discussion

Panelists:
PETER J. WALLISON, AEI
ALEX J. POLLOCK, AEI

Moderator:
CHRISTOPHER DEMUTH, AEI

5:00 PM
Adjournment
Event Contact Information

For more information, please contact Keriann Hopkins at Keriann.Hopkins@aei.org, 202.862.5897.

Media Contact Information

For media inquiries, please contact Véronique Rodman at vrodman@aei.org, 202.862.4871.

Event Summary
Many believe that the culprit of the 2008 financial crisis was bankers' greed and recklessness, but Jeffrey Friedman argued Monday in a book forum at AEI that it was instead the idea that systemic risk can be managed by regulators' decisions. In his book "Engineering the Financial Crisis: Systemic Risk and the Failure of Regulation," Friedman and his co-author Wladimir Kraus maintain that risk-weighted capital standards encouraged commercial banks to invest in highly rated mortgage-backed bonds on the theory that these assets were much safer than conventional business loans. Thus, bankers were led to invest not in "reckless" loans but rather in low-yielding loans thought to be extremely safe--a view that was widely shared at the time but turned out to be spectacularly wrong. Regulators as well as those they regulate, Friedman emphasized, have necessarily limited knowledge of the future. But the regulators' ignorance was the larger problem: by homogenizing banks' investment strategies, they uniformly imposed their mistake on all banks. Bankers' mistakes, in contrast, would have been limited and corrected through the competition of multiple strategies. AEI's Peter Wallison applauded Friedman and Kraus's emphasis on "hindsight bias" and demonstration of the weakness of the "executive compensation" and "too big to fail" explanations of the financial collapse but expressed that they should have examined why there were so many subprime and other poor-quality mortgages in banks' mortgage bond portfolios. AEI's Alex Pollock remarked that the source of bankers' and regulators' ignorance is recursiveness

: decisions that feed back into themselves are the most important reasons we are unable to see results of our own actions. He concluded that although markets are efficient, they do not know the future.

 

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Speaker Biographies

Christopher DeMuth was president of AEI from December 1986 through December 2008. Previously, he was administrator for information and regulatory affairs in the Office of Management and Budget and executive director of the Presidential Task Force on Regulatory Relief in the Reagan administration; taught economics, law and regulatory policy at the Kennedy School of Government at Harvard University; practiced regulatory, antitrust and general corporate law; and worked on urban and environmental policy in the Nixon White House.

Jeffrey Friedman
is the coauthor, with Wladimir Kraus, of “Engineering the Perfect Storm: How Banking Regulations Caused the Financial Crisis” (University of Pennsylvania Press, 2011). He is the editor of Critical Review: A Journal of Politics and Society, which he founded in 1987; and a visiting scholar in the government department of the University of Texas at Austin. Mr. Friedman has taught political theory at Barnard College, Columbia University, Dartmouth College and Harvard University. He is also the editor of “What Caused the Financial Crisis” (University of Pennsylvania Press, 2010).

Alex J. Pollock
is a resident fellow at AEI focusing on financial policy issues, including housing finance, government-sponsored enterprises, retirement finance, corporate governance, accounting standards and the banking system. Previously, he spent thirty-five years in banking, including twelve years as president and CEO of the Federal Home Loan Bank of Chicago. He is the author of numerous articles on financial systems and the organizer of the “Deflating Bubble” series of AEI conferences. In 2007, he developed a one-page mortgage form to help borrowers understand their mortgage obligations. He is a director of the Chicago Mercantile Exchange, the Great Lakes Higher Education Corporation and the International Union for Housing Finance, and the chairman of the board of the Great Books Foundation.

Peter J. Wallison
holds the Arthur F. Burns Chair in Financial Policy Studies at AEI, where he codirects the institute’s program on financial market studies. He was also a cochair of the Pew Financial Reform Task Force and a member of the congressionally authorized Financial Crisis Inquiry Commission. Mr. Wallison previously practiced banking, corporate, and financial law at Gibson, Dunn & Crutcher LLP in New York and Washington, DC. During 1986 and 1987, he was White House counsel to President Ronald Reagan. From 1981 to 1985, Mr. Wallison was general counsel of the Treasury Department, where he played a significant role in the development of the Reagan administration’s proposals for deregulation in the financial services industry. He also served as general counsel to the Depository Institutions Deregulation Committee and participated in the Treasury Department’s efforts to deal with the debt held by less-developed countries. Between 1972 and 1976, Mr. Wallison was special assistant to New York governor Nelson A. Rockefeller and, subsequently, counsel to Mr. Rockefeller when he was vice president of the United States.

 

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AEI Participants

 

Christopher
DeMuth
  • Christopher DeMuth was president of AEI from December 1986 through December 2008. Previously, he was administrator for information and regulatory affairs in the Office of Management and Budget and executive director of the Presidential Task Force on Regulatory Relief in the Reagan administration; taught economics, law, and regulatory policy at the Kennedy School of Government at Harvard University; practiced regulatory, antitrust, and general corporate law; and worked on urban and environmental policy in the Nixon White House.

     

  • Phone: 2028625895
    Email: cdemuth@aei.org
  • Assistant Info

    Name: Keriann Hopkins
    Phone: 2028625897
    Email: keriann.hopkins@aei.org

 

Alex J.
Pollock
  • Alex J. Pollock is a resident fellow at the American Enterprise Institute (AEI), where he studies and writes about housing finance; government-sponsored enterprises, including Fannie Mae, Freddie Mac, and the Federal Home Loan Banks; retirement finance; and banking and central banks. He also works on corporate governance and accounting standards issues.


    Pollock has had a 35-year career in banking and was president and CEO of the Federal Home Loan Bank of Chicago for more than 12 years immediately before joining AEI. A prolific writer, he has written numerous articles on financial systems and is the author of the book “Boom and Bust: Financial Cycles and Human Prosperity” (AEI Press, 2011). He has also created a one-page mortgage form to help borrowers understand their mortgage obligations.


    The lead director of CME Group, Pollock is also a director of the Great Lakes Higher Education Corporation and the chairman of the board of the Great Books Foundation. He is a past president of the International Union for Housing Finance.


    He has an M.P.A. in international relations from Princeton University, an M.A. in philosophy from the University of Chicago, and a B.A. from Williams College.


  • Phone: 202.862.7190
    Email: apollock@aei.org
  • Assistant Info

    Name: Emily Rapp
    Phone: (202) 419-5212
    Email: emily.rapp@aei.org

 

Peter J.
Wallison
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