Ross Levine on the causes of the financial crisis

Ross Levine, "An Autopsy of the U.S. Financial System," NBER Working Paper No. 15956, 2010.

The evidence indicates that senior policymakers repeatedly designed, implemented, and maintained policies that destabilized the global financial system in the decade before the crisis. The policies incentivized financial institutions to engage in activities that generated enormous short-run profits but dramatically increased long-run fragility. Moreover, the evidence suggests that the regulatory agencies were aware of the consequences of their policies and yet chose not to modify those policies. On the whole, these policy decisions reflect neither a lack of information nor an absence of regulatory power. They represent the selection -- and most importantly the maintenance -- of policies that increased financial fragility. The crisis did not just happen to policymakers.

Since technical glitches, regulatory gaps, and insufficient regulatory power played only a partial role in fostering the crisis, reforms that rectify these conditions represent only a partial and thus incomplete step in establishing a stable financial system that promotes growth and expands economic opportunities. The entire system of financial regulation -- the system associated with evaluating, reforming, and implementing financial policies – played a key role in the crisis.

Levine focuses on regulatory failures with regard to the rating agencies, credit default swaps, over-the-counter derivatives trading, capital requirements at investment banks, and Fannie Mae and Freddie Mac. The message is that regulators had the tools they needed to prevent the financial bubble that ultimately collapsed, but chose not to use them. Giving new powers to the regulatory agencies, therefore, is not necessarily a solution to the problem. True enough, but the granting of new powers sends a powerful signal to the regulatory agencies about what is expected of them. They got a very clear signal during the Clinton and Bush years that they were expected to exercise their regulatory powers with a light touch if at all; the financial reform bill working its way toward the president's desk gives them a clear message in the other direction. Also, certain reforms in the bill (e.g. the reform of the rating agencies' relationship with securities issuers) directly correct problems that Levine highlights in his paper.