The Unfinished Work Of Reform In The Global Financial System b
Lewis B. Kaden
In the summer of 2007, early signs of distress in the United States housing market signaled the beginning of what Ben Bernanke, then the Chairman of the Federal Reserve Board, would later describe as “the worst financial crisis in global history, including the Great Depression.” Today, almost eight years later, much of the world is still wrestling with the effects of what proved to be “the deepest post World War II recession by far.”
Among many other things, the financial crisis spawned a vigorous public dialogue on the steps that should be taken to prevent any comparable calamity in the future and led to the enactment of a mass of new regulation of financial institutions. Beginning in 2009, as the global financial system emerged from the crisis and began a slow and uneven process of recovery, extensive reforms to the system were set in motion by measures adopted in the U.S., Europe, and, through the G-20, in other significant financial centers around the world. Though there is broad agreement that much remains to be done to implement these reforms, many wise and well-informed participants in global finance now believe that the critical strategic work of reform has been substantially accomplished. This view is exemplified by recent comments by Mark Carney, the highly respected Governor of the Bank of England and Chairman of the Financial Stability Board, who characterized the G-20 meeting in Brisbane, Australia in November 2014 as a “landmark,” and expressed the view that the “prudential requirement and supervisory framework for banking are largely settled . . . [I]t is now a question of implementation . . . [of] the agreed reform [that will make] the system safer . . . , simpler . . . [and] fairer.”
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Although this confidence is cheering, I fear it is misplaced. While there has surely been significant progress, a great deal of important work lies ahead to meet the challenges that the global financial system will face in the course of the next decade. This paper offers a perspective on those challenges and the steps that can be taken to address them. Part I briefly reviews, for the purpose of general background, the context and causes of the financial crisis. Part II identifies the key lessons to be learned from the crisis, and Part III outlines the major reforms adopted to date in the United States, Europe and the G-20. Finally, Part IV highlights what I regard as the principal ongoing issues affecting the financial system and suggests some approaches for dealing with them.
With the benefit of hindsight, it is now widely agreed that the housing and mortgage market in the United States had developed in ways that set the stage for a bursting bubble. For more than a quarter century, U.S. housing policy had promoted home ownership as a milestone for the middle class in its pursuit of the American dream. By 2004, the members of 69% of U.S. households owned their homes, up from 64% just ten years before. From 2000 to 2007, the average price of a home doubled. Although incomes were stagnant during this period, the aggregate amount of mortgage debt also doubled and the average mortgage obligation rose 63%, from $91,500 to $149,500.5 During the same period, mortgage practices deteriorated sharply, especially with respect to low-income borrowers with weak credit histories. Access to credit was easy for these “sub-prime” borrowers, with loans often made without proof of income or other customary documentation and without the requirement of any down payment, at variable or special low initial interest rates. Innovations in securitization of mortgage loans further expanded access to credit, including borrowings by consumers of limited means for speculative investments in additional homes in resort communities. As home prices maintained their seemingly inexorable rise, mortgage securities spread throughout the financial system, with different tranches or slices of mortgage pools providing variable risks to different types of investors.
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