July 7, 2009
THE FINANCIAL CRISIS OF 2007–2009:
THE ROAD TO SYSTEMIC RISK
In early January 2009, George Corcoran, professor at a well-regarded business school in the southern United States, addressed a group of distinguished alumni in New York City. Many of them had experienced firsthand the ongoing global financial crisis; others were curious whether the crisis was finally ending or had only begun. Mindful of a series of record highs in the unemployment numbers and record lows in the stock market, the participants were extremely attentive, the mood in the room somber.
Professor Corcoran had not come to New York to deliver bad news but to engage in a dialogue, to uncover underlying themes, potential lessons, and possible ways out of the dismal financial situation. His main thesis was that it was too early to analyze the many causes in detail but that the fundamental issue was a misjudging of risks taken and an inability to manage or curtail them.
Were the wrong incentives given to those in financial institutions responsible for taking risks and those responsible for risk management? Were these two categories mismatched in terms of power within the organizations? Were the models used inadequate to deal with new phenomena, such as risks taken via securitizations of subprime loans, or would these models only require revision? Was this a new era of banking in which we had mastered the parsing and selling of risk to those most able to bear it? Had we accomplished a financial breakthrough or allowed a breakdown?
The increasingly complex global financial environment had too many players, from financial institutions to rating agencies, the SEC, the Fed, even the general public, any of whom may have inadvertently contributed to the crisis. What roles did each play? What might each have done differently? What were some of the warning signs and wrong assumptions?
Professor Corcoran believed he had included statements in his presentation that were probing enough to generate an informative dialogue. He had outlined the main reasons he thought risk management had failed and how it should change going forward. He had tried to
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envision the future of financial markets and institutions, and, in spite of the prevailing financial turmoil, a few clear signs of the future were obvious: more regulation was coming, although it was unclear what kind or how it might work. The global environment necessitated international coordination and smart regulation, and an obvious place to start was within the banking sector.
During the previous decade, the banking sector had become increasingly complex and, in many ways, unwieldy. Gone was the plain-vanilla model of accumulating deposits and lending money to profitable businesses and individuals. In this complex world of securitization, of collateralized debt obligations, credit default swaps, and structured investment vehicles, risk had become increasingly hard to understand, much less tame. And added to that, banks had gone to great...