The Financial Crisis One Year Later: Proceedings of a Panel Discussion on Lessons of the Financial Crisis and Implications for Regulatory Reform

• Publication year: 2022

43 Creighton L. Rev. 275. THE FINANCIAL CRISIS ONE YEAR LATER: PROCEEDINGS OF A PANEL DISCUSSION ON LESSONS OF THE FINANCIAL CRISIS AND IMPLICATIONS FOR REGULATORY REFORM

THE FINANCIAL CRISIS ONE YEAR LATER: PROCEEDINGS OF A PANEL DISCUSSION ON LESSONS OF THE FINANCIAL CRISIS AND IMPLICATIONS FOR REGULATORY REFORM

BRUCE E. ARONSONT (fn*)

This Article consists of an introductory essay and an edited transcript of an unusual panel discussion on implications of the financial crisis. A panel of experts composed of prominent corporate and banking law scholars, local financial industry executives, and a bank regulator convened at a recent symposium held at the Creighton University School of Law and engaged in a moderated discussion on applying lessons from the first year of the financial crisis to basic considerations underlying financial regulatory reform.

There was a surprising degree of agreement on a number of basic issues between the "pro-regulation" academics and the "pro-market" business executives. In particular, both groups consistently cited the importance of the structure of financial incentives and the necessity of aligning such incentives with organizational goals as both an important cause of, and potential solution to, the financial crisis.

The panel discussion covered six broad topics: (1) causes of the financial crisis, (2) government bailouts and market support, (3) historical analogies and lessons, (4) foreign banks and globalization, (5) systemic risk and its regulation, and (6) consumer issues and executive compensation. In each of these areas, the differing perspectives and experiences of the participants and the interaction among them resulted in thought-provoking discussion on fundamental issues of financial system reform.

TABLE OF CONTENTS

I. INTRODUCTION................................... 276

II. PROCEEDINGS OF THE PANEL, SEPTEMBER 25, 2009 ............................................ 286

III. CAUSES OF THE FINANCIAL CRISIS............. 287

IV. THE GOVERNMENT'S RESPONSE: BAILOUTS AND MARKET SUPPORT.......................... 291

A. The Rescue of Lehman and Bailouts of Nonbanks ......................................291

B. Necessity of Expansive Fed Programs.........294

C. Crisis Responses by the Bush and Obama Administrations................................300

V. HISTORICAL ANALOGIES AND LESSONS........306

VI. FOREIGN BANKS AND GLOBALIZATION.........311

VII. SYSTEMIC RISK AND ITS REGULATION.......... 313

VIII. CONSUMER ISSUES AND ExECUTIVE COMPENSATION .................................. 316

IX. QUESTION AND ANSWER......................... 318

X. CONCLUSION ..................................... 321

I. INTRODUCTION

One year after the fall of Lehman Brothers marks a convenient dividing line in our government's response to the worst financial and economic crisis since the Great Depression of the 1930s. We have completed Phase I-stabilization of the financial system-and are gearing up for Phase II-reform of the financial system's regulatory structure. The crisis invoked unprecedented governmental responses to stabilize the financial system and prompted a far-reaching rethinking of assumptions which were widely accepted over the past two decades concerning the roles of markets and regulation. The outcome of the debate concerning the appropriate extent and form of government regulation will strongly affect the nature and extent of financial system reform measures that are eventually enacted. This introductory essay and the proceedings of the panel discussion which follow explore lessons of the financial crisis and implications for regulatory reform from a variety of perspectives.

Causes. Causes of the crisis remain relevant since they will help in defining solutions. Two well-known and important causes of the financial panic and economic crisis were twin bubbles in credit and housing. The easy availability of cheap credit through low interest rates and the seemingly ever-increasing economic success and rise in housing prices during the period from 2004-2007 resulted in aggres sive overleveraging by both corporations and individuals.(fn1) Such leverage is a two-edged sword, and both corporations and households are now going through the painful process of deleveraging, which itself is an important reason for the lingering effects of the crisis.

The most highly debated cause of the crisis is the extent to which regulatory inadequacies played a role. Beginning in the 1990s, and particularly during this decade, new financial markets developed rapidly. Sometimes popularly referred to as the "shadow banking system," the main components were asset securitization and derivatives. Both of these markets expanded significantly to include securitization of subprime mortgages and a burgeoning volume of credit default swaps. The Gramm-Leach-Bliley Act of 1999(fn2) and the Commodity Futures Modernization Act of 2000(fn3) removed barriers between activities of commercial banks and investment banks, and also ensured that over-the-counter swaps would remain largely unregulated.(fn4) It was believed that this financial innovation would lower overall risk by spreading risk throughout the financial system.(fn5) However, at the same time it had the perverse effect of concentrating risk in the limited number of financial institutions with the size, strength and expertise to act as dealers of financial products in these new markets.

Another difficult aspect of the crisis is its global reach. Our credit and housing bubbles grew so large partly because large purchases of United States Treasuries at relatively low interest rates by the central banks of China and Japan enabled America as a whole to keep spending beyond its means. The emergence of global financial markets and institutions also made it more difficult to respond to the crisis. As a result, the Federal Reserve ("Fed") has, for the first time, included foreign commercial banks and central banks in its efforts to stabilize the financial system.(fn6)

Any panic or crisis also involves a loss of confidence by investors and the public which can act as an important additional factor. A striking contrast between the bursting of the technology bubble in 2000-2002 and the current crisis is that at the beginning of this decade Alan Greenspan had the reputation and credibility to calm markets almost immediately. In 2008 there was no such person or institution on the scene. In fact, in 2008 Greenspan's hands-off policies on markets appeared to be a major contributing factor to the crisis and there was no one in the Federal Reserve ("Fed"), the Bush Administration, or Congress with the stature or policies to calm roiled markets.

Phase I-The Government's Response to Stabilize Financial Markets. Throughout the period of the run-up to the crisis, from the summer of 2007 to September 2008, financial commentators, the press, and the government continually underestimated the scope and severity of financial system problems. The government's initial reaction to serious problems at major financial institutions was both ad hoc and ambivalent, as the response of the Fed and the Bush Administration's Treasury Department vacillated between doing what was necessary in times of crisis and adhering to a free market philosophy.(fn7)

Matters came to a head in September 2008 as the government oversaw the sale of Merrill Lynch to Bank of America, but let Lehman Brothers fail. The result was a full-blown financial crisis. Three-month Treasury bills essentially yielded zero, as panicked investors accepted no return for a safe place to park their money. Markets froze, banks became reluctant to lend to each other in the interbank market, and risky assets could only be sold at fire-sale prices. The failure to rescue Lehman Brothers was seen as a huge mistake, especially in Europe and Japan where the "Lehman shock" was credited as causing a global financial crisis which was "made in America."(fn8) One result of the strong market reaction was the government's rescue of the giant insurer AIG, whose subsidiary was the largest provider of protection in the credit default swap market.

One immediate consequence of the crisis was the end of independent investment banks on Wall Street. This is ironic since the leading investment banking firms on Wall Street may have also been a significant contributing factor in causing the crisis due to their transforma tion from private partnerships to public corporations.(fn9) With public shareholders now providing their permanent capital, investment bankers may have become more focused on short-term performance and annual bonuses and more willing to assume outsized risks. As credit markets and funding sources froze, the investment banks all became bank holding companies with banking subsidiaries whose savings accounts provided a more stable source of funding. Today no "pure" independent investment bank remains on Wall Street.

Despite some ambivalence about rescuing individual financial institutions, in the fall of 2008 the Fed took two sets of unprecedented steps in an effort to stabilize the entire financial system. First, it encouraged bank borrowing from its discount window. It sought to remove the stigma of the discount window as a place where a "troubled bank" went as a last resort, paying high interest rates and providing bulletproof collateral such as United States Treasuries.(fn10) Second, and of even greater significance, were numerous Fed (and also...