Understanding financial crises: theory and evidence from the crisis of 2007-8.

• Author: Acharya, Viral

For those who study economic history, financial crises are recurring phenomena, not as rare as they are often perceived to be, but showing up in new guises each time. There are often common economic forces at work across different crises, and my current research uses the financial and economic crises that erupted in August of 2007 as a laboratory for theoretical and empirical analysis of those forces. In the past, I focused on market failures, which can arise due to externalities ("neighborhood" or "spillover" effects) from the distress of financial firms, and regulatory failures, which can arise due to timeinconsistency problems, cognitive capture, or capture that is rooted in political economy problems. This article summarizes my research on these two failures and their interactions. In the conclusion, I mention my ongoing work on government failures, which can arise due to myopia of decision-making in fiscal and debt policy, and in policy designed to bail out a distressed financial sector.

Market Failure I: Short-term Debt, Default, and Externalities

Financial firms that lend to households and corporations (both banks and "shadow banks" that perform similar economic functions) have always featured short-term debt in their funding structures. The underlying economic rationale for this can be understood by considering the problem of the financier who funds a bank but, because of information problems, lacks precise knowledge and contractibility over loans made by the bank. The financier responds to this problem by saving the option not to roll over--in other words, by providing only short-term debt to the bank.

Financial crises occur when the economy is hit by shocks that lead the financier to exercise the option not to roll over the short-term debt because the bank is under-capitalized--that is, because bank-owners have little equity capital left as "skin-in-the-game" to continue lending prudently. If shocks are idiosyncratic to a bank, then the under-capitalized banks can be acquired, or their activities re-intermediated, by better-capitalized banks. If shocks instead are aggregate in nature, and the entire banking sector is heavily short-term financed, then banks suffer a coincident loss of capital, and efficient re-intermediation cannot take place. There may be disorderly liquidations or allocation inefficiency. This induces financiers to not roll over the short-term debt, and a "crisis" materializes. (1) Indeed, absent a sufficient pool of long-term capital in the economy, even relatively small aggregate shocks and inefficiencies perceived by financiers can lead to complete short-term debt "freezes." (2) Interestingly, losses to financiers are less likely in good economic times when the likelihood attached to aggregate shocks is small, leading to greater short-term leverage for the financial sector as a whole - including the entry of under-capitalized institutions. Therefore, somewhat counter-intuitively, crises can be more severe if an adverse aggregate shock materializes in good times than in bad times.

This market failure arises because of the coincidence of short-term debt in the capital structures of banks and related financial firms and aggregate shocks to their asset portfolios. Regulation might attempt to address this market failure with a "tax"--for example, a requirement that a bank hold a minimum level of equity capital that is dependent not just on its own asset portfolio risk and short-term debt but also on "systemic risk"--that depends on the aggregate component of asset risk and the level of system-wide short-term debt. (3) Policies of this type would link regulations to macro-prudential concerns that are related to financial crises and externalities, rather than (or not just) micro-prudential concerns related to the health of individual financial institutions.

In modern financial systems, much leverage is "embedded" in derivative contracts rather than associated with traditional short-term debt. A related but subtler externality arises in the context of derivatives. When an insurer sells protection against a risk to a number of counter-parties, each party's position potentially affects the payoff on the other parties' positions, in a state of the world where the insurer lacks capital to honor its contractual promises. To reflect this counterparty risk externality suitably in the price of insurance, market participants need to know more than the bilateral positions; they need to know "what else is being done." When risks being hedged are aggregate in nature...