Thursday, July 16, 2009

Eerily Prescient

In the 2003 book Too Big to Fail: Policies and Practices in Government Bailouts (edited by Benton E. Gup), GW Law Professor Arthur Wilmarth has a chapter on financial liberalization and systemic banking crises (SSRN) that's so eerily prescient I just have to post part of the introduction. Remember, this was written in 2003:
[B]anking crises associated with deregulation occur in seven general stages. First, financial liberalization broadens the lending powers and permissible investments of banks, and deregulation also places greater competitive pressures on banks. As a result, banks have incentives to increase their profits by expanding their lending commitments and equity investments in the real estate and securities markets. Second, the expanded availability of debt and equity financing produces an economic boom. Boom conditions are fueled by positive feedback between rising asset values and the willingness of creditors and investors to provide additional financing based on their belief that asset values will continue to rise. Third, asset markets ultimately overshoot and reach levels that cannot be justified by economic fundamentals (e.g., the cash flow produced by real estate projects and business ventures). Fourth, the asset boom becomes a bust when investors and creditors (1) realize that market prices for real estate and securities have diverged from economic fundamentals, and (2) engage in a panicked rush to liquidate their investments and collect their loans. Fifth, the asset bust creates adverse macroeconomic effects, because it (a) impairs the liquidity and market value of assets held as investments or pledged as collateral for loans, and (b) discourages investors and creditors from making new investments or extending additional loans, thereby depressing economic activity and reducing the ability of borrowers to pay their debts. Sixth, the continuing fall in asset values and rise in nonperforming loans inflict large losses on many banks. Those losses impair the confidence of depositors and threaten a systemic crisis in the banking sector. Seventh, to prevent such a crisis, governmental authorities spend massive sums to protect depositors and recapitalize banks. In sum, deregulated financial markets generally promote faster growth rates by providing more extensive financing to consumers and business firms during economic expansions. However, by encouraging a greater reliance on external funding, deregulation creates a higher risk that consumers and firms will become overextended and insolvent if external funding sources shut down during economic contractions.
Sound familiar? Look at Wilmarth's other papers on SSRN too. They're all like this. Professor Wilmarth: you, sir, were right.


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