Leverage, System Risk and Financial System Health: How Do We Develop a Healthy Financial System?

Abstract

The subprime crisis of 2007–2009 was the most devastating financial crisis since the Great Depression, cost the US economy trillions of dollars (see Atkinson, Luttrell and Rosenblum, 2013) and caused significant economic stress worldwide.¹ In response, new financial-market regulations were adopted in many countries, including the Dodd-Frank Act in the US, which is a massively complex piece of legislation that touches most financial intermediaries in significant ways and imposes a host of new proscriptions and requirements on all sorts of intermediaries. Moreover, the crisis also required unprecedented government intervention in the financial market and the real economy, with the issuance of ex post guarantees against failure to a multitude of a priori uninsured investors and institutions, in order to stave off a complete collapse of the financial system. While there is much debate over whether the regulatory interventions were the appropriate ones (see Lo (2012), and Thakor (2013b) for detailed discussions), these interventions raise concerns about potential moral hazard insofar as expectations of future bailouts may influence present behaviour, and greater political involvement in the functioning of credit markets (see Song and Thakor, 2012).