Abstract
The paper analyses the causes of the current crisis of the global financial system, with particular emphasis on the systemic elements that turned the crisis of subprime mortgage-backed securities in the United States, a small part of the overall system, into a worldwide crisis. The first half of the paper explains the role of mortgage securitization as a mechanism for allocating risks from real estate investments and discusses what has gone wrong and why in the implementation of this mechanism in the United States. The second half of the paper discusses the incidence of systemic risk in the crisis. Two elements of systemic risk are identified. First, there was excessive maturity transformation through conduits and structured-investment vehicles (SIVs); when this broke down in August 2007, the overhang of asset-backed securities that had been held by these vehicles put significant additional downward pressure on securities prices. Second, as the financial system adjusted to the recognition of delinquencies and defaults in US mortgages and to the breakdown of maturity transformation of conduits and SIVs, the interplay of market malfunctioning or even breakdown, fair value accounting and the insufficiency of equity capital at financial institutions, and, finally, systemic effects of prudential regulation created a detrimental downward spiral in the overall financial system. The paper argues that these developments have not only been caused by identifiably faulty decisions, but also by flaws in financial system architecture. In thinking about regulatory reform, one must therefore go beyond considerations of individual incentives and supervision and pay attention to issues of systemic interdependence and transparency.
Article PDF
Similar content being viewed by others
References
Akerlof G. (1970) ‘The Market for ‘Lemons’: Quality Uncertainty and the Market Mechanism’. Quarterly Journal of Economics 84: 488–500
Allen F., Carletti E. (2006) ‘Credit Risk Transfer and Contagion’. Journal of Monetary Economics 53: 89–111
Allen F., Carletti E. (2008) ‘Mark-to-Market Accounting and Cash-in-the-Market Pricing’. Journal of Accounting and Economics 45: 358–378
Allen F., Gale D.M. (2004a) ‘Financial Intermediaries and Markets’. Econometrica 72: 1023–1061
Allen F., Gale D.M. (2004b) ‘Financial Fragility, Liquidity, and Asset Prices’. Journal of the European Economic Association 2: 1015–1048
Allen F., Gale D.M. (2006) ‘Systemic Risk and Regulation’. In: Carey M., Stulz R. (eds) The Risks of Financial Institutions. University of Chicago Press, Chicago, pp 341–375
Baltensperger E., Dermine J. (1987) ‘Banking Dregulation in Europe’. Economic Policy 4: 63–109
Bank for International Settlements (2007), ‘77th Annual Report: April 1, 2006 – March 31, 2007’, Basel 2007.
Bank for International Settlements (2008), ‘78th Annual Report: April 1, 2007 – March 31, 2008’, Basel 2008.
Ben-David, I. (2006/2008), ‘Manipulation of Collateral Values by Borrowers and Intermediaries’, Discussion Paper, Graduate School of Business, University of Chicago, http://search.ssrn.com/sol3/papers.cfm?abstract_id=991387.
Benston G.J., Carhill M., Olasov B. (1991) ‘The Failure and Survival of Thrifts: Evidence from the Southeast’. In: Hubbard R. (eds) Financial Markets and Financial Crises. University of Chicago Press, Chicago, pp 305–384
Berglöf E., Sjögren H. (1998) ‘Combining Arms’ Length and Control-Oriented Finance: Evidence From Main-Bank Relationships in Sweden’. In: Hopt K.J., Kanda H., Roe M.J., Wymeersch E., Prigge S. (eds) Comparative Corporate Governance: The State of the Art and Emerging Research. Clarendon Press, Oxford
Bernanke, B.S. (2008), ‘Mortgage Delinquencies and Foreclosures, Speech at the Columbia Business School 32nd Annual Dinner’, http://www.federalreserve.gov/newsevents/speech/Bernanke20080505a.htm.
Bernanke B.S., Lown C. (1991) ‘The Credit Crunch’. Brookings Papers on Economic Activity 2: 205–247
Bichsel R., Blum J. (2001) ‘Gearing Ratios’. Swiss National Bank, Quarterly Bulletin 3: 48–58
Bichsel R., Blum J. (2005) ‘Capital Regulation of Banks: Where Do We Stand and Where Are We Going?’. Swiss National Bank, Quarterly Bulletin 4: 42–51
Blattner, N. (1995), ‘Panel Discussion – Statements and Comments’, Schweizerische Zeitschrift für Volkswirtschaft und Statistik/Swiss Journal of Economics and Statistics, 131, pp. 819–830, http://www.sjes.ch/papers/1995-IV-18.pdf.
Blum J.M. (1999) ‘Do Capital Adequacy Requirements Reduce Risks in Banking?’. Journal of Banking and Finance 23: 755–771
Blum J.M. (2008) ‘Why ‘Basel II’ May Need a Leverage Ratio Restriction’. Journal of Banking and Finance 32: 1699–1707
Blum J.M., Hellwig M. (1995) ‘The Macoeconomic Implications of Capital Adequacy Requirements for Banks’. European Economic Review 39: 739–749
Blum J.M., Hellwig M. (1996) ‘Die makroökonomischen Wirkungen von Eigenkapitalanforderungen für Banken’. In: Duwendag D. (eds) Finanzmärkte, Finanzinnovationen und Geldpolitik, Schriften des Vereins für Socialpolitik, NF 242. Duncker und Humblot, Berlin, pp 41–71
Boyd J., Gertler M. (1994) ‘The Role of Large Banks in the Recent US Banking Crisis’. Federal Reserve Bank of Minneapolis Quarterly Review 18: 2–21
Calomiris C.W. (1999) ‘Market-Based Banking Supervision’. The Financial Regulator 4: 33–36
Calomiris C.W., Kahn C.M. (1991) ‘The Role of Demandable Debt in Structuring Optimal Banking Arrangements’. American Economic Review 81: 497–513
Carosio G. (1990) ‘Problems of Harmonization of the Regulation of Financial Intermediation in the European Community’. European Economic Review 34: 578–586
Case, K.E., J.M. Quigley and R.J. Shiller (2005), ‘Comparing Wealth Effects: The Stock Market versus the Housing Market’, Advances in Macroeconomics, 5(1), Article 1, available at: http://www.bepress.com/bejm/advances/vol5/iss1/art1.
Chomsisengphet S., Pennington-Cross A. (2006) ‘The Evolution of the Subprime Mortgage Market’. Federal Reserve Bank of St. Louis Review 88: pp 31–56
Crockett, A. (2007), ‘The Evolution and Regulation of Hedge Funds’, in: Banque de France (ed.), Financial Stability Review – Special Issue on Hedge Funds, April 2007, pp. 19–28, http://www.banque-france.fr/gb/publications/rsf/rsf_042007.htm.
Curry T., Shibut L. (2000) ‘The Costs of the Savings and Loan Crisis: Truth and Consequences’. FDIC Banking Review 13: 26–35
Demyanyk, Y. and O. Van Hemert (2008), Understanding the Subprime Mortgage Crisis, mimeo. Stern School of Business, New York University, http://ssrn.com/abstract=1020396.
Dewatripont M., Tirole J. (1994) ‘The Prudential Regulation of Banks’. MIT-Press, Cambridge, USA
Diamond D.W. (1984) ‘Financial Intermediation and Delegated Monitoring’. Review of Economic Studies 51: 393–414
DiMartino D., Duca J.V. (2007) ‘The Rise and Fall of Subprime Mortgages’. Economic Letter: Insights from the Federal Reserve Bank of Dallas 2: 11
Dodd, R. (2007), ‘Subprime: Tentacles of a Crisis’, Finance and Development, 44, Nr. 4, pp. 15–19, http://www.imf.org/external/pubs/ft/fandd/2007/12/dodd.htm.
Dodd, R. and P. Mills (2008), ‘Outbreak: U.S. Subprime Contagion’, Finance and Development, 45, Nr. 2, pp. 14–18, http://www.imf.org/external/pubs/ft/fandd/2008/06/dodd.htm.
Duffie, D. (2007), Innovations in Credit Risk Transfer: Implications for Financial Stability mimeo. Stanford University, Stanford, CA, http://www.stanford.edu/duffie/BIS.pdf.
Englund P. (1990) ‘Financial Deregulation in Sweden’. European Economic Review 34: 385–393
Englund P. (1999) ‘The Swedish Banking Crisis: Roots and Consequences’. Oxford Review of Economic Policy 15: 80–97
Financial Crimes Enforcement Network: Regulatory Policy and Programs Division, Office of Regulatory Analysis (2006), ‘Mortgage Fraud: An Industry Assessment Based on Suspicious Activity Report Analysis’, Washington, http://www.fincen.gov/news_room/rp/reports/pdf/MortgageLoanFraud.pdf.
Franke G., Krahnen J.P. (2006) ‘Default Risk Sharing Between Banks and Markets: The Contribution of Collateralized Debt Obligations’. In: Carey M., Stulz R. (eds) The Risks of Financial Institutions. University of Chicago Press, Chicago, pp 603–631
Gale D.M. (1992) ‘Standard Securities’. Review of Economic Studies 59: 731–755
Hakenes, H. and I. Schnabel (2008), Credit Risk Transfer in Banking Markets with Hard and Soft Information, mimeo. Max Planck Institute for Research on Collective Goods, Bonn.
Hellwig M. (1994a) ‘Liquidity Provision, Banking, and the Allocation of Interest Rate Risk’. European Economic Review 38: 1363–1389
Hellwig, M. (1994b), ‘Banking and Finance at the End of the Twentieth Century’, WWZ Discussion Paper 9426, University of Basel, Switzerland.
Hellwig, M. (1995), ‘Systemic Aspects of Risk Management in Banking and Finance’, Schweizerische Zeitschrift für Volkswirtschaft und Statistik/Swiss Journal of Economics and Statistics, 131, pp. 723–737, http://www.sjes.ch/papers/1995-IV-9.pdf.
Hellwig, M. (1996), ‘Capital Adequacy Rules as Instruments for the Regulation of Banks’, Schweizerische Zeitschrift für Volkswirtschaft und Statistik/Swiss Journal of Economics and Statistics, 132, pp. 609–612, http://www.sjes.ch/papers/1996-IV-6.pdf.
Hellwig M. (1998a) ‘Banks, Markets, and the Allocation of Risks in an Economy’. Journal of Institutional and Theoretical Economics 154: 328–345
Hellwig M. (1998) ‘Systemische Risiken im Finanzsektor’. Zeitschrift für Wirtschafts- und Sozialwissenschaften, Beiheft 7: 123–151
Hellwig M. (2005) ‘Market Discipline, Information Processing, and Corporate Governance’. In: Hopt K.J., Wymeersch E., Kanda H., Baum H. (eds) Corporate Governance in Context: Corporations, States, and Markets in Europe, Japan, and the US. Oxford University Press, Oxford, UK, pp 379–402
Hellwig, M. (2007), ‘Switzerland and Euroland: European Monetary Union, Monetary Stability and Financial Stability’, in: Swiss National Bank (ed.), The Swiss National Bank 1907–2007, Neue Zürcher Zeitung Publishing, Zürich, pp. 741–779.
Hellwig, M. and M. Staub (1996), ‘Report on a Panel “Capital Requirements for Market Risks Based on Inhouse Models – Aspects of Quality Assessment”’, Swiss Journal of Economics and Statistics, 132, pp. 755–776, http://www.sjes.ch/papers/1996-IV-22.pdf.
Hendershott P.H., Shilling J.D. (1991) ‘The Continued Interest-Rate Vulnerability of the Thrifts’. In: Hubbard R. (eds) Financial Markets and Financial Crises. University of Chicago Press, Chicago, pp 259–282
Holmström B., Milgrom P.R. (1991) ‘Multitask Principal-Agent Analyses: Incentive Contracts, Asset Ownership and Job Design’. Journal of Law, Economic sand Organization 7(suppl.): 24–52
International Monetary Fund (2007), ‘Market Developments and Issues, Global Financial Stability Report’, Washington, DC, April 2007, http://www.imf.org/External/Pubs/FT/GFSR/2007/01/text.pdf.
International Monetary Fund (2008a), ‘Containing Systemic Risks and Restoring Financial Soundness, Global Financial Stability Report’, April 2008, http://www.imf.org/External/Pubs/FT/GFSR/2008/01/index.htm.
International Monetary Fund (2008b), ‘Financial Stress and Deleveraging: Macro-Financial Implications and Policy, Global Financial Stability Report’, October 2008, http://www.imf.org/External/Pubs/FT/GFSR/2008/02/index.htm.
Jensen M.C., Meckling W.H. (1976) ‘Theory of the Firm: Managerial Behavior, Agency Costs and Ownership Structure’. Journal of Financial Economics 3: 305–360
Kane E.J. (1985) ‘The Gathering Crisis in Federal Deposit Insurance’. MIT-Press, Cambridge, USA
Kane E.J. (1989) The S & L Insurance Mess: How Did It Happen?. Urban Institute Press, Washington, DC
Kiff, J. and P. Mills (2007), ‘Money for Nothing and Checks for Free: Recent Developments in U.S. Subprime Mortgage Markets’, International Monetary Fund Working Paper 07/188.
King M. (1990) ‘International Harmonization of the Regulation of Capital Markets’. European Economic Review 34: 569–577
Kuran T. (1995) Private Truths, Public Lies – The Social Consequences of Preference Falsification. Harvard University Press, Cambridge, Massachusetts
Mélitz J. (1990) ‘Financial Deregulation in France’. European Economic Review 34: 394–402
Myers S.C., Rajan R.G. (1998) ‘The Paradox of Liquidity’. Quarterly Journal of Economics 113: 733–771
OECD (1992), Banks Under Stress. OECD Publications, Paris.
Peltzman S. (1975) ‘The Effects of Automobile Safety Regulation’. Journal of Political Economy 83: 677–725
Reid M. (1982) The Secondary Banking Crisis 1973–1975: Its Causes and Course. Macmillan, London
Rochet J.-C. (1992) ‘Capital Requirements and the Behaviour of Commercial Banks’. European Economic Review 36: 1137–1178
Rona-Tas, A. and S. Hiß (2008), ‘The Art of Corporate and the Science of Consumer Credit Rating’, Paper Presented at the 38th World Congress of the International Institute of Sociology.
Schaefer S.M. (1990) ‘The Regulation of Banks and Securities Firms’. European Economic Review 34: 587–597
Schnabel I., Shin H.S. (2004) ‘Liquidity and Contagion: The Crisis of 1763’. Journal of the European Economic Association 2: 929–968
Schütz D. (1998). Der Fall der UBS. Weltwoche-Verlag, Zürich.
Schwartz E.S., Torous W.N. (1991) ‘Caps on Adjustable Rate Mortgages: Valuation, Insurance, Hedging’. In: Hubbard R. (eds) Financial Markets and Financial Crises. University of Chicago Press, Chicago, pp 283–302
Shleifer A. (2000) Inefficient Markets: An Introduction to Behavioral Finance. Oxford University Press, Oxford, UK
Slacalek, J. (2006), ‘What Drives Personal Consumption? The Role of Housing and Financial Wealth’, Discussion Paper 647, Deutsches Institut für Wirtschaftsforschung, Berlin, http://www.diw.de/documents/publikationen/73/44944/dp647.pdf.
Staub, M. (1998a), ‘Inter-Banken-Kredite und systemisches Risiko’, Schweizerische Zeitschrift für Volkswirtschaft und Statistik/Swiss Journal of Economics and Statistics, 134, pp. 193–230, http://www.sjes.ch/papers/1998-II-5.pdf.
Staub, M. (1998b), ‘The Term Structure of Interest Rates and the Swiss Regional Banking Crisis – Empirical Evidence and its Limits’, Schweizerische Zeitschrift für Volkswirtschaft und Statistik/Swiss Journal of Economics and Statistics, 134, pp. 655–683, http://www.sjes.ch/papers/1996-IV-19.pdf.
Staub, M. (1998c), ‘Report on a Panel “International Contagion: What Is It and What Can be Done Against It?”’, Schweizerische Zeitschrift für Volkswirtschaft und Statistik/Swiss Journal of Economics and Statistics, 134, pp. 715–721, http://www.sjes.ch/papers/1998-IV-23.pdf.
Stiglitz J.E., Weiss A.M. (1981) ‘Credit Rationing in Markets with Imperfect Information’. American Economic Review 71: 393–410
Takala, K., und M.Virén. (1995), ‘Bankruptcies, Indebtedness and the Credit Crunch’, Bank of Finland Discussion Paper No. 28/95, Helsinki.
UBS (2008), ‘Shareholder Report on UBS’s Writedowns’, http://www.ubs.com/1/e/investors/shareholderreport/remediation.html.
Useem M. (1993) Executive Defense: Shareholder Power and Corporate Reorganization. Harvard University Press, Cambridge
Vives X. (1990) ‘Deregulation and Cmpetition in Spanish Banking’. European Economic Review 34: 403–411
Wuffli P. (1995) ‘Comment on the Paper by Professor Hellwig, Systemic Aspects of Risk Management in Banking and Finance’. Schweizerische Zeitschrift für Volkswirtschaft und Statistik/Swiss Journal of Economics and Statistics 131: 139–140
Open Access
This article is distributed under the terms of the Creative Commons Attribution Noncommercial License which permits any noncommercial use, distribution, and reproduction in any medium, provided the original author(s) and source are credited.
Author information
Authors and Affiliations
Corresponding author
Additional information
Revised and expanded text of the Jelle Zijlstra Lecture at the Free University of Amsterdam on May 27, 2008. I am very grateful to the Jelle Zijlstra Professorial Fellowship Foundation for inviting me to visit the Netherlands as Jelle Zijlstra Professorial Fellow 2008 and to the Netherlands Institute for Advanced Study for providing a wonderful environment for this visit. This expanded text tries to respond to comments and questions from the discussant, Gerrit Zalm, and from members of the audience at the Lecture, for which I am very grateful. I am also grateful for comments on this text from Christoph Engel. Kristoffel Grechenig, Hans-Jürgen Hellwig, Isabel Schnabel, and two referees. As the text was being written, its subject itself has been evolving at a catastrophic pace. Some anachronisms are therefore unavoidable. However, the core of the analysis is, I believe, unaffected.
Rights and permissions
Open Access This is an open access article distributed under the terms of the Creative Commons Attribution Noncommercial License (https://creativecommons.org/licenses/by-nc/2.0), which permits any noncommercial use, distribution, and reproduction in any medium, provided the original author(s) and source are credited.
About this article
Cite this article
Hellwig, M.F. Systemic Risk in the Financial Sector: An Analysis of the Subprime-Mortgage Financial Crisis. De Economist 157, 129–207 (2009). https://doi.org/10.1007/s10645-009-9110-0
Published:
Issue Date:
DOI: https://doi.org/10.1007/s10645-009-9110-0
Key words
- mortgage securitization
- subprime-mortgage financialcrisis
- systemic risk
- banking regulation
- capital requirements