Randall Kroszner, an economics professor at the University of Chicago and a former Governor of the Federal Reserve System, spoke with University of Missouri law school faculty and students on April 4 about the weaknesses within the financial system that contributed to the Great Recession. Kroszner identified three key fragilities in the banking system: the small margin of capital cushion around banks, the mismatch in the liquidity of short- and long-term investments, and the over-entanglement of markets and financial institutions.
Kroszner said that banks had capital cushion that was just around 2-3 percent around the time of the crisis but had considerably more leverage than non-financial institutions. This amount of leverage allowed for a wide gap to grow between a bank’s core equity and its amount of borrowing, creating a precarious atmosphere where the 2-3 percent capital cushion was all that separated banks from insolvency and bankruptcy.
With increased leverage came more opportunity for a mismatch of assets and liabilities, which created liquidity problems, Kroszner said. This mismatch became another fragile point within the market.
There is a fundamental difference in the liquidity of short-term deposits and investments, Kroszner said. Deposits have a short horizon and are more liquid since people can get access to their money right away. Meanwhile, with long-term investments such as mortgages, the money owed is returned at a much slower rate. The problem with long-term investments is that their value is very hard to access right away, Kroszner said. This posed a problem, particularly for dealers who found themselves unable to sell subprime mortgages when the value of these assets began to decline.
In addition, the interconnectedness of the markets and the financial system itself also made the economy fragile, Kroszner said. “People had exposure to the housing market everywhere in the world,” he said, which explains why the crash of the U.S. housing market had reverberating effects around the globe.
The interconnectedness of the banking system is not necessarily a bad thing, despite what most people think, Kroszner added. He noted that the Canadian banking system, which is predominantly made up of four large banks, actually helped Canada through the course of the 2008 financial crisis. The key is to maintain a diverse financial portfolio, Kroszner said. “Big is not always bad as long as it well diversified,” he said. “Diversifying lowers risk.”
Kroszner advocated for altering the current bilateral market structure by creating a private clearinghouse that could act as a guarantor of contracts involving things like collateralized debt obligations (CDOs) and derivatives. This agency would exist to ensure that banks and other businesses aren’t taking on too much risk, he said. Using a clearinghouse entity would introduce more homogeneity within the system, which is not always ideal, he said, but the benefit to this trade-off would be greater transparency and more centralized source for information.
In addition to calling for the creation of a clearinghouse agency, Kroszner recommended reform of the housing market and increasing capital cushion for financial institutions as a means for avoiding another financial crisis.