A Systemic Explanation for The 2008 Financial Crisis

In September of 2013, Francis Breedon organized a Round Table discussion at the Money Macro Finance Conference held at Queen Mary College London. The session included myself, Chris Giles of the Financial Times and David Miles of the Monetary Policy Committee as speakers and Sushil Wadwhani as moderator.  Our topic: the Bank of England's remit.

Chris and David chose to speak about monetary policy and the role of the Monetary Policy Committee.  I chose, instead, to focus on the task that faces the newly formed Bank of England's  Financial Policy Committee.  This post will focus on one of the points I made in my talk, the distinction between what I call institutional and systemic explanations of the 2008 financial crisis.  My complete argument is published in a forthcoming paper "Financial Stability and the Role of the Financial Policy Committee", that will appear in The Manchester School.

Recent events have generated widespread consensus that the financial markets are not working as they should. But there is little agreement as to why. One explanation is that financial frictions can sometimes become more disruptive than usual and these frictions can be corrected by regulating financial institutions. An alternative explanation that I have promoted in my own work, is that financial markets do not allocate capital efficiently.  The failure of financial markets occurs because people who will be born in the future cannot trade in current markets. I call this the absence of prenatal financial markets.

The financial frictions view leads to an institutional explanation for financial crises. The absence of prenatal financial markets view leads to the systemic explanation. Quoting from my forthcoming paper...
Distinguishing the institutional from the systemic explanation of financial crises affects the way we respond. If the problem is institutional we should design regulations that help overcome the financial frictions that prevent our banks, insurance companies and pension funds from performing their appropriate roles as intermediaries. If the problem is systemic, the failure of institutions is a symptom and new regulations are analogous to putting an Elastoplast on a gunshot wound.
The consensus amongst economists in the U.K. and the U.S. is that the 2008 financial crisis that led to the Great Recession was an institutional failure. The response has been the passage of the Financial Services Act in the U.K. and the Dodd‐Frank Act in the U.S.; legislation that is designed to regulate the financial services industry. I believe that the consensus is mistaken; the problem is not institutional; it is systemic.
Let me be clear. I am not arguing that existing financial institutions were blameless. Nor am I arguing that the regulatory framework was effective. The crisis has taught us that the design of effective regulation matters: and it matters a lot. I agree wholeheartedly with Anat Admati and Martin Hellwig who argue forcefully that we need much higher capital requirements. Regulating existing institutions is necessary: but we can and should do much more. Quoting again from my forthcoming paper...
... If I am right, and the problem is systemic, regulating our existing institutions will not solve the problem [of preventing future financial crises]. It will lead to the creation of new institutions, shadow‐banks, shadow insurance companies and shadow pension funds; unregulated institutions that will be created to facilitate the trades that willing lenders and willing borrowers want to engage in. Dodd‐Frank and the Financial Services Act cannot prevent the next financial crisis any more than King Canute could prevent the movement of the tides.
...When the next financial crisis occurs, and it will occur, do not blame the members of the Financial Policy Committee. They are guard dogs without teeth. It’s time to move beyond empty rhetoric by giving to the FPC, the tools that will enable it to deliver what is requested of it. If we truly want financial stability; we must act to stabilise markets. 
If you want to read more, you will find a working paper version of the article here where I also explain what tools we should give to the FPC to maintain future financial stability.