Restoring Financial Stability

An insightful look at how to reform our broken financial system

The financial crisis that unfolded in September 2008 transformed the United States and world economies. As each day's headlines brought stories of bank failures and rescues, government policies drawn and redrawn against the backdrop of an historic Presidential election, and solutions that seemed to be discarded almost as soon as they were proposed, a group of thirty-three academics at New York University Stern School of Business began tackling the hard questions behind the headlines. Representing fields of finance, economics, and accounting, these professors-led by Dean Thomas Cooley and Vice Dean Ingo Walter-shaped eighteen independent policy papers that proposed market-focused solutions to the problems within a common framework. In December, with great urgency, they sent hand-bound copies to Washington. Restoring Financial Stability is the culmination of their work.

• Proposes bold, yet principled approaches-including financial policy alternatives and specific courses of action-to deal with this unprecedented, systemic financial crisis
• Created by the contributions of various academics from New York University's Stern School of Business
• Provides important perspectives on both the causes of the global financial crisis as well as proposed solutions to ensure it doesn't happen again
• Contains detailed evaluations and analyses covering many spectrums of the marketplace

Edited by Matthew Richardson and Viral Acharya, this reliable resource brings together the best thinking of finance and economics from the faculty of one of the top universities in world.

Foreword xi

Acknowledgments xiii

Prologue: A Bird’s-Eye View
The Financial Crisis of 2007–2009: Causes and Remedies 1
Viral V. Acharya, Thomas Philippon, Matthew Richardson, and Nouriel Roubini

Part One Causes of the Financial Crisis of 2007–2009 57
Matthew Richardson

Chapter 1 Mortgage Origination and Securitization in the Financial Crisis 61
Dwight Jaffee, Anthony W. Lynch, Matthew Richardson, and Stijn Van Nieuwerburgh

Chapter 2 How Banks Played the Leverage Game 83
Viral V. Acharya and Philipp Schnabl

Chapter 3 The Rating Agencies: Is Regulation the Answer? 101
Matthew Richardson and Lawrence J. White

Part Two Financial Institutions 117
Matthew Richardson

Chapter 4 What to Do about the Government-Sponsored Enterprises? 121
Dwight Jaffee, Matthew Richardson, Stijn Van Nieuwerburgh, Lawrence J. White, and Robert E. Wright

Chapter 5 Enhanced Regulation of Large, Complex Financial Institutions 139
Anthony Saunders, Roy C. Smith, and Ingo Walter

Chapter 6 Hedge Funds in the Aftermath of the Financial Crisis 157
Stephen J. Brown, Marcin Kacperczyk, Alexander Ljungqvist, Anthony W. Lynch, Lasse H. Pedersen, and Matthew Richardson

Part Three Governance, Incentives, and Fair Value Accounting Overview 179
Viral V. Acharya and Rangarajan K. Sundaram

Chapter 7 Corporate Governance in the Modern Financial Sector 185
Viral V. Acharya, Jennifer N. Carpenter, Xavier Gabaix, Kose John, Matthew Richardson, Marti G. Subrahmanyam, Rangarajan K. Sundaram, and Eitan Zemel

Chapter 8 Rethinking Compensation in Financial Firms 197
Gian Luca Clementi, Thomas F. Cooley, Matthew Richardson, and Ingo Walter

Chapter 9 Fair Value Accounting: Policy Issues Raised by the Credit Crunch 215
Stephen G. Ryan

Part Four Derivatives, Short Selling, and Transparency 229
Viral V. Acharya

Chapter 10 Derivatives: The Ultimate Financial Innovation 233
Viral V. Acharya, Menachem Brenner, Robert F. Engle, Anthony W. Lynch, and Matthew Richardson

Chapter 11 Centralized Clearing for Credit Derivatives 251
Viral V. Acharya, Robert F. Engle, Stephen Figlewski, Anthony W. Lynch, and Marti G. Subrahmanyam

Chapter 12 Short Selling 269
Menachem Brenner and Marti G. Subrahmanyam

Part Five The Role of the Federal Reserve 277
Thomas F. Cooley and Thomas Philippon

Chapter 13 Regulating Systemic Risk 283
Viral V. Acharya, Lasse H. Pedersen, Thomas Philippon, and Matthew Richardson

Chapter 14 Private Lessons for Public Banking: The Case for Conditionality in LOLR Facilities 305
Viral V. Acharya and David K. Backus

Part Six The Bailout 323
Thomas F. Cooley and Thomas Philippon

Chapter 15 The Financial Sector Bailout: Sowing the Seeds of the Next Crisis? 327
Viral V. Acharya and Rangarajan K. Sundaram

Chapter 16 Mortgages and Households 341
Andrew Caplin and Thomas F. Cooley

Chapter 17 Where Should the Bailout Stop? 353
Edward I. Altman and Thomas Philippon

Part Seven International Coordination 363

Chapter 18 International Alignment of Financial Sector Regulation 365
Viral V. Acharya, Paul Wachtel, and Ingo Walter

About the Authors 377

Index 381

"In conclusion, this book should be read by every serious observer of the crisis. It is an outstanding contribution." (Lombard Street)

"…ably tackles complex issues and covers a wide spectrum of the current debate, including the multiplicity of regulators, the need for international regulatory coordination, transparency, fair value accounting, compensation reform, and the extent to which monetary policy should address systemic asset bubbles." (The Investment Professional)

“…the book that best combines history, analysis and prescription is “Restoring Financial Stability”, a series of essays by academics at New York University’s Stern School of Business. The 60-page prologue is packed with telling facts and sophisticated analysis, and alone is worth the steep cover price. The individual chapters deal methodically with the myriad issues raised by the crunch, and the policy changes that will be needed, covering everything from the American mortgage market to the need for international cooperation in regulating finance." (The Economist)

"We are always better analysts with a 20/20 hindsight. Indeed, an ex post reading about events leading up to a crisis appears logical, and often leaves one with the question about why the evolution of the crisis could not be seen and corrected in time. Still, policy-makers know that such a review and understanding are important to learning from mistakes. Restoring Financial Stability (Wiley) acts as a catalyst to that understanding by offering a comprehensive sequencing of the causes and progression of the build-up of the financial strains that . . evolved into a full-blown global financial crisis. . . highly recommended even though bankers will remain bankers and will probably figure out ways to beat the new system." (Business Standard)

VIRAL V. ACHARYA is Professor of Finance at New York University Stern School of Business and London Business School. He is Academic Advisor to the Federal Reserve Banks of New York and Philadelphia and Academic Director of the Coller Institute of Private Equity. Professor Acharya earned a Bachelor of Technology in computer science and engineering from the Indian Institute of Technology, Mumbai, and a PhD in finance from NYU Stern. He lives in New York City with his wife and son.

MATTHEW RICHARDSON is the Charles E. Simon Professor of Financial Economics and the Sidney Homer Director of the Salomon Center for the Study of Financial Institutions at New York University Stern School of Business. Professor Richardson received his PhD in finance from Stanford University and his MA and BA in economics concurrently from the University of California at Los Angeles. He lives in New York City with his wife and three children.

RESTORING FINANCIAL STABILITY

The financial crisis that unfolded in September 2008 transformed the United States and world economies. As each day's headlines brought stories of bank failures and rescues, government policies drawn and redrawn against the backdrop of an historic presidential election, and solutions that seemed to be discarded almost as soon as they were proposed, a group of thirty-three academics at New York University Stern School of Business began tackling the hard questions behind the headlines. Representing fields of finance, economics, and accounting, these professors—led by Dean Thomas Cooley and Vice Dean Ingo Walter—shaped eighteen independent policy papers that proposed market-focused solutions to the problems within a common framework. In December, with great urgency, they sent hand-bound copies to Washington.

This book, Restoring Financial Stability: How to Repair a Failed System, is the culmination of their work. For policymakers and business executives alike, the book proposes bold ideas—financial policy alternatives and specific courses of action—to deal with this unprecedented, systemic financial crisis. Their remedies acknowledge the power and potential of the free market. Some require modest regulatory intervention; others will shake regulatory practice to its very foundation.

To better understand the origins of the current financial crisis as well as the options for restoring financial health, don't miss this important and timely work. Edited by Viral Acharya and Matthew Richardson, this reliable resource brings together the best thinking of finance and economics faculty from one of the top universities in world. "This an excellent book. It is the first academic book to consider the crisis in depth and to propose policy responses and solutions. . . broad and deep overview of the crisis [that makes] suggestions for how to minimize the chances of a recurrence going forward. . . essential institutional detail and makes sensible and often original suggestions for reform. One of the remarkable aspects of the book is the speed with which it was produced. . . This book should be read by every serious observer of the crisis. It is an outstanding contribution."
—Franklin Allen., Nippon Life Professor of Finance, Wharton School of the University of Pennsylvania in FinReg21.com

"The best available on this extraordinary and fascinating subject. . . brilliant idea, superbly executed, and has first-class content. Buy it."
—VoxEu.org