3 - Crisis management and legitimacy

Summary

Central banks as firefighters

When the global financial crisis erupted in 2007, central banks were unprepared. Their policies, since adopting inflation targeting, formally or informally at different points since the 1980s, had focused almost exclusively on achieving their inflation targets. Price stability was, of course, intended to provide the basis for economic and financial stability. The crisis was not meant to happen. Central banks – more broadly, macroeconomics – failed to see it coming. This was the first blow to their credibility, even though central banks were, in a sense, a victim of their own success. A decade of macroeconomic stability sowed the seeds for the subprime crisis. Risks were neglected or underestimated, very much in line with Hyman Minsky’s (1992) financial instability hypothesis or Claudio Borio and William White’s (2004) “paradox of credibility”.

Distorted incentives in the financial system, combined with imperfect information, meant that complex and opaque financial instruments, such as collateralized debt obligations (CDOs) backed by mortgagebacked securities (MBSs), could be created. These instruments transferred risk from those who originated subprime loans in the United States to banks not only in that country but also in the European Union and Iceland. Total risks on bank balance sheets were underestimated, partly because of grade inflation by credit rating agencies and partly because of lax regulatory practices that allowed large international banks to use their own risk models. As a result, banks did not have sufficient capital to absorb losses, although their capital adequacy met regulatory standards. This was reflected in a dramatic increase in bank leverage – the ratio of bank assets to equity – as leverage that does not depend on risk weights. Risk weights themselves were falling, because of the proliferation of triple-A-rated assets, while aggregate risk in balance sheets, as well as in the financial system, was rising.

When the US property bubble finally burst, and risks began to be reassessed, money markets started to freeze, from the autumn of 2007. The collapse of Lehman Brothers on 15 September 2008 was a massive shock to confidence: if Lehman could collapse without being bailed out, no bank could be considered safe.