Monday, May 3, 2010

Financial Crises

Free Exchange:
I READ an interesting story last week about a French banker. His bank relied on new financial innovations and complex transactions. The innovations allowed the bank and its clients to become highly leveraged. Rampant speculation, lack of transparency and easy money fed a large asset bubble. The bubble became so big it diverted capital from traditional industries that made goods and towards pure financial speculation. By the time the asset bubble burst, investors and the bank were so highly leveraged that the financial system nearly collapsed. The banker’s name was Eugene Bontoux. If you’ve never heard of him, that’s because he’s been dead a long time. The financial crisis he’s associated with occurred in 1882.

Emphasis mine. Finding a way to regulate leverage is the key to preventing future crises. FLG would like to point out that to the extent that normal individuals take on the most leverage to buy their houses and consequently many financial crises start in the housing sector.

In fact, everybody is talking about regulating leverage, but often indirectly. We ought not let people get in over their heads with mortgages -- too much leverage. We ought to split safe retail banking from investment banking -- leverage. Derivatives are dangerous and OTC derivatives double-secret dangerous -- leverage.

This is all very obvious, but FLG hears a lot of discussions about financial regulation that are really various people's pet peeves with finance. So, they want a consumer agency or to reinstate Glass-Steagall or payday loans or credit card fees or to look at this or that, when the primary and perhaps only systematic issue is leverage.

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