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April 17, 2014

The End of Our Financial Illusions

“The global financial crisis that broke out following the collapse of Lehman Brothers in September 2008 was a big shock. This is literally true in terms of the impact on investors and market prices; a wide range of financial variables moved rapidly in unexpected and worrying directions. But what happened was also a shock to the realm of ideas about finance.”

“Before September 2008 — or at least before 2007, when some of the underlying problems first became more clearly manifest — the prevailing consensus among officials and specialists was that financial innovation was a good thing. In isolated instances, a particular new product might not work out as planned, as happens, for example, with medical innovation. But over all, the consensus went, financial innovation led by the private sector was making the system safer and more efficient.”

“This view was wrong.”

“In its day, this line of thinking justified the legal and regulatory changes that allowed some banks to become very large and to build up a much more complex range of activities in the 1990s and early 2000s, including through various kinds of opaque derivatives transactions.”

“In retrospect, much of the financial innovation in the previous decades built up risk for the financial system in ways that were not properly understood by regulators or, arguably, by management at some of the largest banks.”

“Of course, some bankers knew exactly what they were doing as their companies increased their debt relative to their equity. On average, large complex global banks had about 2 percent equity and 98 percent debt on the liability side of the balance sheet before the crisis, meaning they were leveraged 50:1 (the ratio of total assets to equity).”

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Read full New York Times article here.

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