WHAT CAUSED THE CURRENT FINANCIAL MESS AND WHAT CAN WE DO ABOUT IT?

John H. Boyd, Ravi Jagannathan and Sungkyu Kwak

This study reviews the causes and evolution of the financial crisis and surveys some of the recent literature on this topic. It documents how bank regulation became essentially ineffective due to the rise of “quasi-banks,” that is, large financial intermediaries that perform banking functions but are not chartered or regulated as banks. Further, it shows that the problems in banking were primarily concentrated in very large banks, ones that were believed to be too big to fail (hereafter, TBTF) by the market. While we cannot “prove” that the TBTF policy caused the crisis, the data suggest it may have played a key role. The concluding section deals with policy prescriptions and is unabashedly judgmental, reflecting our views. It lays out our policy recommendations for regulatory reform, recent criticisms of those recommendations, and some counter-arguments.