Blame marking to market. And the law of unintended consequences.
Paul Davies in Friday’s Insight column picks up a paper from Tobias Adrian, an economist at the New York Fed, and Hyun Song Shin of Princeton University – the pair who have also lately been writing about financial contagion in the Banque de France’s Financial Stability Review.
In it they argue that the move towards fair value accounting by regulators in the 1990s sped up a process of pro-cyclical balance sheet expansion by the banks.
The paper concludes it was inevitable that an industry buoyed by rising asset prices would pursue increasingly aggressive lending growth. This pushed credit upon ever more risky clients and loan structures, which then fed into asset price growth. This of course added more fuel to the fire — or created “positive feedback loops”.
The most disturbing conclusion is that this system should behave in exactly the same way in reverse, creating “negative feedback loops” with a destructive impact on all kinds of asset values — from structured finance to house prices and equities.
Securitisation, says Davies, also played a role. The lesson for regulators again is that the solution to one problem almost always contains the seeds of another.
Related links
Liquidity, VIEs and “involuntary asset growth” – FT Alphaville