Manufacturing Tail Risk: A Perspective on the Financial Crisis of 2007-09

90 Pages Posted: 25 Feb 2010

See all articles by Viral V. Acharya

Viral V. Acharya

New York University - Leonard N. Stern School of Business; Centre for Economic Policy Research (CEPR); National Bureau of Economic Research (NBER); New York University (NYU) - Department of Finance

Thomas F. Cooley

New York University - Leonard N. Stern School of Business; National Bureau of Economic Research (NBER)

Matthew P. Richardson

New York University (NYU) - Department of Finance; National Bureau of Economic Research (NBER); AQR Capital Management, LLC

Ingo Walter

New York University - Leonard N. Stern School of Business; New York University (NYU) - Department of Finance

Date Written: February 22, 2010

Abstract

We argue that the fundamental cause of the financial crisis of 2007-09 was that large, complex financial institutions (“LCFIs”) took excessive leverage in the form of manufacturing tail risks that were systemic in nature and inadequately capitalized. We employ a set of headline facts about the build-up of such risk exposures to explain how and why LCFIs adopted this new banking model during 2003-2Q 2007, relative to earlier models. We compare the crisis to other episodes in the United States, in particular, the panic of 1907, the failure of Continental Illinois and the Savings and Loan crisis. We conclude that several principal imperfections, in particular, distortions induced by regulation and government guarantees, developed in decades preceding the current one, allowing LCFIs to take on excessive systemic risk. We also examine alternative explanations for the financial crisis. We conclude that while moral hazard problems in the originate-and-distribute model of banking, excess liquidity due to global imbalances and mispricing of risk due to behavioral biases have some merit as candidates, they fail to explain the complete spectrum of evidence on the crisis.

Keywords: Systemic risk, Capital requirements, Regulatory arbitrage, Moral hazard, Too big to fail, Government guarantees, Originate and distribute, Global Imbalances, Greenspan put

JEL Classification: G2, G3, D62, E5, N2

Suggested Citation

Acharya, Viral V. and Cooley, Thomas F. and Richardson, Matthew P. and Walter, Ingo, Manufacturing Tail Risk: A Perspective on the Financial Crisis of 2007-09 (February 22, 2010). Foundations and Trends in Finance, Vol. 4, 2010. Available at SSRN: https://ssrn.com/abstract=1557467

Viral V. Acharya (Contact Author)

New York University - Leonard N. Stern School of Business ( email )

44 West 4th Street
Suite 9-160
New York, NY NY 10012
United States

HOME PAGE: http://pages.stern.nyu.edu/~sternfin/vacharya/public_html/~vacharya.htm

Centre for Economic Policy Research (CEPR)

London
United Kingdom

National Bureau of Economic Research (NBER)

1050 Massachusetts Avenue
Cambridge, MA 02138
United States

New York University (NYU) - Department of Finance

Stern School of Business
44 West 4th Street
New York, NY 10012-1126
United States

Thomas F. Cooley

New York University - Leonard N. Stern School of Business ( email )

44 West Fourth Street, 7-180
Room 7-85
New York, NY 10012
United States
212-998-0870 (Phone)
212-995-4218 (Fax)

National Bureau of Economic Research (NBER)

1050 Massachusetts Avenue
Computer Research Center
Cambridge, MA 02138
United States

Matthew P. Richardson

New York University (NYU) - Department of Finance ( email )

44 West 4th Street
Suite 9-190
New York, NY 10012-1126
United States
212-998-0349 (Phone)
212-995-4233 (Fax)

National Bureau of Economic Research (NBER)

1050 Massachusetts Avenue
Cambridge, MA 02138
United States

AQR Capital Management, LLC ( email )

Greenwich, CT
United States

Ingo Walter

New York University - Leonard N. Stern School of Business ( email )

44 West 4th Street
New York, NY 10012
United States
212-998-0707 (Phone)
212-995-4220 (Fax)

New York University (NYU) - Department of Finance

Stern School of Business
44 West 4th Street
New York, NY 10012-1126
United States

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