Manufacturing tail risk: a perspective on the financial crisis of 2007-2009

In: Foundations and trends in finance v. 4, issue 4, p. 247-325

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