The Cause of the Credit Crisis

In the report, he identifies two competing models of risk management, the first of which argues that securitization in liquid credit markets was supplanting traditional banking concerns about asymmetric information, uncertainty and illiquid markets.

“The claim was that in the ‘90s, securitization was going to make traditional banking obsolete, and that somehow it was more efficient,” says Milne. The problem with this model, according to him, is that it only works during periods of economic growth and prosperity. “When the credit cycle turned, the wheels fell off the model.”

The second model sees increasing securitization as merely obscuring traditional banking problems, which remained important. Milne explains the first model prevailed, and risk managers made false assumptions about the liquidity and transparency of a new generation of credit instruments, (such as securitized real estate loans and asset-backed commercial paper) resulting in the creation of a shadow credit-banking system, where financial institutions that are not deposit-taking banks can borrow short through asset-backed paper markets, and lend long in illiquid assets.

“The really disturbing thing about it is how widespread it is,” he says. In addition to the U.S. and Canada, Milne says other countries affected include Britain, Australia, Germany, Spain, and Ireland.

The paper outlines several possible policy reforms, but according to Milne, the main focus should be on reinstating traditional banking practices while preserving the “good bits” of securitization. He says there are two schools of thought on the issue, with the optimists saying that we will see continued pain as changes are made with regard to securitization followed by a return to normalcy.

Pessimists, including Milne, say the model is fundamentally flawed and requires profound reform which will likely result in further downward movement of the economy before things get better. He points out that the economic malaise in the U.S. and Canada is not confined to the banking sector, as credit card companies and others begin to post reduced profits or losses. “It will permeate through commercial real estate losses and credit cards, and the high price of oil is just slamming everything again,” he says. “Just how deep it goes, no one quite knows.”

Suggested reforms include a thorough review of risk management systems in all financial institutions; a review by regulators of risk management best practices; national systems, practices and policy reviews for the central banks; and co-operation between national central banks, regulators and international regulatory bodies cooperate in testing and rectifying weaknesses in their risk management systems

“We need serious, and I mean serious, investigations, as the structure is very flawed,” says Milne. He says the regulators and central banks in Canada are getting the message, but that it will be some time before the world economy is out of the woods. “It’s going to be a long, hard slog.”

To read the C.D. Howe report, click here.

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