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Engineering the Financial Crisis

Systemic Risk and the Failure of Regulation

By Jeffrey Friedman and Wladimir Kraus

Publication Year: 2011

One of the lasting legacies of Reaganomics is a deep-seated distrust of government intervention in the markets. Despite this still-popular sentiment, the Basel Accords, a set of international standards for banking supervision and regulation, have been the subject of remarkably little public criticism. While academics and practitioners decry the enforcement of the Sarbanes-Oxley Act on accounting reform or attempts by Congress to regulate executive compensation, the Basel Accords have been quietly accepted.

In one of the first studies critically to examine the Basel Accords, Engineering the Financial Crisis reveals the crucial role that bank capital requirements and other government regulations played in the recent financial crisis. Jeffrey Friedman and Wladimir Kraus argue that by encouraging banks to invest in highly rated mortgage-backed bonds, the Basel Accords created an overconcentration of risk in the banking industry. In addition, accounting regulations required banks to reduce lending if the temporary market value of these bonds declined, as they did in 2007 and 2008 during the panic over subprime mortgage defaults.

The book begins by assessing leading theories about the crisis—deregulation, bank compensation practices, excessive leverage, "too big to fail," and Fannie Mae and Freddie Mac—and, through careful evidentiary scrutiny, debunks much of the conventional wisdom about what went wrong. It then discusses the Basel Accords and how they contributed to systemic risk. Finally, it presents an analysis of social-science expertise and the fallibility of economists and regulators. Engagingly written, theoretically inventive, yet empirically grounded, Engineering the Financial Crisis is a timely examination of the unintended—and sometimes disastrous—effects of regulation on complex economies.

Published by: University of Pennsylvania Press


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pp. v

List of Figures and Tables

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pp. vii

Glossary of Abbreviations and Acronyms

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pp. ix-x

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pp. 1-4

This is not the ordinary book about the financial crisis. The product of a collaboration between an economist (Kraus) and a political theorist (Friedman), it is designed for readers who are interested not only in what caused the financial crisis, but in what those causes indicate about the nature of capitalism and of modern government. Along the way to considering these...

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1. Bonuses, Irrationality, and Too-Bigness: The Conventional Wisdom About the Financial Crisis and Its Theoretical Implications

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pp. 5-56

In this chapter, we will confront the six items of conventional wisdom with hard evidence and, we hope, sound reasoning in order to clear the ground for our own argument: that, stripped to its essentials, the crisis was a regulatory failure in which the prime culprit was none of the usually targeted factors, but was, instead, the set of regulations governing banks’ capital levels known as the Basel rules. ...

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2. Capital Adequacy Regulations and the Financial Crisis: Bankers' and Regulators' Errors

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pp. 57-85

A bank’s ‘‘capital’’ is the security blanket it needs because of the fragile nature of banking. Any corporation’s capital boils down to its net worth, or ‘‘the residual after subtracting liabilities from assets’’ (Gilliam 2005, 293, emphasis added). ‘‘The greater a bank’s capital, the more it can absorb net losses before liabilities exceed assets’’: capital serves as a buffer against...

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3. The Interaction of Regulations and the Great Recession: Fetishizing Market Prices

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pp. 86-111

It is doubtful that the U.S. and international financial regulators who, in all three versions of the Basel regime (including the Recourse Rule), assigned a low risk weight to mortgages, anticipated the effect this might have on banks and on the world economy if a housing bubble were to occur—or that they anticipated that this action might have contributed to such a bubble. ...

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4. Capitalism and Regulation: Ignorance, Heterogeneity, and Systemic Risk

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pp. 112-143

The modern democratic method of case-by-case social-problem solving, which Karl Popper (1961, 64–70) called the system of ‘‘piecemeal social engineering,’’ rarely rises to the conceptual level at which it can be labeled a ‘‘principle,’’ let alone a ‘‘system’’; and ‘‘social engineering’’ has acquired totalitarian connotations that Popper did not intend. The engineer is not an...

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pp. 144-156

We began in Chapter 1 with the fact that the mortgage-backed bonds on the balance sheets of U.S. commercial banks appear to have been either guaranteed by the GSEs or rated triple-A. This well-known fact poses serious problems for the two most prominent hypotheses about the cause of the crisis, both of which are ‘‘moral-hazard’’ stories. According to one of the moral-hazard stories, bankers made bets on...

Appendix I. Scholarship About the Corporate-Compensation Hypothesis

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pp. 157-162

Appendix II. The Basel Rules off the Balance Sheet

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pp. 163-174


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pp. 175-187


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pp. 189-200


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pp. 201-210


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pp. 211-212

E-ISBN-13: 9780812205077
Print-ISBN-13: 9780812243574

Page Count: 224
Publication Year: 2011