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Engineering the Financial Crisis: Systemic Risk and the Failure of Regulation Hardcover – September 26, 2011

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Editorial Reviews


Selected by Choice magazine as an Outstanding Academic Title for 2013

"This book argues that the incentive distortions of bank capital-adequacy regulations were the proximate cause of the 2007 financial crisis. The systemic instability that followed was fueled by blind-sided experts who perpetuated the myths of too-big-to-fail and overcompensated corporate managers. A serious read for those struggling to make sense of the worst crisis since the Depression."—Vernon Smith, 2002 Nobel Laureate in Economics

"An excellent conceptual book on the financial crisis, full of deep research and intellectual honesty." —Tyler Cowen, Marginal Revolution

"For anyone wanting to read only a single book about the crisis and its origins, this is the book to read."—Choice

"Jeffrey Friedman and Wladimir Kraus distinguish themselves by presenting the most systematic and rigorously argued empirical analysis of the crash to date."—Perspectives on Politics

"While this is the single best book on the financial crisis, it also offers an outstanding analysis of decision making in modern regulatory states."—Samuel DeCanio, Yale University

"If you thought you understood the causes of the financial crisis, think again. This thought-provoking exploration of the financial crisis provides a convincing argument that much of what we thought we knew about the crisis is, at best, misleading. In thinking about the cause, much more focus needs to be given to ignorance on everyone's part, and models that don't include ignorance will be, at best, incomplete. Ignorance of the importance of ignorance is a sign of ignorance."—David Colander, Middlebury College

About the Author

Jeffrey Friedman is a visiting scholar in the Department of Government at the University of Texas, Austin. He is the editor of What Caused the Financial Crisis, also available from the University of Pennsylvania Press, and editor of the journal Critical Review. Wladimir Kraus is a doctoral candidate in economics at Universite Paul Cezanne Aix-Marseille and associate editor of Critical Review. Together, Friedman and Kraus maintain Causes of the Crisis, a blog that publishes updated information about the financial crisis.
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Product Details

  • Hardcover: 224 pages
  • Publisher: University of Pennsylvania Press (September 26, 2011)
  • Language: English
  • ISBN-10: 0812243579
  • ISBN-13: 978-0812243574
  • Product Dimensions: 9.1 x 6.4 x 1 inches
  • Shipping Weight: 1.1 pounds (View shipping rates and policies)
  • Average Customer Review: 4.1 out of 5 stars  See all reviews (8 customer reviews)
  • Amazon Best Sellers Rank: #1,153,747 in Books (See Top 100 in Books)

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Customer Reviews

Most Helpful Customer Reviews

18 of 19 people found the following review helpful By Jean Parmesan on December 3, 2011
Format: Hardcover
Since the bursting of the real estate bubble in 2008, a slew of books have been published claiming to provide the definitive narrative of what caused the financial crisis and resulting economic malaise. Some blame irrational exuberance while others have attributed the blame to deregulation or poorly aligned economic incentives between bank executives and their principals. Given the irreducible complexity of our global economy, it is quite possible that we will never know the correct narrative - assuming that one exists - and that the whole debate is more ideological posturing than anything else.

Of the books that I have read, "Engineering the Financial Crisis" is the best so far, not because I think that Friedman and Kraus have necessarily identified the correct culprits, but rather they are able to see beyond the economic blinders that cause so many other authors to focus on incentives over information failures. In short, the authors are able to get to the heart of the crisis better than anyone else.

Friedman and Kraus argue that the following elements significantly contributed to the financial crisis by disabling important market information and providing the wrong incentives:

1. The SEC conferred monopoly status on three credit rating agencies, which severely disrupted competition and the dissemination of dissenting information related to the quality of mortgage-backed securities.

2. Bank capital requirements (e.g. the Recourse Rule), as promulgated by various regulatory agencies in the U.S., which provided a large capital subsidy for purchasing mortgage-backed securities over other securities.

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12 of 12 people found the following review helpful By MT57 on November 27, 2011
Format: Hardcover Verified Purchase
This is a spectacularly intelligent work about a systemic risk they aptly call "cognitive hazard", which manifested itself in several regulatory edicts that, the authors cogently demonstrate, "engineered the financial crisis. Specifically, those edicts included not only regulations designed to expand mortgage availability to persons at high risk of default, but more systemically, bank capital regulations that assigned lower risk capital weights to mortgages, mortgage - backed securities, and sovereign debt --- the very classes of debt that have been driving the financial crisis the past four years -- which incentivized such banks to hold and demand more of them (3X what the market in general was holding, according to the appendix). As well, they specify regulatory endorsement of rating agency output among the affirmative directives that steered commercial banks into the portfolio of loans that they held at the inception of the financial crisis, and how mark-to-market regulations, adopted toward the end of the pre-crisis period, acted as an accelerant to fuel the collapse of asset prices, thereby deepening the invasion of bank capital, and the need for central bank intervention.

This is an incisive counter to the MSM and political class's narrative of under-regulation, of regulators being captured and failing to do their job, which is defined to be being tough on greedy bankers. But it differs significantly from the simplistic myth that completely free markets, left alone, always produce optimal results.
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6 of 7 people found the following review helpful By merjet on February 20, 2012
Format: Hardcover
In my opinion Engineering the Banking Crisis would have been a more descriptive title. It has little to say about the housing bubble and burst that led to the crisis at commercial banks. Absent knowing the authors' narrower meaning of "financial crisis", one would find the alternative explanations that they "find no evidence for" on page 1 very questionable. I haven't read What Caused the Financial Crisis, which was co-edited by Friedman, but it appears to be about the financial crisis with the wider, usual meaning.

I still thought the book covered the territory it did pretty well. The authors say the primary cause of the financial crisis -- reduced lending by commercial banks to non-financial companies or consumers in the "real economy" -- was Basel I and the Recourse Rule (an adoption in the U.S. of part of what later became Basel II), which specify capital requirements for commercial banks. These set low capital requirements for mortgage-backed securities compared to much higher capital requirements for loans to non-financial companies and consumers. A secondary cause is mark-to-market accounting, which affected capital adequacy. Another cause was the bond rating agencies. They make a strong case for these. I've read quite a bit about the financial crisis, and this was the first source that addressed the capital requirements and their effect.

A major thesis of the book is ignorance--of both regulators and bankers. Regulators acted lacking understanding of the full range of regulations that apply to the regulated and unintended consequences. It appeals to the difference between "uncertainty" and "risk" ala Frank Knight and Keynes. They don't do so mainly to cast blame, since they regard economic uncertainty as inevitable.
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