In 2007 and 2008, America's financial system faced its greatest challenge in seventy years. The crisis originated in America's subprime mortgage market and spread quickly to other debt and equity markets. Some large financial institutions failed, and others were imperiled. How could such a sophisticated financial system go so wrong and cause so much damage? Brookings senior fellows Martin Baily, Douglas Elmendorf, and Robert Litan explain what happened and put forward a specific agenda of policy actions to reduce the chance that history will repeat itself.
The authors, all leading economists with considerable government experience, believe that financial innovation has provided major benefits to the global economy and should continue. In fact, markets and institutions are already responding to the crisis and learning from it, and that process should be allowed to continue. However, the scope and nature of the problems experienced point to inadequacies in our financial regulation and supervision. More should have been done to forestall the erosion of mortgage lending standards, for example. Financial institutions were too highly leveraged and were holding assets whose risks were much greater than their ratings indicated. Much greater transparency was needed at many different points and by many different participants. These are just a few of the lessons drawn from a tumultuous year, one that demands corrective actions both from market participants and from policymakers.
