Restoring Financial Stability

VIRAL V. ACHARYA is Professor of Finance at New York University Stern School of Business and London Business School. He is Academic Advisor to the Federal Reserve Banks of New York and Philadelphia and Academic Director of the Coller Institute of Private Equity. Professor Acharya earned a Bachelor of Technology in computer science and engineering from the Indian Institute of Technology, Mumbai, and a PhD in finance from NYU Stern. He lives in New York City with his wife and son. MATTHEW RICHARDSON is the Charles E. Simon Professor of Financial Economics and the Sidney Homer Director of the Salomon Center for the Study of Financial Institutions at New York University Stern School of Business. Professor Richardson received his PhD in finance from Stanford University and his MA and BA in economics concurrently from the University of California at Los Angeles. He lives in New York City with his wife and three children.

• Foreword xiAcknowledgments xiiiPrologue: A Bird’s-Eye ViewThe Financial Crisis of 2007–2009: Causes and Remedies 1Viral V. Acharya, Thomas Philippon, Matthew Richardson, and Nouriel RoubiniPart One Causes of the Financial Crisis of 2007–2009 57Matthew RichardsonChapter 1 Mortgage Origination and Securitization in the Financial Crisis 61Dwight Jaffee, Anthony W. Lynch, Matthew Richardson, and Stijn Van NieuwerburghChapter 2 How Banks Played the Leverage Game 83Viral V. Acharya and Philipp SchnablChapter 3 The Rating Agencies: Is Regulation the Answer? 101Matthew Richardson and Lawrence J. WhitePart Two Financial Institutions 117Matthew RichardsonChapter 4 What to Do about the Government-Sponsored Enterprises? 121Dwight Jaffee, Matthew Richardson, Stijn Van Nieuwerburgh, Lawrence J. White, and Robert E. WrightChapter 5 Enhanced Regulation of Large, Complex Financial Institutions 139Anthony Saunders, Roy C. Smith, and Ingo WalterChapter 6 Hedge Funds in the Aftermath of the Financial Crisis 157Stephen J. Brown, Marcin Kacperczyk, Alexander Ljungqvist, Anthony W. Lynch, Lasse H. Pedersen, and Matthew RichardsonPart Three Governance, Incentives, and Fair Value Accounting Overview 179Viral V. Acharya and Rangarajan K. SundaramChapter 7 Corporate Governance in the Modern Financial Sector 185Viral V. Acharya, Jennifer N. Carpenter, Xavier Gabaix, Kose John, Matthew Richardson, Marti G. Subrahmanyam, Rangarajan K. Sundaram, and Eitan ZemelChapter 8 Rethinking Compensation in Financial Firms 197Gian Luca Clementi, Thomas F. Cooley, Matthew Richardson, and Ingo WalterChapter 9 Fair Value Accounting: Policy Issues Raised by the Credit Crunch 215Stephen G. RyanPart Four Derivatives, Short Selling, and Transparency 229Viral V. AcharyaChapter 10 Derivatives: The Ultimate Financial Innovation 233Viral V. Acharya, Menachem Brenner, Robert F. Engle, Anthony W. Lynch, and Matthew RichardsonChapter 11 Centralized Clearing for Credit Derivatives 251Viral V. Acharya, Robert F. Engle, Stephen Figlewski, Anthony W. Lynch, and Marti G. SubrahmanyamChapter 12 Short Selling 269Menachem Brenner and Marti G. SubrahmanyamPart Five The Role of the Federal Reserve 277Thomas F. Cooley and Thomas PhilipponChapter 13 Regulating Systemic Risk 283Viral V. Acharya, Lasse H. Pedersen, Thomas Philippon, and Matthew RichardsonChapter 14 Private Lessons for Public Banking: The Case for Conditionality in LOLR Facilities 305Viral V. Acharya and David K. BackusPart Six The Bailout 323Thomas F. Cooley and Thomas PhilipponChapter 15 The Financial Sector Bailout: Sowing the Seeds of the Next Crisis? 327Viral V. Acharya and Rangarajan K. SundaramChapter 16 Mortgages and Households 341Andrew Caplin and Thomas F. CooleyChapter 17 Where Should the Bailout Stop? 353Edward I. Altman and Thomas PhilipponPart Seven International Coordination 363Chapter 18 International Alignment of Financial Sector Regulation 365Viral V. Acharya, Paul Wachtel, and Ingo WalterAbout the Authors 377Index 381

"In conclusion, this book should be read by every serious observer of the crisis. It is an outstanding contribution." (Lombard Street) "…ably tackles complex issues and covers a wide spectrum of the current debate, including the multiplicity of regulators, the need for international regulatory coordination, transparency, fair value accounting, compensation reform, and the extent to which monetary policy should address systemic asset bubbles." (The Investment Professional)“…the book that best combines history, analysis and prescription is “Restoring Financial Stability”, a series of essays by academics at New York University’s Stern School of Business. The 60-page prologue is packed with telling facts and sophisticated analysis, and alone is worth the steep cover price. The individual chapters deal methodically with the myriad issues raised by the crunch, and the policy changes that will be needed, covering everything from the American mortgage market to the need for international cooperation in regulating finance." (The Economist)"We are always better analysts with a 20/20 hindsight. Indeed, an ex post reading about events leading up to a crisis appears logical, and often leaves one with the question about why the evolution of the crisis could not be seen and corrected in time. Still, policy-makers know that such a review and understanding are important to learning from mistakes. Restoring Financial Stability (Wiley) acts as a catalyst to that understanding by offering a comprehensive sequencing of the causes and progression of the build-up of the financial strains that . . evolved into a full-blown global financial crisis. . . highly recommended even though bankers will remain bankers and will probably figure out ways to beat the new system." (Business Standard)