Risk-Pricing and the Sub-Prime Crisis

As the sub-prime crisis celebrates its first birthday, what lessons have been learnt? The crisis was rooted in a misperception problem among end-investors, facilitated by financial engineers selling “tail risk†products. Contrary to the precrisis rhetoric, this tail risk was often transferred to those least able to manage and price it. Once crisis struck, bank balance sheets needed to be repaired. The article argues that the authorities have a key coordinating role to play in ensuring individual bank balance sheet adjustments strengthen, rather than weaken, the financial system as a whole. A credit crunch-an uncoordinated credit contraction—is an example of what policy should be seeking to avoid. Finally, the article considers two medium-term prophylactic policy measures-countercyclical regulatory policy and central trading, clearing and settlement of systemically-important financial instruments. On both theoretical and practical grounds, there are good reasons for believing their time may have come.