NEW HAVEN – The severity of the global financial crisis that we have seen over the last two years has to do with a fundamental source of instability in the banking system, one that we can and must design out of existence. To do that, we must advance the state of our financial technology.
In a serious financial crisis, banks find that the declining market value of many of their assets leaves them short of capital. They cannot raise much more capital during the crisis, so, in order to restore capital adequacy, they stop making new loans and call in their outstanding loans, thereby throwing the entire economy – if not the entire global economy – into a tailspin.
This problem is rather technical in nature, as are its solutions. It is a sort of plumbing problem for the banking system, but we need to fix the plumbing by changing the structure of the banking system itself.
Many finance experts – including Alon Raviv, Mark Flannery, Anil Kashyap, Raghuram Rajan, Jeremy Stein, Ricardo Caballero, Pablo Kurlat, Dennis Snower, and the Squam Lake Working Group – have been making proposals along the lines of “contingent capital.”