The financial crisis which began in the summer of 2007 has its roots in a big collective mistake: the under estimation of systemic risk. This mistake has two important dimensions. A first dimension is the absence of a macroprudential view in the design and practice of financial regulation and economic policy (especially monetary policy, but possibly also the fiscal and exchange rate policies that helped sustain global imbalances). A second dimension is the excessively optimistic judgment of the process of securitization and the supposed virtues of the originate-to-distribute (OTD) model of banking.
This second dimension of the mistake was partly sustained by the lack of data and historical experience with the OTD model, as well as by the general acceptance of naïve extrapolations of financial theory, regarding the virtues of diversification and greater market completeness. Potential asymmetric information and agency problems were overlooked, ignoring many of the insights provided by the academic corporate finance and banking literatures over the last 30 years.
The risks associated with in the OTD model of banking, including risks due to maturity mismatch, were not essentially different in nature to those present in the traditional domestically oriented banking systems. However, due to the effective lack of transparency of the OTD model, its greater complexity and interconnectedness, and the lack of prudence resulting from both ignorance and negligence, these risks were both less well understood and much more dangerous.
A truth evidenced by the crisis (but denied by many before its outburst) is that short term wholesale liabilities constitute, in practice, a less stable source of funds for banks than retail deposits. This lower stability comes partly from the fact that banks' non- deposit, short-term debt lacks an arrangement similar to deposit insurance. Deposit insurance protects the financial system against traditional deposit runs by reassuring depositors about the value of their deposits when there are rumors about the likely insolvency of their banks. Short-term wholesale creditors did not get similar reassurances until very late in this crisis.
