Guardians of Finance

January 16, 2012
Despite the complex subject, this incisive book presents a straightforward thesis: the financial meltdown of 2007–2009 happened largely because the “Guardians of Finance” (market regulatory agencies) failed to represent the public interest. In lively prose, Barth (Auburn University finance scholar), Caprio (economics professor at Williams College), and Levine (economics professor at Brown University) review how and why this happened, focusing on changes in organizational structure. The evolution of banks and brokerages from partnerships to limited liability corporations encouraged risk taking and put a premium on expansion, high volume, and quick turnover. For market participants, this was a rational response to the prevailing incentives. Securitization enabled mortgage originators to package bundles of mortgages for sale and pass along the consequences of potential loan default to others, while rating agencies knew that traditional caution might send business to more compliant rivals. Exploding the myth that banks were unregulated during this period, the authors instead ask why regulators were ineffective even though Fed staff understood “the growing fragility of the financial system in the decade before the crisis.” Rejecting rote expansion of regulatory ranks and authority, they propose creating an independent “Sentinel” agency, staffed with experts, to provide “an ongoing assessment that seeks to identify problems with financial regulation before they trigger a crisis,” and present a strong case for this informed outside perspective.