Policy Matters is a quarterly series of reports that provide timely research and guidance on issues that are of concern to policymakers at the local, state, and national levels.

Volume 4, Issue 1 by John Cioffi is entitled: The Global Financial Crisis: Conflicts of Interest, Regulatory Failures, and Politics.


Executive Summary

The Lehman Brothers investment bank collapsed on September 10, 2008 and filed for bank- ruptcy five days later. As credit froze and debt market liquidity evaporated, a global economic collapse became an imminent possibility—and was only averted by unprecedented governmental and central bank interventions around the world. Some have argued that the crisis was the product of a “perfect storm” of random market developments, or of the failure of economic models to account for outlier market conditions. As this report shows, however, these explanations do not get at the root of the problem, as it was pervasive regulatory failures that created the conditions for the crisis and fueled the catastrophic contagion of financial sector collapses from 2007 through 2009.

This report outlines the ways in which the financial crisis spread from the unregulated and least regulated areas of the financial system. These included mortgage lending practices and standards, securitized debt instruments, derivatives, credit rating agencies, financial institution leverage ratios, and the investment banks, off-balance sheet vehicles, hedge funds, and the array of entities, markets, and counterparty relationships comprising the shadow banking system. Furthermore, these regulatory deficiencies were the products of politics, of a neoliberal turn of American economic and regulatory policy embraced by both the Republican and Democratic parties. This policy trajectory eroded state regulatory capacity while it enriched and empowered the financial sector.

After detailing the financial and regulatory frameworks surrounding mortgage-backed securities (MBS) and collaterized debt obligations (CDO), this report considers the role of the MBS and CDO markets in triggering and worsening the financial crisis of 2007-2009. Finally, the report outlines the contours of financial reform proposed in the aftermath of the crisis. What is clear from these reform efforts is that, in order to minimize continued risks to national and global financial systems, rules must effectively regulate derivatives, address the “too-big-to-fail” problem of systemically vital financial institutions, and extend financial regulation to the broader shadow banking system. Finally, conflict of interest regulation should extend to debt ratings agencies, and stronger enforcement mechanisms are needed to ensure that legal reforms are not rendered meaningless in practice.

John W. Cioffi is assistant professor of political science at UC Riverside, and has written extensively in public law, comparative regulation, and comparative political economy. This report draws on work from his forthcoming book Public Law and Private Power, from Cornell University Press. Professor Cioffi can be reached by email: john.cioffi@ucr.edu. or by phone: (951)827-7269.