in financial regulation in the past decade, coupled with the loose
monetary policy of former Federal Reserve Chairman Alan Greenspan, are
partly to be blamed for the financial crisis that has brought the world
into the brink of recession, according to INSEAD Affiliate Professor of
Accounting and Dean of the MBA programme, Jake Cohen.

“The issue to some extent is a perfect storm of regulatory policy,” says Cohen.Jake

Following the Great Depression of the 1930s, the US Congress passed the
Glass-Steagall Act to separate investment and commercial banking
industries. As a result some banks split up, with JPMorgan becoming a
commercial bank and Morgan Stanley an investment bank.

However, the act was repealed in 1999 as banks lobbied Congress to
allow them to be both commercial and investment banks again.

As such, Cohen says banks were able to give mortgages, securitise these
mortgages and sell them as collateralised debt obligations (CDOs) to
institutional investors. This allowed the banks to lend more because
the sale of CDOs gave them access to a new source of funding apart from
customer deposits.

Low interest rates in the 1990s along with rising housing prices
spawned reckless lending practices that gave birth to subprime lending
or lending to people who did not qualify for loans. The subprime
borrowers bet that housing prices would continue to rise and allow them
to refinance their mortgages at lower interest rates.

They were wrong.

US housing prices peaked in 2005 and have since fallen by nearly 30 per
cent from their highs, according to Standard & Poor’s Case-Shiller
home price indices.

Subprime borrowers were unable to refinance their loans as the value of
their homes fell below the level of their outstanding mortgages,
forcing many to default on their mortgage payments and triggering a
collapse in the value of CDOs held by banks and institutional investors.

banks faced mounting mortgage defaults, new accounting rules that took
effect in 2007 required banks to mark-to-market their assets, including
securities such as the CDOs. Valuations of these assets collapsed as
investors stayed away from such risky assets, forcing banks to
write-off the value of these assets and subsequently weakening their
balance sheets.

needed to raise fresh capital to replenish their balance sheets
and improve financial ratios but cautious investors were unwilling to
lend capital, creating a credit crunch that is now dragging the global
economy into recession.

“The crisis may well be subsequently blamed on mark-to-market
accounting. It is making things worse because it came into existence at
a time when subprime mortgages were already causing problems,” says

As the crisis deepens, investors are waiting for the next bank to fail,
not only in the US but also in Europe. 

In recent months, Lehman Brothers went bust, the Fed had to bail out
insurance giant AIG and mortgage giants Fannie Mae and Freddie Mac had
to be nationalised. More American banks are in danger of failing, with
Merrill Lynch bought over by Bank of America and Wells Fargo taking
over Wachovia.

Troubled European banks have also emerged, including Fortis and HBOS.
So far no Asian bank has failed as a result of global financial crisis
but the outlook remains shaky because a recession in the US and Europe
would dampen demand for Asia’s exports, which contribute significantly
to the domestic economies in the region.

It remains to be seen whether the $700 billion bailout plan in the US
and concerted efforts by governments around to world to ease the credit
crunch and stimulate their economies will work. But one thing is
clear: what began as a financial crisis is turning into an economic
downturn that could last through next year.

Republished with permission from Knowledge@INSEAD (, the online research and business analysis journal of INSEAD.