The political, regulatory, and market failures that caused the US financial crisis

PurposeThe purpose of this paper is to discuss the key regulatory, market, and political failures that led to the 2008‐2009 US financial crisis and to suggest appropriate recommendations for reform.Design/methodology/approachThe approach is to examine the underlying incentives that led to the crisis and to provide supporting data to support the hypotheses.FindingsWhile Congress was fixing the savings and loan crisis, it failed to give the regulator of Fannie Mae and Freddie Mac normal bank supervisory power. This was a political failure as Congress was using government sponsored enterprise (GSE) resources and the resources of narrow constituencies for their own advantage at the expense of the public interest. Second, in the mid‐1990s, to encourage home ownership, the Administration changed enforcement of the Community Reinvestment Act, effectively requiring banks to use flexible and innovative methods to lower bank mortgage standards to underserved areas. Crucially, this disarmed regulators and the risky mortgage standards then spread to other sectors of the market. Market failure problems ensued as banks, mortgage brokers, securitizers, credit rating agencies, and asset managers were all plagued by problems such as moral hazard or conflicts of interest.Originality/valueThe paper focuses on the political economy reasons for why Congress and US administrations provided these perverse incentives to the GSEs and banks to lower mortgage standards. It also proposes some innovative methods of improving bank regulation that address the regulatory capture problem.