Abstract
Although debates still rage over the causes of the financial crisis of 2007–2009, one thing is clear: several of the world's largest financial institutions — including Fannie Mae, Freddie Mac, Citigroup, UBS, AIG, Bear Stearns, Lehman Brothers, and Merrill Lynch — had amassed huge and concentrated asset risks relating to sub-prime mortgages and other risky investments, but they maintained equity capital that was too small to absorb the losses that resulted from those risky investments. In other words, relative to risk, equity capital proved inadequate to insulate these firms, and many others, from insolvency when their risks were realized.
Why did the regulatory system perform so badly? There were two central reasons that prudential regulation failed to require financial institutions to maintain adequate capital. Incentive problems that: (1) Distorted the measurement of risk, and (2) Discouraged the timely replacement of lost equity capital.