Economics, 3rd Edition

SELF TEST 

Use the concept of the reverse multiplier to explain how the financial crisis led to a global 

economic downturn.

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CHAPTER 37  THE FINANCIAL CRISIS AND SOVEREIGN DEBT  793

regulators spend too much time ‘ticking boxes’ rather than identifying poor practice and intervening. There 

have been accusations that the existence of rules means that regulators are able to hide behind them and 

shift blame. For example, there were a number of subsidiaries of the three Icelandic banks which failed 

(Kaupthing, Glitnir and Landsbanki) operating in the UK but the FSA argued that these were, technically, 

outside its jurisdiction. In the US it has been estimated that the total assets of entities which were outside 

the banking system and the scope of regulation, but which act like banks, is as big as the ‘official’ banking 

system itself – a value of around 

$10 trillion in late 2007.

Part of the reason for these problems stems from internal problems of the regulators themselves. To 

have a high level of understanding of the financial system to be able to regulate it effectively, employees of 

the regulators have to be highly experienced and knowledgeable about the system itself. Over-regulation, 

it has been argued, was partly responsible for creating the incentives for financial innovation to generate 

improved returns. These new products were complex and highly interconnected to the extent that regu-

lators and government financial departments had insufficient understanding of them. It has been argued 

that a number of senior executives in the banks themselves did not fully understand the complexity of 

securitization models, lacked the skills in asset valuation techniques and risk models and were unaware of 

the extent to which ‘tail losses’ ( the extremes of the normal distribution) could impact on their operations. 

One reason for this was that such models were based on statistics from the ‘good times’ and had not 

been ‘tested’ by a downturn. If those at the forefront of such operations did not understand what they 

were dealing with is it possible to expect those working at the FSA, for example, to do so?

Recruitment of the expertise and skills necessary to staff regulatory bodies effectively is a further issue. 

Why work for the FSA, for example, for a salary of 

£116,000 when the skills possessed by individuals of 

the calibre to work in the FSA could be sold to other sectors of the industry for many millions? Without the 

resources to do the job properly therefore, regulators will always be hampered.