The recent financial crisis triggered by subprime mortgages has evoked a wide rage of comments on its causes and consequences. Amid the cacophony of opinions, doubts concerning classical issues in financial theory remain unaddressed. A first issue concerns the assessment of credit risk. Clearly, there was gross mismeasurement of the risk of defaulting on mortgages. It is harder to assign the blame for the crisis, since responsibility for it is shared by at least two classes of agents: the credit intermediaries that granted the subprime mortgages, and the financial markets that allowed securitization and financing of those mortgages.

Banks and other financial intermediaries clearly made major mistakes and did not properly fulfill what is their institutional role: to evaluate and manage risks. Falling into such errors was made easier by the perceived certainty that the default risk could be transferred onto others. In the case of financial markets, it is clear that neither the buyers of assets issued against securitized mortgages, neither the world's major rating agencies have proved able to correctly assess the risks involved.

In short, the split of credit from risk has not worked at all. According to the theory of finance, this should occur in the course of the transition from credit to asset markets. The latter's role should be to split risks by sharing it between investors and brokers on one side, and rating agencies on the other. In particular, investors should assess the risk of insolvency, and intermediaries and agencies should produce and spread market information, in order to reduce inevitable information asymmetries.

Theory assigns financial intermediaries and markets different roles in the assessment and management of risk. The former are said to have higher operational efficiency, while the latter are said to have higher allocational efficiency. But the subprime crisis has thrown both into question, as banks have weakened rigor of evaluation procedures, and markets have spread faulty information, resulting in the incorrect pricing of risk. These inefficiencies may be linked to an excess of financial innovation, and to contagion processes due to the uncontrolled globalization of finance.

All the emphasis hitherto put on the primacy and desirability of the market mechanism in finance now appears misplaced. Financial liberalization must occur gradually, safeguard the traditional monetary and lending roles of banks, and ensure that financial intermediaries and rating agencies be independent from issuers, as well as constantly monitored by government regulators.

by Pier Luigi Fabrizi,
Full Professor of Stock Market Economics and Financial Systems at Bocconi