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Banking, Monetary Policy and the Political Economy of Financial Regulation

Banking, Monetary Policy and the Political Economy of Financial Regulation

Essays in the Tradition of Jane D'Arista

Edited by Gerald A. Epstein, Tom Schlesinger and Matías Vernengo

The many forces that led to the economic crisis of 2008 were in fact identified, analyzed and warned against for many years before the crisis by economist Jane D’Arista, among others. Now, writing in the tradition of D’Arista's extensive work, the internationally renowned contributors to this thought-provoking book discuss research carried out on various indicators of the crisis and illustrate how these perspectives can contribute to productive thinking on monetary and financial policies.

Chapter 15: A new measure of liquidity premium

Perry Mehrling and Daniel H. Neilson

Subjects: economics and finance, financial economics and regulation, political economy, politics and public policy, political economy


The role played by investment banks in creating the conditions that led to the global financial crisis that broke out in 2007 is well chronicled. These banks took excessive risks and used excessive leverage to support their immensely profitable proprietary trading; they were a major source of credit to other financial institutions, such as hedge funds, that were also major speculators; and they created, perfected and distributed the innovations in financial products at the center of the financial collapse. The proprietary character of the banks’ trading was often hidden within the banks’ inventories, in their role as market-makers who buy and sell securities to help create and sustain “liquid” security markets. It was thus easy to disguise holdings of securities purchased with the intention to sell at some future date for the bank’s profit – proprietary trading – as securities being kept in inventory for the bank’s market-making activity. To prevent the recurrence of excessive risk-taking with excessive leverage in institutions that are considered too big to fail and therefore potential wards of the state in a serious financial crisis, the U.S. government enacted the Volcker Rule, intended to prohibit proprietary trading as part of the Dodd–Frank financial reform legislation. Not surprisingly, the politically powerful giant investment banks and banking conglomerates that dominate the industry and had successfully lobbied on behalf of radical financial market deregulation for decades have fought tooth and nail against the effective implementation of the Volcker Rule.

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