FEATURE — Summer 2010

Anjan Thakor, PhD, the John E. Simon Professor of Finance at the Olin Business School, twice presented his research on the causes of the economic downturn to the Federal Reserve Bank of New York. Here, he is pictured outside the Federal Reserve Bank of St. Louis.

Causes of the Collapse

Assessing the current economic downturn, Anjan Thakor, professor of finance, analyzed intersecting phenomena that led to what he calls “infectious leverage.” His research has gained traction among financial regulators, and it may help avoid a future cataclysm.

By Shula Neuman

Across the United States (and globe), the Great Recession dispensed negative impacts that are hard to overlook. Massive personnel layoffs, hundreds of business and bank closings, and millions of home foreclosures now dot the country’s map. Yet some people cannot help but see an economic downturn as an opportunity.

Anjan V. Thakor, PhD, the John E. Simon Professor of Finance at the Olin Business School, is one such person. Please be clear: Thakor does not rejoice in the difficulties people are facing during this global crisis. However, as a longtime scholar of banking and finance, he recognizes the situation as a chance to study what caused the collapse, and whether or not it is something that could be avoided in the future.

“Prior to the crisis that began in 2007, we saw two interesting phenomena,” Thakor says. “First, household borrowing was at record levels. Second, in terms of book value, banks were extremely highly leveraged. This was happening at a time when nonfinancial corporations were de-leveraging.”

High rates of borrowing from both consumers and lenders led to a phenomenon that Thakor calls “infectious leverage.” He examined this in a theoretical paper that mathematically models both what happened and what the implications are for setting future economic policy.

Thakor explains that in the early years of the new century, home prices increased at a steady rate with the expectation that the trend would only continue. As a result, most of the leverage came from people borrowing against home equity. People were taking out loans to buy a house, only to flip the house in a very short time and make a substantial profit.

“From a bank’s perspective, the higher the future price of the house, the lower the risk is that the borrower would default,” Thakor explains. “Also, banks have an incentive to keep only as much equity capital as is necessary to absorb default risk and satisfy regulatory capital requirements, because keeping equity capital is costly. The less equity a bank has, the more return on equity it can expect.”

According to Thakor, banks therefore kept lower capital during this period of high house prices because they perceived lower default risk from home buyers. “However, in leveraging so highly, the banks also had a greater risk of going under if their assumptions about future house prices turned out to be incorrect,” Thakor continues.

Added to the environment were regulators who were not terribly vigilant about monitoring banks’ portfolios. The system, therefore, became very fragile. Thakor calls it a perfect storm where the slightest negative economic shock could topple the whole configuration.

By autumn 2008, exactly that started to happen.

“What happened wasn’t a fluke,” Thakor says. “It was highly correlated with the fact of high housing prices. We should expect to see a repeat of this unless we see regulation that prevents banks from making high loans or that limits leverage when things are going well.”

Thakor acknowledges that the parallel pattern of consumer and bank leverage was not the only factor that led to the economic crisis, but he contends that understanding the underlying weaknesses in the banking system can help us understand what happened and help us avoid similar situations in the future.

In fact, Thakor’s paper contains a prescription for setting policy that could minimize the deleterious effects of infectious leverage. For starters, he makes the case for regulators to impose higher capital requirements on banks. Thakor also advocates for tightening lending requirements so that banks are only lending to qualified borrowers with sufficiently high equity. Another recommendation is to examine the trade-off between imposing higher capital requirements on banks versus bailing out the banks that have failed by buying their equity.

“Requiring higher capital requirements up front is a better solution because it encourages banks to maintain higher equity,” Thakor says. “The other option, injecting banks with capital after they’ve failed, creates a moral hazard. Banks know that they will be bailed out, so they can continue to over-leverage.”

“Requiring higher capital requirements up front is a better solution because it encourages banks to maintain higher equity,” Thakor says. “The other option, injecting banks with capital after they’ve failed, creates a moral hazard. Banks know that they will be bailed out, so they can continue to over-leverage.”

Thakor’s work on infectious leverage has received a lot of attention from policymakers across the country and could influence banking regulation in the future. He twice presented his work to the Federal Reserve Bank of New York, as well as the Deutsche Bundesbank in September 2009.

It is too early to tell whether the regulators and economists he has spoken with will adopt his recommendations, Thakor says, but he plans to continue to work with them in an advisory capacity.

Energetic, enthusiastic and prolific
The fact that Thakor’s theory of infectious leverage resonates outside the halls of academia does not surprise his colleagues at the Olin Business School. Even before Thakor joined Olin in 2004, he was known for being one of the most prolific researchers around.

Todd Milbourn, PhD, professor of finance, had Thakor as a dissertation adviser at Indiana University. Milbourn contends that the attention Thakor’s work on infectious leverage is garnering isn’t anomalous.

“His early work on the economic functions of banks and bank loan commitments influenced banking policy,” Milbourn says. “His tenacity makes his output feasible. He always seeks out new problems and new topics that are interesting to him, and, when he needs to, he develops new skills to be able to understand. His drive is unquenchable, and when he gets a paper published, he’s just as happy about getting number 85 published as he was for number 10. You can’t continue to write that 85th paper unless you have that tenacity.”

Those who join forces with Thakor must be prepared to keep up with his seemingly indefatigable energy. Both Milbourn and his colleague Radhakrishnan Gopalan, PhD, assistant professor of finance, collaborate with Thakor. They tell multiple tales of receiving e-mails from him with time stamps from the wee hours of the morning, or of being wary of picking up the phone on weekends because they expected Thakor to be on the other end ready to talk about progress on a paper.

“He’s very sharp; it’s in his DNA. Add to that a seemingly boundless amount of energy and enthusiasm…” Gopalan says. “If you look at his publication record, it’s stupendous. What I find most admirable about him, though, is that his teaching ratings also are outstanding.”

When it comes to Thakor’s teaching skills, Gopalan also knows firsthand; Thakor was his doctoral adviser at the University of Michigan. To this day, Gopalan says he never attends a meeting with Thakor without being fully prepared. According to Gopalan, Thakor juggles so many balls that he justifiably has little patience with someone who is unprepared or who does not deliver results.

Thakor’s enthusiasm transcends research and teaching. Five years ago he assumed the mantle of senior associate dean and has been as dogged about getting results for Olin.

Serving under the current business school dean, Mahendra Gupta, PhD, Thakor engages in the usual array of duties, such as faculty recruitment and reviews, program reviews and seminars. True to form, however, he also tackles large projects. In 2007, he spearheaded revamping the Executive MBA program, something that has facilitated the program’s expansion from St. Louis and Shanghai into Kansas City.

Thakor also played a critical role in finding new leadership for the Weston Career Center. He oversaw the launch of a Master of Science in Finance program several years ago and, thanks to its success, the school has now launched the new Master of Science in Supply Chain Management. Additionally, Thakor helped usher in Olin’s two new research centers, the Center for Finance and Accounting Research and the Institute for Innovation and Growth.

And that only encompasses his work at Olin.

When Thakor is not writing, teaching, presenting his research to policymakers or fulfilling his role as senior associate dean, he is active with the Financial Intermediation Research Society, a group he helped found in 2003. His work with the society is no small task. Until recently he was president of the international organization, which regularly receives 500 paper submissions for its annual meeting, and served as editor of the Journal of Financial Intermediation.

“Time is the big problem,” Thakor says without a trace of irony. “My work on infectious leverage has received a bit of attention. I was invited to the IMF to present my work, but it interfered with my teaching. Then I was invited to the Federal Reserve Bank of Chicago to talk about it and related work, but I’m discovering that I may not be able to do that either.”

Even Thakor may realize his limits, although given the impact of his work, many people are hoping that he finds a way to get around the “time problem.”

Shula Neuman is a freelance writer based in Seattle.