Why US Financial Regulators Are Unprepared For The Next Financial Crisis

The Great Recession from 2007-2009 represented a toxic mixture of failures by market participants and financial regulators. The Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 patched some of the holes. but not nearly all of them. At least, that's the conclusion I reach from a three-paper "Symposium on Financial Stability Regulation" in the Winter 2019 issue of the Journal of Economic Perspectives. (Full disclosure: I have worked as Managing Editor of JEP since the first issue back in 1987, so I am perhaps predisposed to find its articles persuasive.) The papers are:

To understand the underlying perspective here, you need to think about recessions in two parts. All grown-ups know that bad things are going to happen to economies from time to time: oil price shocks, trade shocks, price bubbles in stock markets or housing markets, and so on. If an economy is reasonably resilient, any resulting recessions can be fairly mild and brief. On the other side, if an economy and its financial sector is fragile, with high levels of debt that often need to be rolled over and refinanced on a short-term basis, then a recession that could otherwise have been fairly mild turns into a Great Recession.

From this perspective, the role of financial regulators goes beyond the traditional tasks of looking at individual financial institutions to make sure they are reasonably solvent and are providing timely and accurate information to investors. For some years now, financial regulators have been talking about "macroprudential" regulation (for example, here and here), which goes beyond looking at individual financial institutions to see whether the financial system as a whole is robust. The idea is to avoid the mistake of looking at individual trees while missing risks that involve the entire forest. This view recognizes that recessions will continue to happen, but hopes that with a robust financial system, they will not mushroom into another Great Recession.

In the context of the Great Recession, the team of Aikman, Bridges, Kashyap, and Siegert argue that if US financial regulators had the legal authority and the foresight to take steps to protect the overall robustness of the US financial system in the years before 2008, the Great Recession would have been only one-third or one-fourth as large. They write: "Our diagnosis centers on two overlapping but distinct vulnerabilities: the increase in leverage and short-term funding at financial intermediaries, and the build-up in indebtedness in the household sector. These factors, we argue, can account for around two-thirds to three-quarters of the fall in US GDP that followed the financial crisis."

They describe what macroprudential policy tools would have been needed to address these issues. For example, at least in theory, a government regulator could have required that mortgage lenders impose certain loan-to-income rules, to hold down on the rise in household debt. Or at least, in theory, a government regulator could have imposed rules to prevent investment banks from relying so heavily on extremely short-term borrowing that needed to be rolled over every day--which made them highly vulnerable when that borrowing was not rolled over. However, they point out that these changes were not part of the power given to regulatory authorities by the Dodd-Frank legislation They write:

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Moon Kil Woong 1 week ago Contributor's comment

The good news is unless the banking sector is tied to these shadow institutions and are not declared TBTF then at least the taxpayer is off the hook unless the bureaucrats agree to pilfer the government and taxpayer to bail them out.

I do not think this will boil over anytime soon. First you will see the very leveraged housing market and all the gambling on property go under along with the heavily indebted cash flow negative companies go under like smaller players in the oil sector. The good news is the Federal Reserve is at least cutting down some of their balance sheet and has raised interest rates modestly. Something is better than nothing.

We may hit bad times in about a year and a half or maybe we won't. The issue is, are central banks planning for the inevitable cyclical downturn. Sadly, too few of them are.