In the aftermath of the Great Recession, it seemed blindingly clear that the financial sector needed reform. But what kind of reform was needed, and what progress has been made? Stanley Fischer takes on these questions in the 2014 Martin Feldstein Lecture, \”Financial Sector Reform: How Far Are We?\” published in the NBER Reporter (2014, vol. 3).
Everyone in academic economics knows who Fischer is, but for those outside, he\’s a man with an
extraordinary resume. He is currently vice-chairman of the Federal Reserve. Before that, he was governor of the Bank of Israel for eight years. Before that, at various times, he was chief economist at the World Bank, first deputy managing director of the International Monetary Fund, vice chairman at Citibank, and a very prominent economics professor at MIT. His Fischer\’s quick summary of the nine main items on the financial sector reform agenda:
Several financial sector reform programs were prepared within a few months after the Lehman Brothers failure. These programs were supported by national policymakers, including the community of bank supervisors. The programs – national and international – covered some or all of the following nine areas: (1) to strengthen the stability and robustness of financial firms, \”with particular emphasis on standards for governance, risk management, capital and liquidity\” (2) to strengthen the quality and effectiveness of prudential regulation and supervision; (3) to build the capacity for undertaking effective macroprudential regulation and supervision; (4) to develop suitable resolution regimes for financial institutions; (5) to strengthen the infrastructure of financial markets, including markets for derivative transactions; (6) to improve compensation practices in financial institutions; (7) to strengthen international coordination of regulation and supervision, particularly with regard to the regulation and resolution of global systemically important financial institutions, later known as G-SIFIs; (8) to find appropriate ways of dealing with the shadow banking system; and (9) to improve the performance of credit rating agencies, which were deeply involved in the collapse of markets for collateralized and securitized lending instruments, especially those based on mortgage finance.
In his talk, he focuses on three of these items: \”Rather than seek to give a scorecard on progress on all the aspects of the reform programs suggested from 2007 to 2009, I want to focus on three topics of particular salience mentioned earlier: capital and liquidity, macroprudential supervision, and too big to fail.\”
Capital ratios have been substantially increased, which means that banks will in the future have a bigger buffer the next time their loan portfolio turns unexpectedly bad. Here\’s Fischer:
The bottom line to date: The capital ratios of the 25 largest banks in the United States have risen by as much as 50 percent since the beginning of 2005 to the start of this year, depending on which regulatory ratio you look at. For example, the tier 1 common equity ratio has gone up from 7 percent to 11 percent for these institutions. The increase in the ratios understates the increase in capital because it does not adjust for tougher risk weights in the denominator. In addition, the buffers of HQLAs [high-quality liquid assets] held by the largest banking firms have more than doubled since the end of 2007, and their reliance on short-term wholesale funds has fallen considerably. At the same time, the introduction of macroeconomic supervisory stress tests in the United States has added a forward-looking approach to assessing capital adequacy, as firms are required to hold a capital buffer sufficient to withstand a several-year period of severe economic and financial stress. The stress tests are a very important addition to the toolkit of supervisors, one that is likely to add significantly to the quality of financial sector supervision.
As is well known, the United Kingdom has reformed financial sector regulation and supervision by setting up a Financial Policy Committee (FPC), located in the Bank of England; the major reforms in the United States were introduced through the Dodd-Frank Act, which set up a coordinating committee among the major regulators, the Financial Stability Oversight Council (FSOC). Don Kohn … sets out the following requirements for successful macroprudential supervision: to be able to identify risks to financial stability, to be willing and able to act on these risks in a timely fashion, to be able to interact productively with the microprudential and monetary policy authorities, and to weigh the costs and benefits of proposed actions appropriately. Kohn\’s cautiously stated bottom line is that the FPC is well structured to meet these requirements, and that the FSOC is not. In particular, the FPC has the legal power to impose policy changes on regulators, and the FSOC does not, for it is mostly a coordinating body.
What about the efforts to address the \”too big to fail\” problem, where large financial firms that have taken big risks and earlier earned large profits then need to be bailed out by the government, because they are so large and so interconnected to the rest of the economy that their failure could lead to even larger public costs?
One can regard the entire regulatory reform program, which aims to strengthen the resilience of banks and the banking system to shocks, as dealing with the TBTF [too big to fail] problem by reducing the probability that any bank will get into trouble. There are, however, some aspects of the financial reform program that deal specifically with large banks. The most important such measure is the work on resolution mechanisms for SIFIs, including the very difficult case of G-SIFIs [global systemically important financial institutions]. In the United States, the Dodd-Frank Act has provided the FDIC with the Orderly Liquidation Authority (OLA) – a regime to conduct an orderly resolution of a financial firm if the bankruptcy of the firm would threaten financial stability. …
Work on the use of the resolution mechanisms set out in the Dodd-Frank Act, based on the principle of a single point of entry, holds out the promise of making it possible to resolve banks in difficulty at no direct cost to the taxpayer — and in any event at a lower cost than was hitherto possible. However, work in this area is less advanced than the work on raising capital and liquidity ratios. … [P]rogress in agreeing on the resolution of G-SIFIs and some other aspects of international coordination has been slow. …
What about simply breaking up the largest financial institutions? Well, there is no \”simply\” in this area. … Would a financial system that consisted of a large number of medium-sized and small firms be more stable and more efficient than one with a smaller number of very large firms? … That is not clear, for Lehman Brothers, although a large financial institution, was not one of the giants — except that it was connected with a very large number of other banks and financial institutions. Similarly, the savings and loan crisis of the 1980s and 1990s was not a TBTF crisis but rather a failure involving many small firms that were behaving unwisely, and in some cases illegally. This case is consistent with the phrase, \”too many to fail.\” Financial panics can be caused by herding and by contagion, as well as by big banks getting into trouble. In short, actively breaking up the largest banks would be a very complex task, with uncertain payoff.
Fischer\’s overall tone seems to me cautiously positive about how financial reform has proceeded. My own sense is more negative. By Fischer\’s accounting, capital ratios have clearly improved, but macroprudential regulation and avoiding too big to fail remain works in progress.
As I have pointed out before on this website, the Dodd-Frank Act of 2010 required the passage of 398 rules, and a little more than half of those rules have been finalized in the last few years. But to be clear, a \”finalized\” rule doesn\’t actually mean that businesses have figured out how to comply with the rule, and the rule itself may still be under negotiation. In certain areas from Fischer\’s list of rule, like #8 concerning the risks of shadow banking (for discussion, see here and here) and #9 concerning credit rating agencies (for discussion, see here and here), Dodd-Frank required almost no changes at all. I understand that financial reform is like changing the course of an enormous ocean liner, not like steering a bicycle. But we are now six years past the worst of the crisis in 2008, and much remains to be done.