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:
- \”Financial Regulation: Still Unsettled a Decade after the Crisis,\” by Daniel K. Tarullo
- \”Prone to Fail: The Pre-crisis Financial System,\” by Darrell Duffie
- \”Would Macroprudential Regulation Have Prevented the Last Crisis?\” by David Aikman, Jonathan Bridges, Anil Kashyap, and Caspar Siegert
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 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:
We argue that the US Financial Stability Oversight Council would likely make little difference were we to experience a rerun of the factors that caused the last crisis. It has no macroprudential levers under its direct control, and not all of its members have mandates to protect financial stability. … And given the role played by loosely regulated nonbank financial institutions prior to the last crisis—and the continuing evolution of the financial system—a successful macroprudential intervention would likely require political backing to be nimble in widening the perimeter of regulation to capture such institutions. More generally, such a regulator would have to be fairly aggressive in using its powers. Given the novelty of these powers, there is no clear evidence on whether such forceful interventions would be realistic were risks to escalate again. …
As one example of the powers that US regulators do not have:
After the crisis, the Dodd–Frank Act did ban certain types of mortgages, such as interest-only mortgages or those with negative amortization. But it left the question of minimum down-payment restrictions to a group of six regulators involved in housing, which ultimately opted against introducing such a requirement. While risks in the housing market have significantly declined since the crisis, average loan-to-value ratios on mortgages are not lower than they were in the early 2000s. Furthermore, no US regulator has the ability to impose loan-to-income requirements, even if the Financial Stability Oversight Council wished to recommend this action. … Moreover, the Fed lacks authority over many parts of the financial system and has no tools that can be used to tackle household debt vulnerabilities. A June 2015 “war game” exercise conducted by four Reserve Bank presidents concluded that the Fed had insufficient macroprudential powers to address a build-up in risks that resembled the earlier financial crisis. Also, Fed officials have cast doubt on whether its mandate permits it to use monetary policy to act against a build-up in financial stability risks.
Thus, Aikman, Bridges, Kashyap, and Siegert are pointing out that financial regulators are unprepared for a literal rerun of the financial crisis that already occurred. The regulators also remain unprepared for financial crises that arise form other sources or in other forms.
For example, Daniel Tarullo points out in his essay that most of the regulatory attention has focused on banks. but potential dangers remain in the rest of the financial system. Tarullo writes:
Within the perimeter of prudentially regulated banking organizations, post-crisis financial regulation has made considerable strides, though liquidity regulation needs more work and capital requirements for the biggest banks should probably be somewhat higher. … While there is at least a chance for maintaining the progress toward more resiliency for the largest banks, it is considerably harder to conjure up a benign outcome with respect to financial activity that occurs outside the perimeter of banking organizations. Recycled or new forms of shadow banking will almost surely increase over time, whether from existing nonbank financial firms or from new fintech (financial technology) entrants. Some of these will present risks to financial stability.
For an example of one set of shadow banking issues, Amit Seru argues that \’Regulation of the Mortgage Market Must Consider Shadow Banks\” in a Policy Brief written for the Stanford Instituted for Economic Policy Research (December 2018). As he notes: \” Mortgage lending in this country is highly segmented and traditional banks represent only an increasingly small part of the story. For many decades, banks have competed with independent mortgage companies that don’t take deposits and typically don’t have brick-and-mortar branches, a group that can be called `shadow banks.\’” This figure shows that the share of mortgage lending that doesn\’t come from banks is over half and rising.
The mortgages from these independent companies are then bundled together into financial securities, which are in turn sliced and diced into pieces and resold to investors (including banks, pension funds, insurance companies, hedge funds, money market funds, and others). Because the financial reforms have focused so heavily on banks, they do not delve into the potential system risks from the nonbanks.
For other examples, Darrell Duffie discusses in his JEP essay \”the run-prone designs and weak regulation of the markets for securities financing and over-the-counter derivatives.\” For example, one rule change is that there is now strong encouragement for financial derivatives to be bought and sold through central clearinghouses–but there has been little attention to the risks that might be accumulated in these clearinghouses. If a clearinghouse seemed close to failing, and as a result it appeared that many derivatives contracts could fail or go into limbo for a time, the effects on fhe financial system could be nasty. Duffie writes:
A key change is the increased use of central clearing, which was directly mandated in post-crisis regulation and further encouraged by new regulatory capital requirements that, in effect, expressed a preference for central clearing. A central counterparty (CCP), also known as a clearinghouse, enters a derivatives trade as the buyer to the original seller, and as the seller to the original buyer. In this way, original counterparties become insulated from each other’s default risk—provided of course that the clearinghouse meets its own obligations. Central clearing also improves the transparency of derivatives positions and enforces uniform collateral practices that are more easily supervised by regulators. …
There do remain, however, important concerns over the ability to resolve the failure of central counterparties, which have become enormous concentrations of risk under post-crisis regulations. If a clearinghouse has insufficient resources to manage the default of the derivatives obligations of a clearing member, the consequences could be catastrophic, now that hundreds of trillions of derivatives have been cleared by a small number of systemically important central counterparties. The default management resources of the central counterparty consist primarily of the margins provided by clearing members against their positions, and by a default fund to which all clearing members contribute. If the initial margin of a failed clearing member is not enough to cover the losses, the default fund is then applied. If the clearinghouse burns through both of these paid-in default management resources, and a small layer of its own capital, it then has the contractual right to stop paying clearing members the amounts otherwise due on their derivatives, even to the point of “tearing up” their derivatives positions. In the worst scenarios, the cessation of payments to clearing members and tear-ups would be catastrophic, and contagious. The largest clearing members are generally also large members of other central counterparties. This tail contagion risk is subject to regulatory stress tests and ultimately to regulations that could trigger a failure resolution process for central counterparties. However, actual implementable plans for the failure resolution of clearinghouses have still not been designed, at least in the United States…
In November 2018, the Federal Reserve started publishing a Financial Stability Report, with lots of information about various possible sources of financial risk in the economy, as well as a Supervision and Regulation Report about trends and patterns in these areas. My general sense is that there aren\’t any major systematic financial risks threatening the US economy right now. But one hopes that financial regulators can be proactive, rather than reactive, to risks that could easily emerge in the future.