Five years ago, a massive failure on the part of financiers and financial regulators precipitated the fall of Lehman Brothers and nearly crashed the global economy. Today, investors, taxpayers, and elected officials are entitled to ask: Are we safer now?
At one level, yes. We are both healthier and smarter. We are healthier because both banks and households have repaired their balance sheets, improving the economy’s ability to withstand future shocks. We are smarter, because we have discarded the myth that the Federal Reserve can easily clean up the fallout from financial excesses and replaced it with an attitude of vigilance and caution about financial excesses.
This raises another question: have we created public policies that make us safer?
It is hard to say. We know more today about how Washington can inflate bubbles. Government-sponsored enterprises encouraged excessive risk-taking in housing finance. Easy monetary policy in the early 2000s not only kept mortgage interest rates low, but also encouraged investors to reach for yield and amplify that reach with leverage. If investors perceive low rates to be lasting, the incentive for leverage is particularly great. Fed officials focused on low rates as coming from a global savings glut, without emphasizing large flows in to the United States from global banks, particularly European banks. The Fed did not restrain the housing bubble, and it was not alone. The European Central Bank stood back as credit surged in peripheral European economies. And, of course, tax policy encouraged leverage.
Since the crisis, the Dodd-Frank Act increased transparency in many derivatives – a good thing. But it also made a complex system of bank and nonbank regulators more complex and created a class of systemically important banks (and even non-banks), codifying “too big to fail.” It did not – nor did other legislation – seriously address reform of housing finance or direct the central bank to focus more on financial stability. Writing the Act’s web of rules will take years. Globally, an emphasis on higher capital requirements leaves open questions of how one measures the risks taken against that capital – recall the sovereign bonds were deemed “riskless” for that purpose before the crisis – or how to limit the incentive for “shadow banking” forms of intermediation to grow outside more heavily regulated sectors.
One key reason for skepticism that policy has put us on a course toward financial stability is that we have treated the loose ends of the financial crisis as technical problems to be solved …
- If proprietary trading by financial institutions is risky – though such risk-taking paled alongside old-fashioned bad lending before the crisis – ban it.
- If taxpayers and investors lost money in the crisis, force institutions to hold much larger amounts of capital to mitigate future losses.
- If securitization led to losses, force mortgage originators to hold more “skin in the game.”
… and so on.
This technical approach misses two big things. First, it fails to focus adequately on trade-offs: between lower risk taking and economic growth; between higher capital requirements and growth in shadow banking; between reduced risk of securitization and benefits of securitization in the cost of funds. We lack a policy framework for assessing these trade-offs. Dodd-Frank’s Financial Stability Oversight Council will not accomplish this discussion.
Second, it fails to consider structural and organizational changes in financial regulation, as opposed to technical remedies. A technical approach is akin to generals fighting the last war. The next crisis may well not start in the housing market. But financial history teaches us about the perils of a range of large credit booms, opening the door for broad questions about how regulation can be more streamlined and how to make policymakers more aware of emerging developments in financial markets and institutions. And organizational change, too: For example, should the Federal Reserve have a mandate for financial stability that would force Fed officials to be more vigilant as financial excesses mount? While taking away the proverbial punch bowl is never easy, the Fed’s independence is a big plus here. Of course, conventional monetary policy tools are blunt for this purpose, but the Fed has – or could have – others, such as capital rules, maximum loan-to-value ratios for mortgages, or rules on “haircuts” in repo transactions. There are many views on how to sort out this broader discussions, but many groups are doing so, including the Committee on Capital Markets Regulation, which I co-chair.
The fifth anniversary of an important series of events in September 2008 should unleash reflections on not just the sources of the financial crisis, but on what steps public policy has taken to mitigate future crises with their accompanying costly economic fallout. Rather than focus on the failure of specific financial institutions, we need to examine regulatory institutional failure – whether we need broader changes in regulation to address the run-up to, and not just the costly clean-up of financial crises.