New Research: How Prepared Would Today’s Regulators Have Been for the Financial Crisis?

New Research: How Prepared Would Today’s Regulators Have Been for the Financial Crisis?

A new paper published by the Bank of England examines the effects of the financial crisis on both the financial sector and the real economy. In addition to the paper’s review of the literature related to the costs and consequences of the credit crunch that accelerated the financial crisis, the authors examine what tools financial regulators would have needed to mitigate the crisis, and how well today’s regulators would have handled the financial crisis.

How well equipped are today’s macroprudential regimes to deal with a re-run of the factors that led to the global financial crisis? We argue that a large proportion of the fall in US GDP associated with the crisis can be explained by two factors: the fragility of financial sector – represented by the increase in leverage and reliance on short-term funding at non-bank financial intermediaries – and the build-up in indebtedness in the household sector. We describe and calibrate the policy interventions a macroprudential regulator would wish to make to address these vulnerabilities. And we compare and contrast how well placed two prominent macroprudential regulators – the US Financial Stability Oversight Council and the UK’s Financial Policy Committee – are to implement these policy actions.

While there is no grand unified theory to neatly explain the causes of the financial crisis, the authors identify two major causes: excessive leverage in the financial sector and the explosion of mortgage lending in the early and mid-2000s.

The financial sector, particularly firms not covered by traditional financial regulations (“shadow banks”) and government sponsored enterprises that benefit from the implicit backing of the U.S. government, were particularly overleveraged. “Broker-dealers…and government-sponsored agencies (GSEs) employed substantially more leverage than commercial banks and saving institutions,” found the authors.

While the leverage of most institutions was stable or even fell in the years leading up to the crisis, it increased materially at broker-dealers. The assets of broker-dealers increased from 28 to 45 times their equity between 2001 and 2007, meaning that a roughly 2% decline in the value of their assets would have been sufficient to wipe out broker-dealers’ equity in its entirety.

The authors go on to discuss the explanatory power of various contributors to the financial crisis, but the broad result is that the “credit crunch” caused by excessive leverage and a lack of capital magnified the effects of the crisis, both in the financial sector and the real economy.

[A]bsent the credit crunch and the deleveraging by households, the cumulative fall in GDP growth during the recession would have been two-thirds to three-quarters smaller…Taking the unweighted average across all [studies examined related to the costs of the financial crisis] the credit crunch can explain around 35 percent of the decline in GDP.

The more interesting findings of the paper are related to the ability of U.S. regulators to predict the financial crisis, and how the structure of post-crisis regulatory agencies makes them more or less able to deal with a future crisis.

Looking backwards, the paper argues that while the Federal Open Market Committee (FOMC) did identify a potential bubble as early as 2005, it did not conduct stress tests with methodologies available at the time to examine how a downturn would have influenced the financial sector more broadly.

The authors find that the best tools available to regulators would be the ability to set countercyclical capital requirements and restrict mortgage lending based on creditworthiness and loan-to-value ratios (LTVs). The former is a tool the U.K.’s Financial Stability Committee has, while only modest restrictions on mortgage lending were included in the Dodd-Frank Act. In general, the Financial Stability Committee has more effective tools at its disposal than its U.S. Counterpart, the Financial Stability Oversight Council.

Ultimately, the paper’s conclusions are pessimistic about the ability of financial regulators to successfully identify an impending crisis and the willingness of political bodies to empower these regulators to act swiftly.

To address concerns about regulators’ ability (or lack thereof) to serve both as watchdogs and first responders, the authors identify higher static capital requirements as a front-end regulation that makes the financial system more resilient. Higher capital requirements make systemic failure less likely, meaning “macroprudential regimes need to do less heavy-lifting, reducing the need for a powerful institutional framework.”

Like death and taxes, economic downturns are another certainty in life. It’s important to have institutions insulated from political pressure and regulatory capture that can respond quickly and effectively in the face of a crisis. Just as important are regulations that guard against financial meltdowns that would require a response from these entities.

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By |2018-08-21T13:23:09-07:00August 21st, 2018|Blog, Financial Regulation|