TODAY’S FINANCIAL markets will inevitably suffer another crash. It might come soon, especially if recent inflation proves to have more staying power than the authorities suggest. But even if markets escape trouble in the immediate future, wild swings are an unavoidable feature of financial markets. Nor can any reasonable regulation guard against them, certainly not those Washington put in place after the last crisis. Regulation is simply inadequate to the task.
The only taming mechanism that might work would so tighten regulatory control that the United States would lose much of the contribution finance makes to the nation’s prosperity and economic development, a cure worse than the disease. Since governors from the past—gold and fiscal discipline, for instance—have little practical application today, a best solution, perhaps the only one, would keep regulations as a moderator but admit that the goal of control lies beyond our reach, that severe risks remain present always. Perhaps such a sense might instill in financial management more prudence than it has shown in some time, enough at least to ameliorate boom-bust tendencies. Such a sense and the caution it instills among financial players have done so at times in the past.
THE REGULATORY approach did little to prevent the crash in 2008–09. Dodd-Frank regulation did not exist at the time, but several authorities—the Federal Reserve (the Fed), the Comptroller of the Currency, and state regulatory bodies in this country; the Bank for International Settlements (BIS) in Basel, Switzerland, internationally, and equivalents in most other countries—imposed regulations to guard against financial excess and collapse. Yet all their rules failed to stop the preceding boom and that terrifying collapse. When the investment bank and broker-dealer Bear Stearns revealed problems and began the crisis early in 2008, the firm was in full compliance with all regulations. It was fully solvent by all the most up-to-date accounting standards. Nonetheless, it was unable to meet all its immediate trading obligations. Almost as an admission that the regulations were inadequate, the authorities tried to control events by immediately reaching outside regulatory structures. They forced Bear Stearns to sell itself at a bargain price to J.P. Morgan—a preemptory move that may in retrospect have created more uneasiness among investors than it alleviated.
Even though all major financial institutions had adhered to existing regulations, the financial crisis got worse before it got better. At each stage in the collapse, the authorities met the challenge of the moment by moving outside their own regulatory structures. Ultimately, the Treasury Department put billions of taxpayer dollars at risk, lending to financial institutions through what it called the Troubled Asset Relief Program. The Fed and other central banks brought lending rates around the world down to inordinately low levels, near zero in fact, and found novel ways to make billions in financial liquidity available to otherwise failing banks and other financial institutions. The authorities forced sales, made extraordinary loans, took over financial firms, and let others go bankrupt in the process. If this jerry-rigged approach did not exacerbate the panic, it certainly confirmed the feeling at the time that no one had control. More than anything else, the extraordinary measures pointed up the inadequacy of the regulations.
Following the crisis, Washington set out to put safeguards in place largely by doubling down on the regulatory approach that had just failed. Though the details of their new rules are even more complex than the old, they mostly just strengthen what had previously existed. The BIS’ latest set of guidelines, for example, under the heading Basel IV to distinguish them from the old Basel II and III rules, deals with the problem by stipulating that banks should set aside a total of some 8 percent in capital of various kinds, depending on the risk of their asset mix. This emergency capital is typically held in very safe repositories, government debt or deposits at the central bank, where the financial institution can draw on it quickly and reliably to meet obligations when the normal course of business fails to do so. The Dodd-Frank financial reform in the United States essentially has done the same. It includes two additional noteworthy measures. It singles out larger institutions where failure might threaten the financial system, designates them “too big to fail,” and imposes on them especially stringent capital requirements. It also stipulates that these institutions undergo periodic “stress tests” to see how much financial trouble they could withstand.
These new, more stringent, and intrusive rules may provide some safeguards. They may help the regulators—and the public—feel more secure. They may even give comfort to people involved in finance. At bottom, however, they, like the old rules, are chimerical. At least three reasons stand out: 1) because rules, by nature, focus on particular institutions, financial vehicles, and processes, they cannot cope with finance’s protean ability to create new institutions and new processes that effectively sidestep the regulations; 2) regulations do little to counteract the tendency for finance to build on success and so inexorably move in good times toward extremes that ultimately create problems; and 3) the capital ratios and stress tests imposed on financial institutions do little to alleviate the inherent risks banks and other financial institutions must take in the normal course of their business, risks that can easily swamp even the most severe capital requirements demanded by regulators. The following three sections take up each of these regulatory inadequacies in turn.
THE FIRST of these problems lies with the unavoidably legalistic nature of regulation. Rules must state explicitly to which sorts of institutions they apply and under which conditions. While such constraints may limit risk in the sorts of institutions and activities they identify, the constraints themselves only invite the development of new institutions, practices, and arrangements not explicitly covered by the rules. Dodd-Frank, for example, constrains how much risk banks can take and what provisions for loss they must make at each level of lending risk. But because risky borrowers still want funds and will pay relatively high rates to get them, new institutions and practices have arisen to fill the gap left by the constrained banks. A so-called “shadow banking system” has taken considerable business from conventional banks, especially smaller regional banks, since Dodd-Frank went into effect. It has effectively taken on the risks banks once took. Despite the tightened regulations, the financial system as a whole remains exposed to those risks and remains as vulnerable as it was. All that has happened is that the epicenter of risk has moved.
Similarly, the regulations put in place after the 2008–09 crisis primarily focus on real estate. The system’s vulnerability at the time centered on failing mortgages. The banks are loath to extend themselves into this area because the regulations stipulate so many constraints and because the bankers are well aware that the regulators are watching. Until recently, they exercised greater prudence in real estate lending than even the rules require. But they also want to provide attractive returns to their stockholders. They have, accordingly, lent more actively than before to risky corporate borrowers that will eagerly pay higher rates to get the funds. Depending on how one measures them, these so-called leverage loans have grown some 7–10 percent a year since the Dodd-Frank regulations came into effect. Today, they verge on $3.5 trillion outstanding. Because leveraged loans were not the cause of past trouble, they are of a lesser importance to regulators and are not as covered in written regulations. Again, risks have simply shifted, not disappeared.
No doubt some would suggest that the system would find better protection if the regulators had the freedom to adjust which institutions and practices the rules cover and impose similar strictures on any new, potentially threatening practices or financial instruments. If such an approach might offer comfort about future crises, it would impose other difficulties. It would, in fact, shift decisions on the allocation of the economy’s financial resources from financial decisionmakers and markets to regulators. Because regulations by design have a one-sided focus on risk reduction, such a “solution” would limit the financial resources available to build new businesses and expand established ones. After all, some of the most productive developments throughout time have looked very risky at their inception. Society would accordingly suffer slower rates of growth and job creation. Such regulatory discretion would not quite count as the sort of central planning that failed in the Soviet Union. It would actually be worse, since risk aversion would be its only consideration.
NOR CAN regulations effectively stop the tendency for the financial system to go to extremes. This problem develops because past lending successes, presumably in good economic times, increase the flows of profits to financial firms, with which they can enlarge the capital base and, accordingly, extend more loans and investments. As that lending increases profits even further and likely also raises the value of financial assets as well, this capital base rises even higher, encouraging further lending. The system effectively builds on itself. Indeed, the rising base all but impels financial managers to lend more and more, and so take on more risk. If prudence holds them back, they seem to waste opportunities for profits and put their positions at risk. In the words of the ex-CEO of Citigroup, Charles Prince, “as long as the music is playing, you have to get up and dance.”