Regulatory Reform, Stability and Central Banking
In a paper published by the Hutchins Center on Fiscal and Monetary Policy at Brookings, Tucker writes, “the crisis that broke in 2007 and brought the international financial system to its knees in late 2008, threatening a repeat of the Great Depression, left the credibility of financial regulation and supervision in tatters. Until this is repaired, confidence in the financial system itself will remain fragile.”
Of course there were plenty of other factors behind the crisis: a badly unbalanced global economy, with much of the West owing too much to the high-saving economies of the East; a rampant search for yield associated with declining global real interest rates and persistently easy monetary conditions; myopia about risk; soporific reliance on highly liquid markets; herding, on the way up as well as, later, to the exit; moral hazard from a perceived and, as it turned out, available taxpayer safety net; and a legion of agency problems in banks and investment managers.
Those agency problems were serious, with no one stopping dealers and banks expanding their balance sheets to maintain, or increase, leverage as rising asset prices inflated the value of their equity.1 Others—in all types of banking, and throughout the West—gradually adopted copy-cat strategies under pressure from their boards and stockholders. Risk was underpriced. The resulting credit boom left many borrowers over-indebted and assets overvalued.
But the crisis would not have been as deep, nor its economic effects so long lasting, if the core of the financial system had not been fatally weak. Economies can survive over-valued property markets and overly indebted borrowers if their financial systems can weather the losses and so maintain the supply of credit. They couldn’t.
Key money markets dried up. So few banks held reliably liquid assets, so many were excessively reliant on skittish short-term funding, so many had promised liquidity insurance to off-balance sheet vehicles that found their market funding cut off, that central banks were acting as lenders of last resort (LOLR) from mid- 2007—before anything much had happened in the real world.
Even though the liquidity fragility inherent in the mismatch between shortterm liabilities and longer-term assets was the very point of regulating banking in the first place, it should have been remarkable that the whole system could be pushed over the edge by small losses originating in the U.S. subprime mortgage market. Opacity created uncertainty about which securities were tarnished, and who held damaged portfolios. A complex network of credit exposures amongst banks and other financial institutions prompted concerns that, at least indirectly, pretty well everybody was exposed. But surely the fatal fault line was the woeful undercapitalisation of the banks (and their “shadow banking” cousins), tipping some over the edge as the storm broke and, crucially for the economy, leaving the banking system incapable of re-intermediating the provision of credit as capital markets closed. Although undoubtedly exacerbated by the liquidity crisis that began in 2007, too many firms were unsound to begin with.