Central Banking after the Great Recession: Lessons Learned, Challenges Ahead

4. Regulator Reform: What's Done? What Isn't?

4 Regulatory Reform What’s Done? What Isn’t? Paul Tucker 53 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 from expanding their balance sheets to maintain, or increase, My thanks to Svein Andresen, Dick Berner, Steve Cecchetti, Darrell Duffie, Randy Guynne, Sam Hanson, Don Kohn, Eric Rosengren, Vicky Saporta, David Scharfstein, Hal Scott, Andrei Shleifer, David Wessel, and participants in a Harvard Business School seminar for comments and discussions. Thank you to Asfandyar Nadeem for the graphics. Views and mistakes are my own. 04-2608-1 ch4.indd 53 3/11/14 9:56 PM 54 PAUL TUCKER leverage as rising asset prices inflated the value of their equity.1 Others— in all types of banking, and throughout the West—gradually adopted copycat strategies under pressure from their boards and stockholders. Risk was underpriced. The resulting credit boom left many borrowers overindebted 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 overvalued property markets and overindebted borrowers if their financial systems are able to weather the losses and thus 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 short-term 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 among 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 undercapitalization 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 reintermediating 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. 1. See Adrian and Shin (2010). They study a process working through the marking-tomarket of assets, but other mechanisms involved gearing up with term debt on the back of unusually profitable commercial banking operations, increasing risk exposures as value-atrisk measures fell due to declining volatility, and heavy use of securitization as an apparently cheap funding source (as in the case of Northern Rock in the United Kingdom). Each instance combines misperceptions of the durability of unusual market conditions, myopia about tail risk, and weak incentives to wake up. 04-2608-1 ch4.indd 54 3/11/14 9:56 PM Regulatory Reform 55 While borrowers and lenders were responsible for their own imprudence , responsibility for the stability of the system as a whole lay squarely with the authorities. This was a failure of prudential supervision and regulation on a grand scale—on both sides of the Atlantic. The authorities had been blind to the buildup of banking-type risks—leverage and maturity transformation—outside of de jure...