Why tighter regulations won't prevent the next financial crisis

Mar 27, 2023

Synopsis
One approach to this challenge is to limit banks to “safer” assets and to impose capital requirements. These are good ideas, but they don’t solve the problem. For one, if banks are limited to safer assets, that will tend to make them less profitable in normal times and bring them closer to insolvency in troubled times.

For all of you following the banking crises in the US and Europe, and asking why this is all happening again, I have bad news: Regardless of what laws are passed, or which regulations are issued, banking crises will recur — and not infrequently.

It makes sense to try to limit and prevent these crises, and the systemic reforms the US and EU mandated more than a decade ago were appropriate. But there’s only so much that can be done. Part of the reason stems from nature of regulation itself. And part of it is that more restrictions imposed on banks will inevitably lead to more financial intermediation taking place outside the banking system.

Consider the classic banking model, in which liquid liabilities are used to fund relatively illiquid, hard-to-value assets, such as loans to businesses. This discrepancy between the qualities of the assets and liabilities is why banks are needed in the first place. It is also what makes banks so hard to regulate: If the value of bank assets is not entirely transparent to the marketplace, it won’t be fully transparent to regulators either, or for that matter to depositors.

One approach to this challenge is to limit banks to “safer” assets and to impose capital requirements. These are good ideas, but they don’t solve the problem. For one, if banks are limited to safer assets, that will tend to make them less profitable in normal times and bring them closer to insolvency in troubled times.

For another, an effort to make banks safer can effectively push risk into other sectors of finance. It can move into money market funds, commercial credit lenders, fintech, insurance companies, trade credit, and elsewhere. These institutions are generally less regulated than are banks and don’t have the same kind of direct access to the Federal Reserve’s discount window.

This is no mere hypothetical: In the 2008 crisis there were major problems with both money market funds and insurance companies.

There is a temptation, in light of recent events, to greatly stiffen bank capital requirements — to raise them to, say, 40%. Again, that would make banks safer, but it would not necessarily make the financial system as a whole safer.

And so policymakers allow banks to continue along their potentially precarious path. Whatever their reasons, the fact remains that bank regulations can get only so tough before financial risk starts spreading to other, possibly more dangerous, corners of the system.

To be clear, I am not arguing for zero regulation. My point is that any regulatory regime is a temporary patch, not a permanent solution. It is an ongoing game of whack-a-mole. This is a defect inherent to all regulation: Both regulators and the regulated tend to deploy a backward-looking definition of a risky asset or portfolio position.

During the 2008 financial crisis, for example, there was an excess concentration of derivatives activity in AIG, later necessitating a bailout. Financial derivatives acquired a bad name in many quarters, and government securities were viewed as a safe haven. With Silicon Valley Bank, the problem was the inverse: Its portfolio was insufficiently hedged with derivatives and interest-rate swaps, leaving it vulnerable to major swings in interest rates. It should have used derivatives more.

It is easy enough to say, “We can write regulations so this won’t happen again.” But those regulations won’t prevent new kinds of mistakes from happening.

Then there is the issue of slowly intensifying moral hazard. Often crises result in some kind of bailout, which in turn lowers at least some risk safeguards for the next time around.

The biggest problem, however, may be that in a healthy economy, the financial sector tends to grow in size. Financial intermediation is typically applied to wealth, not income. Yet over time the ratio of wealth to income tends to go up. Economies produce more, many structures become more durable, and investment returns compound above and beyond depreciation. The size of the financial sector thus becomes increasingly large relative to GDP, even if it is a roughly constant proportion of wealth.

As the financial sector becomes larger, can all of it really be bailed out, with inevitably limited resources? Can it all be monitored so carefully, whether through government or private market incentives? Is there a large enough supply of truly safe assets, such as short-term Treasuries, to cover the risks? The answer to all of these questions, sooner or later, is no.

Which is why, if you ask me when you should prepare for the next financial crisis, my answer is always … now.

This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.

[Bloomberg]