Will New Regulations Avert Another Meltdown?

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After the Great Recession, U.S. and European authorities enacted new regulations to shore up the global financial system and patch deep vulnerabilities that surfaced during the crisis. The rules are meant to strengthen banks and non-bank financial institutions as well as mitigate their risk-taking activities, which required government bailouts and extraordinary central bank efforts that, by one tally, cost $12.8 trillion just in the U.S.

U.S. financial reforms are encapsulated in the Dodd-Frank Wall Street Reform and Consumer Protection Act, the biggest financial reform package since the Great Depression, which was signed into law in 2010. (The Trump administration later eased regulations for banks with assets below $250 billion.) The key features of Dodd-Frank are the following: It requires banks to improve capitalization so they are better able to absorb losses, raise liquidity levels for the first time to be more equipped to handle cash demands at short notice and develop a resolution plan for orderly failure without jeopardizing the financial system.

Moreover, Dodd-Frank not only seeks to strengthen individual financial institutions but the financial system as a whole. The Act “shifted the emphasis of financial regulation away from microprudential supervision (monitoring risk at an individual institution) to a macroprudential approach (monitoring risk of the banking system as a whole) with the goal of enhancing financial stability and resiliency for the entire system,” according to “The Interplay among Financial Regulations, Resilience and Growth,” a working paper of the Federal Reserve Bank of Philadelphia co-authored by Wharton finance professor Itay Goldstein, Wharton finance professor emeritus Franklin Allen and Julapa Jagtiani,  a senior special advisor at the Philadelphia Fed.

In Europe, the main post-crisis financial reforms are contained in the Basel III international regulatory standards — a set of measures to strengthen the regulation, supervision and risk management of banks. Basel III introduced a “stricter definition of capital, a higher quality and quantity of capital, two dynamic capital buffers, a minimum leverage ratio, and two minimum liquidity ratios,” according to “Financial Regulation in Europe: Foundations and Challenges,” a paper from Goldstein and others. It is implemented through the Capital Requirement Directive IV, which seeks to create a level playing field among countries.

Notably, a big change in the Eurozone is the creation of a common, financial safety net in the form of a banking union, comprising a Single Supervisory Mechanism, which supervises all banks in the Euro area; a Single Resolution Mechanism, tasked to manage resolutions of bank failures with minimal cost to taxpayers and the real economy; a Single Rule book and harmonized but decentralized deposit insurance scheme, according to the Financial Regulation in Europe paper.

“The Great Financial Crisis revealed that banks were gravely undercapitalized and too dependent on their ability to borrow to manage their liquidity needs.” Richard Herring

Importantly, the new U.S. and European regulations sought to shift from government bailouts to a “bail-in” approach where shareholders and investors carry the burden of a failure. “Banks are required to hold sufficient convertible liabilities that would be converted into common equity capital when additional capital is needed” such as during a serious economic downturn “to ensure sufficient time for insolvent banks to be smoothly restructured and recapitalized,” according to the Philadelphia Fed paper. “This move is important to ensure that banks (and their investors), rather than taxpayers, bear the cost of bank failures.”

More Needs to Be Done

But a decade after the 2008 crisis, Wharton experts agree that while the regulations have made the financial system stronger, more work needs to be done. The complexity of securities that led to the crisis brought about more complex rules to govern them, which may push activity to the less-regulated non-bank sector, as well as result in other unintended consequences. Also, stress tests that banks are required to undergo to prove they can withstand a downturn might not be rigorous enough; there’s concern that rules should be even more forward-looking; and regulatory oversight is less effective since it sits in a patchwork of jurisdictions among competing agencies amid other challenges.

“The Great Financial Crisis revealed that banks were gravely undercapitalized and too dependent on their ability to borrow to manage their liquidity needs,” says Wharton finance professor Richard Herring, who also is co-chair of the Shadow Financial Regulatory Committee. “Worse still, the authorities were complicit in the build-up of excessive leverage by instituting a complex, incoherent system of capital regulation that enabled banks to take on enormous concentrations of risk relative to their ability to sustain loss.” He says the FDIC, which maintains a leverage constraint as part of capital requirements, did protect the U.S. from the worst of the leverage binge but it had no control over the leverage of investment banks, which took “full-advantage of Basel II–like capital regulations to grow their balance sheets.”

“Excessive leverage, when combined with heavy reliance on short-term borrowing, meant that many of the largest banks were vulnerable to a sudden and devastating loss of confidence when doubts arose about the value of some of their assets,” Herring continues. “Most bankers and many regulators characterized the Great Financial Crisis as a liquidity crisis, but this was surely a misdiagnosis. Liquidity would not have been imperiled if market participants had been confident in the underlying value of bank assets. But leverage had expanded to such an extent that even a relatively small decline in the value of bank assets could raise solvency concerns.”

“A lot of damage was caused when Lehman Bros. collapsed. They didn’t know exactly how to resolve it, and I think this hurt the financial system and led to the deepening of the financial crisis.” –Itay Goldstein

The Philadelphia Fed paper noted that the “new financial landscape” that emerged as a result of the new regulations after the crisis revealed that a series of deeply indebted non-bank institutions not protected by the FDIC faced the “equivalent of bank runs as creditors or shareholders started to doubt their solvency. Lehman Brothers’ failure demonstrated that the largest financial firms were deeply interconnected, causing regulators to extend the safety net beyond the banking sector, covering essentially more than half of the financial sector.”

Some Regulatory Shortcomings

While stronger capital requirements are good, such metrics didn’t help banks leading up to the crisis, Goldstein says. “When the real test came, we saw that effectively they didn’t have such great capital ratios, because a lot of it is was measured based on book values and it may not be updated market information — it might be misleading. More recently, you have risk-weighted capital issues that are trying to put the right weights on different assets depending on how much risk they impose. That was a good thought that goes in the right direction but then we found out it’s subject to discretion and maybe even manipulation.”

Also, it does not necessarily follow that making each individual bank safer would make the entire financial system safer. “As individual banks try to make themselves safer, they can potentially behave in ways that their behaviors collectively would undermine the entire banking system,” the Philadelphia Fed paper said. For example, one bank could sell its unwanted assets in a fire sale, but it would drive down prices in the asset market and affect other banks. Moreover, banks tend to focus on “their own risk-sharing and hedging motives” without considering how it would affect the rest of the financial system, the paper said.

As for the stress tests, Goldstein says they serve a purpose but the testing could be improved. “By and large, most of them pass the stress tests and the conclusion is that everything is good — even if there will be a two standard deviation event with big drops in the stock market and output and so on — still banks are going to be fine. And you have to ask yourself, to what extent do you believe that?” He said there also is a tendency to reveal to banks what will be tested. “There has to be some element of surprise that the banks are not anticipating.”

“Could it be that individuals believe more and more that risks originating in the financial sector will ultimately be absorbed by the government … ?” Stephan Dieckmann

As for the banks’ resolution plans, or “living wills,” the idea behind it is laudable. A failing bank would have a pre-determined plan on how it would fail in an orderly manner under the U.S. bankruptcy code. “A lot of damage was caused when Lehman Brothers collapsed. They didn’t know exactly how to resolve it, and I think this hurt the financial system and led to the deepening of the financial crisis and to this big recession,” Goldstein says. “But who knows whether this is feasible and realistic?”

The Philadelphia Fed paper added, “there have been concerns that this would not actually work in practice, owing to a lengthy bankruptcy process based on the U.S. bankruptcy laws, especially since the SIFIs (systemically important financial institutions) typically have a very complex structure with hundreds or thousands of interconnected entities around the globe.” To date, the eight largest and most complex U.S. banks submitted improved resolution plans, but regulators said they have more work to do, according to The Wall Street Journal.

Flaws in the “living wills” include the following: They assume that at the time the banks fail, economic conditions would be normal, so the plan would not work if there is a financial downturn or crisis; they assume that it would be a one-off failure and no other large bank would be failing as well. As such, these resolution plans “would not be expected to work effectively in the case of multiple failures or under less-than-normal economic conditions,” according to the Philadelphia Fed paper.

Another shortcoming: In the U.S., there is a patchwork quilt of federal and state regulators overseeing the financial system with overlapping responsibilities. Dodd-Frank created the Financial Stability Oversight Council, or FSOC, to address this problem by bringing together the heads of different agencies so they can coordinate their efforts in one central body. But Herring says “our attempt to enhance oversight of the non-bank financial system through FSOC has fallen short of the kind of surveillance we should have in place to anticipate emerging sources of risk.”

Goldstein adds that FSOC was a “good change” but there’s been “a lot of opposition coming up from politicians, from some of these regulatory bodies that were concerned about losing their independence, losing their power essentially. Nowadays, I’m not sure this coordination is [being] done as well as it should be.”

In Europe, steps have been taken to harmonize banking rules that apply across the EU. However, “unlike in the U.S., most European countries have been very slow at recognizing losses incurred during the crisis and forcing or supporting banks in their recapitalization,” according to the financial regulation in Europe paper. Politics is one reason why the European Central Bank moved later towards quantitative easing. Meanwhile, banks there remain weaker than their American counterparts.

Credit Default Swaps

Another step European regulators took was to restrict credit default swaps, securities that insure against the default of a borrower, the kind that nearly felled AIG. “The market has sort of collapsed” to half of its volume from the peak of the crisis, says Wharton finance professor Stephan Dieckmann, who studied swaps that insured European government bonds. EU Regulation 236 made it tough for speculators to trade them. “That regulation requires that you can only buy insurance against a certain country [as protection from a debt default] if you have some exposure to this country whether it’s through the bond market or stock market. The idea was to drive pure speculation away from this market.”

Dieckmann’s work in this area harkens back to the crisis, when he and some peers noticed “very elevated prices” of credit default swaps on European sovereigns. That means many investors are buying them to insure against countries defaulting on their debts. At the time, the crisis was centered on financial institutions, not countries as yet. That got Dieckmann thinking: “Could it be that individuals believe more and more that risks originating in the financial sector will ultimately be absorbed by the government, therefore they will end up on the balance sheet of the government and then contribute to a higher likelihood of default?”

“In regulating potential risks, there is always a tradeoff — too little leaves the system vulnerable, but too much makes it unprofitable for regulated institutions to provide financial intermediation.” Krista Schwarz

Dieckmann did find such a correlation, as explained in a highly cited paper he co-authored, “Default Risk of Advanced Economies: An Empirical Analysis of Credit Default Swaps during the Financial Crisis.” They found that “the countries that were more exposed to the financial sector, their credit default swaps [spreads] increased more than countries that were less exposed to the financial sector. We also found that countries that were more exposed to the global financial system … their spreads were also higher than were those that were less exposed,” he says.

Dieckmann’s research further found that concerns about defaults changed as the crisis went on. In the first phase of the meltdown, investors in the European debt market focused on the “private to public” risk transfer — private companies backstopped by governments. Later, concern shifted to “public to public” risk transfer, as economically stronger EU countries were seen as backstops for weaker nations. “Essentially, northern European countries were potentially seen as the backstop for some of these southern European countries,” he says.

Striking the Right Balance

Overall, “there were many important measures that have been taken following the crisis to make the banking system safer and the financial system generally safer,” Goldstein says. “But I don’t think those things are necessarily sufficient to prevent future crisis or even to reduce fragility in a significant way.” For one, regulations tend to be “backward looking. Many of these measures are designed to prevent the problems of the past.” Financial institutions and other players are always looking at ways around regulations to resume profit-making activities that carry risks. “We see that over time they find those ways, so I think that regulation has to be much more forward-looking,” he says.

It is important to strike a balance, adds Wharton finance professor Krista Schwarz. “In regulating potential risks, there is always a tradeoff; too little leaves the system vulnerable, but too much makes it unprofitable for regulated institutions to provide financial intermediation.” She says federal deposit insurance, introduced following the Great Depression, successfully deterred runs on short-term liabilities related to commercial banking.

“On the other hand, interest rate ceilings that were introduced by regulators to reduce bank risk-taking ultimately led to the emergence of non-bank competitors that could offer higher rates,” Schwarz says. As a result of the cap, a large segment of deposits moved from the commercial banking system to non-banks, such as newly created money market mutual funds that did not face the same regulations or guarantees as banks.

“We need to remember that we benefit from this globalization and integration.” –Itay Goldstein

But that lack of guarantee became a problem during the crisis. There was a run on money market mutual fund shares, which was halted only after the government temporarily guaranteed all of their liabilities, Schwarz says. The upshot is that “ideally, regulation would be assessed and updated periodically as the market is always evolving,” she adds. “Unfortunately, the political process does not easily allow for rapid and flexible rule making.”

At the end of the day, it is important to remember that the global financial system works to facilitate money flows and financial transactions on a daily basis. “We need to remember that we benefit from this globalization and integration,” Goldstein says. “Banks invest all over, basically transfer money to where it is needed, and this assists with growth and prosperity in different parts of the world. The fact that people can save in one place and invest in another place — all these are things the free movement of capital and money and goods clearly contributes to the world.”

While steps must be taken against excessive risk, Goldstein adds, “we need to remember that the financial system has served us, and served the economy in many ways. … Financial institutions taking risks and investing and lending is a good thing. This is how new firms start, this is how new products are being developed and, at the end of the day, how everyone can live a better life.”

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