Regulation in the Wake of the Crisis

By late 2009, interventions by governments and central banks around the world had restored calm to financial markets. However, huge damage had been done to the global economy. In much of the advanced world, countries suffered their deepest slumps since the 1930s. And all indications were that the typical pattern of slow recovery after a financial crisis would be repeated, with unemployment remaining high for years to come.

562

The banking crisis of 2008 demonstrated, all too clearly, that financial regulation is a continuing process—that regulations will and should change over time to keep up with a changing world. The dependence on very short-term loans (called repos), the lack of regulation, and being outside the lender-of-last-resort system made the shadow banking sector vulnerable to crises and panics. So what changes will the most recent crisis bring? One thing that became all too clear in the 2008 crisis was that the traditional scope of banking regulation was too narrow. Regulating only depository institutions was clearly inadequate in a world in which a large part of banking, properly understood, is undertaken by the shadow banking sector.

In the aftermath of the crisis, then, an overhaul of financial regulation was clearly needed. And in 2010 the U.S. Congress enacted a bill that represented an effort to respond to the events of the preceding years. Like most legislation, the Wall Street Reform and Consumer Protection Act—often referred to as the Dodd-Frank bill—is complex in its details. But it contains four main elements:

  1. Consumer protection
  2. Derivatives regulation
  3. Regulation of shadow banks
  4. Resolution authority over nonbank financial institutions that face bankruptcy

1. Consumer Protection One factor in the financial crisis was the fact that many borrowers accepted offers they didn’t understand, such as mortgages that were easy to pay in the first two years but required sharply higher payments later on. In an effort to limit future abuses, the new law creates a special office, the Consumer Financial Protection Bureau, dedicated to policing financial industry practices and protecting borrowers.

2. Derivatives Regulation Another factor in the crisis was the proliferation of derivatives, complex financial instruments that were supposed to help spread risk but arguably simply concealed it. Under the new law, most derivatives have to be bought and sold in open, transparent markets, hopefully limiting the extent to which financial players can take on invisible risk.

3. Regulation of Shadow Banks A key element in the financial crisis, as we’ve seen, was the rise of institutions that didn’t fit the conventional definition of a bank but played the role of banks and created the risk of a banking crisis. How can regulation be extended to such institutions? Dodd-Frank does not offer an explicit new definition of what it means to be a bank. Instead, it offers a sort of financial version of “you know it when you see it.” Specifically, it gives a special panel the ability to designate financial institutions as “systemically important,” meaning that their activities have the potential to create a banking crisis. Such institutions will be subject to bank-like regulation of their capital, their investments, and so on.

4. Resolution Authority The events of 2008 made it clear that governments would often feel the need to guarantee a wide range of financial institution debts in a crisis, not just deposits. Yet how can this be done without creating huge incentive problems, motivating financial institutions to undertake overly risky behavior in the knowledge that they will be bailed out by the government if they get into trouble? Part of the answer is to empower the government to seize control of financial institutions that require a bailout, the way it already does with failing commercial banks and thrifts. This new power, known as resolution authority, should be viewed as solving a problem that seemed acute in early 2009, when several major financial institutions were teetering on the brink. Yet it wasn’t clear whether Washington had the legal authority to orchestrate a rescue that was fair to taxpayers.

563

All this is now law in the United States, but two things remain unclear. (1) How will these regulations be worked into the international financial system? Will other nations adopt similar policies? If they do, how will conflicts among different national policies be resolved? (2) Will these regulations do the trick? Post-1930s bank regulation produced decades of stability, but will that happen again? Or will the new system fail in the face of a serious test?

Nobody knows the answers to these questions. We’ll just have to wait and see.

Bent Breaks the Buck

In September 2008, the $65 billion Reserve Primary Fund broke the buck after it was caught with bankrupt Lehman Brothers debt, leaving investors in a panic.
iStockphoto

In 1970 a financial innovator named Bruce Bent introduced a new concept to American finance: the money market mutual fund. Most mutual funds offer ways for small investors to buy stocks: when you buy a share in a mutual fund like Fidelity or Vanguard, you are indirectly acquiring a diversified mix of stocks. Bent, however, created a mutual fund that invests only in short-term assets, such as Treasury bills and commercial paper issued by highly rated corporations, which carry a low risk of default. The idea was to give people a safe place to park their money, but one that offered a higher interest rate than a bank deposit. Many people eventually began seeing their investments in money market funds as equivalent to bank accounts, but better.

But money placed in money market funds was different from money deposited in a bank in one crucial dimension: money market funds weren’t federally insured. And on September 16, 2008, the day after Lehman Brothers fell, it became known that one major money market fund had lost heavily on money placed with Lehman, to such an extent that it had “broken the buck”; that is, it no longer had enough assets to pay off all the people who had placed their money at its disposal. As a result, the fund had to suspend withdrawals; in effect, a “bank” had suddenly shut its doors.

And which fund was in this predicament? Reserve Primary Fund, controlled by none other than Bruce Bent. Panicked money market mutual fund customers pulled hundreds of billions of dollars out of money market funds over a two-day period.

The federal government stemmed the panic by instituting a temporary insurance scheme for money market funds, giving them the same protected status as bank deposits. But the money market fund panic was an object lesson in the extent to which financial innovation had undermined the traditional bank safety net.

Quick Review

  • When the panic hit after Lehman’s fall, governments and central banks around the world stepped in to fight the crisis and calm the markets. Most advanced economies experienced their worst slump since the 1930s.
  • In 2010 Congress enacted the Dodd-Frank bill to remedy the regulatory oversights exposed by the crisis of 2007–2009. It created the Consumer Financial Protection Bureau to protect borrowers and consumers, implemented stricter regulation of derivatives, extended the reach of regulation to the shadow banking sector, and empowered the government to seize control of any financial institution requiring a bailout.

Check Your Understanding 18-5

  1. Question

    BAQSWeYGL3xAp3VKQnMJeH/veA2VxwjEzCALCzAb/fHqUzJR2oIZKTJc5Lh/nJsAipy1OxWLSrd6+PDjfgOg5UvaWqE9aiFRsTVBe/9QyE6JmJkL/+5tRqbpMrhDV73dOtOq4OTxa6JJqw+CTQYxkH8TEGEQOUBwdIYfig==
    False. Repo is a form of very shortterm borrowing. Because shadow banks like Lehman relied on repo to fund their operations, fears about their soundness could quickly lead lenders to immediately cut off their credit and force them into failure.
  2. Question

    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
    If there had been only a formal depository banking sector, several factors would have mitigated the potential and scope of a banking crisis. First, there would have been no repo financing; the only short term liabilities would have been customers’ deposits, and these would have been largely covered by deposit insurance. Second, capital requirements would have reduced banks’ willingness to take on excessive risk, such as holding onto subprime mortgages. Also, direct oversight by the Federal Reserve would have prevented so much concentration of risk within the banking sector. Finally, depository banks are within the lender-of-last-resort system; as a result, depository banks had another layer of protection against the fear of depositors and other creditors that they couldn’t meet their obligations. All of these factors would have reduced the potential and scope of a banking crisis.
  3. Question

    X8vZyRSgnyP3Sm5FZFmdqWpFEkX8B8hZ8gXBOSUSjPEakFp81Hnq3XdMwq045PaqdUB+kPz5BFK34kezKo5UpXkGbpkPiYpRu+tze3oLaVwHcI8bIsB0czghg19swtawwzTeSyx/96D21Q6REwnin2J+QUswIMCUZYIv8JZYG8i1pY0PLowibMgJlJ4+ia7uJJ2VFbElhHwYouuOYwX7JTTfLSwlcP83ROyyed0VH1WmYYZpUddESDErN7c=
    True. Because the shadow banking sector had become such a critical part of the U.S. economy, the crisis of 2007–2009 made it clear that in the event of another crisis the government would find it necessary to guarantee a wide range of financial institution debts, including those of shadow banks as well as depository banks. This created an incentive problem because it would induce shadow banks to take more risk, knowing that the government would bail them out in the event of a meltdown. To counteract this, the DoddFrank bill gave the government the power to regulate “systemically important” shadow banks (those likely to require bailing out) in order to reduce their risk taking. It also gave the government the power to seize control of failing shadow banks in a way that was fair to taxpayers and didn’t unfairly enrich the owners of the banks.

Solutions appear at back of book.

564