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The Brookings Institution hosted a conference last week on the regulatory response to the global financial system with that provocative title. The conference featured former Fed Chairman, Ben Bernanke, and other prominent speakers, including professor Gary Gorton of Yale University and Fed Governor, Dan Tarullo. See the conference program, here.

The title could be considered provocative in light of the massive amount of new regulations introduced since the global financial crisis exploded in 2007. The Dodd-Frank act alone runs to over 2,300 pages. "Surely," you might think, "all of that regulation means a more resilient financial system; one that is better able to absorb the kind of shocks that I very nearly brought global collapse." As the conference discussion revealed, there are some who would argue with you.

As noted previously, before the crisis, international banking was incredibly efficient in terms of transforming a small of capital into a much, much larger volume of assets. Unfortunately, the system was also very unstable. The metaphor I used to describe the situation was an inverted pyramid.

In the immediate aftermath of the global financial crisis I wondered if we would see a 'pole switching' problem--that is, a jump from too little regulation to  too much regulation in a "never again!" reaction. That response might be understandable, but it would not be without potential costs: a financial system that is impervious to shocks by virtue of holding a surfeit of capital is unlikely to be in a position to finance the investments that will be needed to deal with the challenges of climate change or meet the infrastructure needs of the 21st century. As in most fields of human endeavor, the optimal outcome is unlikely to be a so-called "corner solution." If we want a financial system that is capable of funding risky investments supporting innovation (that lead, ultimately, to higher growth), we need to accept some degree of fragility.

To some extent, the story of the past decade is a lax regulatory regime that led to crisis, which in turn triggered a regulatory response. That response has included higher capital and liquidity requirements. The question is whether those higher standards have had unintended effects.

For example, while regulations have largely driven out the Structured Investment Vehicles (SIVs) that played a role in the run up to the crisis, they may have fostered the growth of shadow banking. As Gary Gorton put it, regulations determine whether an activity is carried out in the formal (regulated) banking sector or in the shadows of unregulated banking. Darrell Duffie, meanwhile, argued that regulations have inadvertently equalized capital requirements on safe assets (collateralized by Treasuries) with, say, real estate loans. Since the expected returns on real estate loans exceed the return on safe assets, one effect has been to increase the relatively risky activity.

All of this isn't a fatal criticism of regulations. After all, every (well-designed) constraint changes behavior in the way it was intended;  and sometimes in subtle ways that are not anticipated. The issue is whether the negative unintended effects are greater than the ills that the regulation was designed to prevent. That is the $15 trillion question, the estimated cost of the global financial crisis.

A follow up post will tackle that question.

Program
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