The floor of the New York Stock Exchange on August 22, 2018. (AP Photo/Richard Drew)
The floor of the New York Stock Exchange on August 22, 2018. (AP Photo/Richard Drew)

A decade after the financial crisis, it’s still uncertain whether the regulation enacted to protect financial stability will prevent another crisis. Regulators worldwide have spent countless hours agonizing about how to reduce systemic risk, the chance that instability will cause a recession or worse. Unfortunately, they have little precedent to rely upon.

Without precedent, regulators are experimenting with a range of approaches, which they describe as an assortment of “tools.” These include, for example, increased capital requirements, stricter resolution mechanisms for troubled firms, and greater regulation of securitization and derivatives transactions. Some argue that the tools “almost certainly will not optimally reduce, and might even increase systemic risk.” Regulators themselves worry that vulnerabilities remain.

Until it is tested, there is no way to know whether the post-crisis regulation will be sufficient to protect financial stability. There are fundamental flaws. For example, although the financial system has three critical elements — firms, markets and infrastructure — most of the post-crisis regulation focuses on firms, in particular, systemically important financial institutions (SIFIs). That regulation largely ignores markets, even though market panics arguably triggered the financial crisis. And, although some of that regulation addresses infrastructure, its ultimate impact remains questionable.

Even some of the post-crisis regulation that focuses on firms may be misguided. In accord with the human tendency to assign blame for harm, the media, politicians and regulators have assigned primary blame for the financial crisis on excessive SIFI risk taking. They argue this risk taking was motivated by moral hazard: the temptation felt by persons — previously protected from the consequences of their risky actions — to take more risks. SIFIs, they contend, were protected from the consequences of their risk taking because they were too big for governments to let them fail (TBTF). To prevent excessive future risk taking, regulators have framed TBTF, moral hazard and associated wrongdoing as central targets of post-crisis regulation. For example, the Financial Stability Board, an organization established by the Group of Twenty nations to monitor and make recommendations about regulating the global financial system, has made ending TBTF a central part of its policy agenda.

That framing, however, is questionable. There is no evidence that moral hazard caused excessive SIFI risk taking. The economic studies purporting to “prove” that claim merely show that SIFIs can borrow at lower-than-average cost. Economists presume that this funding advantage is born of investors’ belief that firms will be bailed out before they default. But, in reality, there are many other reasons besides the expectation of a bailout — economies of scale and better access to debt markets, to name but two — why SIFIs can borrow at lower-than-average cost. Furthermore, the idea that TBTF causes SIFIs to engage in morally hazardous risk taking is antithetical to managerial incentives. Managers are almost certain to lose their jobs if the government fails to bail out their firm, whereas a bailout may well be conditioned on culpable managers resigning or otherwise giving recompense. In either case, the reputational damage could destroy a manager’s financial career.

Other factors may better explain excessive SIFI risk taking. For example, the “shareholder-primacy” model of corporate governance encourages risk taking that should benefit the firm and its shareholders, even though it could harm (and thus be excessive from the perspective of) the public — unless that harm is legally prohibited or internalized through tort law. Although this governance model is sensible for most firms, it fails for SIFIs, because systemic harm is neither legally prohibited nor internalized through tort law. Regulation could correct this flaw by reforming SIFI governance. However, regulators have not yet taken that step, which would engage the long-standing debate about whether corporate governance law should require a duty to the public.

Instead, post-crisis financial regulation indirectly tries to mitigate third-party harm caused by excessive SIFI risk taking. These efforts are epitomized by capital requirements, which require SIFIs to hold minimum levels of equity and the like. However, the ability of these requirements to reduce SIFI risk taking, much less to control systemic risk, is unclear. The cost of imposing capital requirements is also uncertain. In their 2013 book, The Bankers’ New Clothes: What’s Wrong with Banking and What to Do about It, Anat Admati and Martin Hellwig argue that capital requirements impose no public costs. Others, such as Jean Dermine in his paper “Bank Regulations after the Global Financial Crisis: Good Intentions and Unintended Evil,” argue the contrary.

However, post-crisis regulation does, wisely, focus on controlling the risk of maturity transformation — the asset-liability mismatch that results from the short-term funding of long-term projects. Although essential to providing funding, maturity transformation can create a maturity gap — namely, the risk that cash flows from long-term projects may be insufficient to pay maturing short-term liabilities, leading to a default. Although regulators historically worried about maturity gaps in the context of a “bank run” (when panicked short-term depositors try to draw their money from a bank all at once; even a solvent bank may lack the liquidity to make those payments), the financial crisis showed that these gaps can arise outside of traditional banking. As a result, post-crisis regulation requires certain SIFIs to maintain sufficient liquidity (such as cash on hand) to pay any short-term obligations.

Significant risk remains, however, because not all financial firms that engage in maturity transformation have been designated as SIFIs. Furthermore, a recent policy trend might disfavour SIFI designation and regulation, substituting for it the regulation of systemically risky financial activities. That creates a new challenge: how to regulate maturity transformation as an activity?

One possibility might be to innovate on an approach used for years by special purpose vehicles (SPVs), which fund themselves by issuing short-term securities (called commercial paper), to control the risk of maturity transformation. Those SPVs carefully monitor and try to cover payment of their maturing commercial paper with cash received from their long-term projects and from issuing new commercial paper. They also enter into “liquidity” facilities with creditworthy banks, which obligate the banks to purchase the newly issued commercial paper if, due to market disruptions, a solvent SPV cannot otherwise sell those securities. Because the banks only take the timing risk of a cash-flow mismatch and do not bear any credit risk, these liquidity facilities have been — and as applied more broadly to non-SPV financial firms, should likewise be — low-cost and practical.

We also need to think more systematically about designing regulation to stabilize finance. One such approach would be to correct market failures that could trigger and transmit systemic risk. That poses a future challenge: to try to identify and better understand those triggers and transmission mechanisms, and their underlying market failures.

This article draws in part from the author’s article, Systematic Regulation of Systemic Risk, which is available online and in a forthcoming edition of the Wisconsin Law Review (volume 2019, issue 1).

The opinions expressed in this article/multimedia are those of the author(s) and do not necessarily reflect the views of CIGI or its Board of Directors.
  • Steven L. Schwarcz

    Steven L. Schwarcz is a CIGI senior fellow and the Stanley A. Star Professor of Law & Business at Duke University. At CIGI, Steven leads research on systemic risk and financial regulation, corporate governance of systemically important firms, cross-border resolution measures and sovereign debt restructuring.

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