The Regulatory Confidence Cycle

CAMBRIDGE – Late last month, the Federal Reserve released the transcripts of the Federal Open Markets Committee (the Fed’s monetary-policy-setting body) meetings from the run-up to the 2008 financial crisis. Unfortunately, too many reports on the transcripts miss the big picture. Criticizing the Fed for underestimating the dangers from the underground rumblings that were about to explode makes it seem that particular players just got it wrong. In fact, underestimating financial risk is a general problem – the rule, not the exception.

Even after the investment bank Bear Stearns failed in March 2008, Fed leaders believed that the institutional structure was strong enough to prevent a crisis. New York Federal Reserve President Timothy Geithner thought that banks had enough capital to withstand the potential losses. Likewise, Fed Vice Chair Donald Kohn told the US Senate that losses in the mortgage market would not threaten banking viability. Tellingly, academic opinion was similar. Too big to fail was no longer a big problem, a prominent view had it, as the banking laws of the previous decade had laid it to rest.

Even if some leaders failed to foresee the power of the coming explosion, they managed the aftermath as well as one could expect. Indeed, the transcripts themselves show that Fed leaders were worried about an economic downturn and were ready to employ their macroeconomic tools, but that they thought the banking system was well capitalized and could withstand more stress. And optimistic public statements – for example, by Vice Chair Donald Kohn – were often accompanied by worries that were expressed privately.

So what can we learn from this episode? When the economy is performing well and financial failures have been few and far between, regulators are lured into granting the regulated their requests to lower capital requirements, enter new business lines, and take on more risk. A crisis is hard to imagine, so it seems okay to relax the rules. Regulators see how well financial firms are doing, become convinced that they themselves are regulating effectively, that the regulated can at last run their banks well, and that policy tools can save the financial system and spare the real economy if a crisis unexpectedly occurs. They update their regulatory thinking with what they see, and what they see looks stable. Academics validate their judgment.

Indeed, there is a cycle in regulatory confidence. Regulators react to an explosion by creating new rules. The economy recovers, the regulators conclude that they did their job well (which they have), and the regulated then resist further tightening. The problem has been solved, the industry argues, and further regulatory tightening will harm the economy. As the recovery continues and the memory of the financial crisis grows faint, the appetite for regulatory change dissipates. Why fix something that is no longer broken?

We can already see the cycle repeating. After the 2010 Dodd-Frank financial-reform legislation was enacted in the US, and after financial firms’ capital requirements were raised and some of their riskiest activities limited, industry leaders announced that the battle had largely been won. The financial sector had been made safe for the twenty-first century. Further regulation would be punitive and ill-considered, for it would prevent banks from doing their job – lending to the real economy.

Meanwhile, regulators will have reason to believe that they have achieved a new safety paradigm: tighter rules that prevent banks from failing, and new ways to resolve any banks that fall through the cracks and fail anyway. A half-dozen years after the financial crisis, regulators will find it discouraging to conclude anything other than that they have solved the problem or are close to doing so. Fatigued by years of effort and beset by criticism from the industry, regulators will ease up.

And that is when things become dangerous. For example, because many view the Lehman Brothers collapse as sparking, or exacerbating, the financial crisis, much of the regulatory focus has been on developing the means to handle the failure of a similarly large financial firm. New regulatory authority from Congress has encouraged the view that regulators will soon be able to handle a Lehman-size failure smoothly.

But, if regulators become too confident too soon, they could consider the financial system safe from collapse, just as many did in 2008. Like generals fighting the last war, regulators, academics, and industry observers will be confident that regulators can handle and defuse another Lehman explosion before it happens. The financial industry itself will believe that finance has been made safe; indeed, it has already started down this road. And fatigued regulators, eager to declare victory, may concur. Yet finance can fail in many ways; the Lehman collapse is only one.

If this cycle is even approximately right, regulatory fatigue from battling to make finance safer will soon turn into regulatory confidence that the last war has now been won. In a strong economy, finance will look stronger and existing regulation will appear to be effective. It is common for people to update their views of the world with what they have last seen; if what they last see is a strong economy and a stable financial system, they will conclude that they have stabilized the system. The Fed’s 2008 transcripts reveal that its leaders saw such a world.

It will be easy to interpret future looming crises as minor road bumps that can be absorbed. But at some point, what looked like a bump will turn out to be a landmine, unseen because it was not the one perceived as having caused the last explosion.

The question is not whether it will happen again. The question is where and how. And when.