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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.