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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.

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.