Remember The Financial Crisis?! – What have we learned?

The economic costs of the crisis were brutal

• Real GDP fell more than 4% and took more than 3 years to return to the pre-crisis peak
• Public debt has increased by more than 30% of GDP, mostly due to cyclical forces
• At market bottom, $15 trillion in household wealth had disappeared

But these costs would have been much greater in the absence of an effective financial rescue

 

Policy Failures – Before and During the Crisis

Failures Ex Ante

• Home equity was too thin
• Capital cushions were too thin—and, more importantly, too narrow in scope
• Too much issuance of shortterm, deposit-like liabilities, without regulatory constraints on leverage and without access to the safety net

Failures In the Crisis

• We escalated too late, mostly because of limitations of authority
• Fiscal policy turned too tight too soon
• Mortgage restructuring authority, resources, and incentives were too weak

 

“Too big to fail” is less of a problem

• The largest institutions are subject to a systemic capital surcharge
• The FDIC has resolution authority to manage the failure of systemic institutions
• We imposed tougher concentration limits on the financial system
• The Fed’s emergency lending authority has been curtailed, and the FDIC’s emergency guarantee authority has been eliminated

 

Unfinished Business

• Lots of economic damage remains from the crisis
• The housing finance system is still broken
• Our firefighting tools are too weak
• The regulatory oversight structure is a mess

 

Tough questions on housing finance

• How do we balance the imperatives of mortgage accessibility and market stability?
• Should we have mandatory down payment requirements? And how high should those down payments be?
• What should the government’s role be in the new system? Guarantee should be explicit, limited in scope, more expensive—with greater role for private capital But government needs authority to step in during crisis
• How do we transition to the new system?

 

Firefighting authorities are too weak

• Our shock absorbers are thicker and broader than they were
• But we will always need firefighting authorities
• Guarantee authority is essential for breaking panics and for recapitalizing the system
• The scope of the standing lender of last resort authority is still too narrow
• We need more “break-the-glass” authority for the President

 

The costs of regulatory balkanization

• There’s too much opportunity for regulatory arbitrage
• Regulators and regulations are too slow to adapt to changing markets and institutions
• The rules are too complex
• There’s little accountability
• There’s too much regulatory capture

 

Principles to govern a streamlined system

• Functional specialization
• More budgetary independence from Congress
• Stronger enforcement
• Better firefighting authority

 

Rule 01  – If you want peace, prepare for war

• The extreme crisis is unimaginable ex ante
• Manias are not preventable, and there’s no over-the-horizon radar for preempting panics and crashes
• So design the system not to prevent failure, but to be safe for failure
• This means you need strong shock absorbers

 

Rule 02 – Design the shock absorbers for the extreme crisis and apply them broadly

• Impose capital, leverage, and funding requirements on bank-like institutions; systemic surcharge on the biggest
• Place margin requirements on repo and derivatives
• Design for the migration problem: Use the regulated system to impose limits on the shadow system Build in the ability to expand the perimeter of prudential regulation
• Require thick down payments for home mortgages
• Have clear accountability for the design and enforcement of these limits

 

Rule 03 – The supplemental arsenal of ex ante tools

• Don’t let your banking system get too large relative to the size of your economy (size and concentration limits)
• Don’t let your “banks” borrow too much in foreign currency
• Transparency
• Deterrence and enforcement

 

Rule 04 – Maintain strong financial capacity and a powerful firefighting arsenal

• Shock absorbers will not save you from the risk of the extreme crisis, so you need firefighting tools and the capacity to use them
• The key sources of financial strength are: Relatively low public debt levels A credible central bank, with a strong record on inflation
• Your firefighting arsenal must include: Liquidity for vulnerable parts of the system Guarantee authority for banks and banklike institutions Capital and resolution authority

 

Rule 05 – When the fire starts, let it burn—but build a firebreak around the core

• At the beginning of a crisis, there is a fog of diagnosis—idiosyncratic or systemic?
• To get it right, let the fire burn—and let the system adjust
• Escalate slowly at the beginning, but accelerate quickly when necessary
• And set the perimeter of protection so that you capture the solvent and the systemic, but not the insolvent and the peripheral

 

Rule 06 – When it’s time to escalate, apply the Powell Doctrine

• Use overwhelming force—fiscal, monetary, and financial Fiscal: as much as you can get Monetary: expansive throughout crisis and deleveraging Financial: liquidity, guarantees, capital, resolution
• None of these are powerful enough to work in isolation
• Together they must be powerful enough to remove risk of depression

 

Rule 07 – Plan for the long war

• Crises that follow booms entail long periods of deleveraging
• That makes growth weak and fragile
• Need sustained period of monetary policy accommodation to keep real rates negative
• And sustained fiscal support
• Avoid applying the brakes too early

 

Rule 08 – Impose conditions on the rescue

• Bagehot: Lend freely at a penalty rate
• Ideally, limit the scope of the rescue to the core of the financial system
• Price it to be valuable in the panic, but expensive when the panic breaks
• No naked, unconditional guarantees
• The guarantees should cover catastrophic risk, but not all risk
• Put the non-viable firms into resolution
• Accelerate restructuring and recapitalization of the core of the system to fuel the recovery
• Do the hard stuff early and quickly

 

Rule 09 – Distinguish the systemic from the idiosyncratic

• Faced with a systemic panic, do the opposite of what makes sense in a typical crisis
• Rather than imposing haircuts, you have to guarantee liabilities
• Rather than worrying about the potential costs of each specific intervention, you must try to limit the risk of broader failures and the greater costs they will entail
• You have to be prepared to take more potential risk if you want to limit actual risk to the taxpayer
• If you misdiagnose the systemic crisis as a normal crisis, then you will end up having to nationalize everything and socialize more risk

 

Rule 10 – Keep some perspective on moral hazard

• You can’t design a financial system or an effective financial rescue that eliminates moral hazard risk—you can wound moral hazard but you can’t kill it
• You can’t break a panic without creating moral hazard
• In a systemic crisis, the failure of small firms can jeopardize the stability of the system
• Without a firewall of guarantees around the core of the system, you won’t be able to get private capital to come in, and you won’t be able to allow failure and facilitate restructuring
• Preserving ambiguity around when you escalate and how broad to extend liquidity support buys you some market discipline
• Systemic capital surcharge and limits on size and/or consolidation are necessary

 

Conclusion – Accept the central paradox of financial crises

• It cannot be morally responsible to allow depression in the hopes of deterring future risk-taking
• What seems politically compelling in the moment is perilous and irresponsible
• What seems unjust is just; what seems risky is prudent
• You can’t solve the crisis by trying to fix the problems that caused the crisis; you have to solve the crisis first

 

Special thanks to Timothy F. Geithner (Lecturer in Management, Yale SOM, Former U.S. Secretary of the Treasury, Yale School of Management) and Andrew Metrick (Michael H. Jordan Professor of Finance and Management, Yale School of Management)