How do you prevent a repeat of the bubble that led to the financial meltdown of 2008?
Easy. Convince the markets that despite 80 years of experience to the contrary, the government will not step in next time to bail banks out.
That greatly oversimplified formulation describes the challenge of financial regulatory reform, former Minneapolis Federal Reserve President Gary Stern and University of Minnesota economics professor V.V. Chari told a downtown Minneapolis Club audience last week.
In a presentation titled “Regulating Our Financial System: What Is Broken and How Can It Be Fixed?” Stern concluded that the Wall Street reforms passed this summer, known as Dodd-Frank, “does have the potential” to prevent a repeat of financial market overreaching “if implemented appropriately.”
Effective reform needs to address built-in contradictions in financial market regulations so “policy makers don’t feel the need to intervene and creditors don’t expect a bailout,” Stern said.
He confessed that he was “mildly surprised that I’m coming out quite as positively about [Dodd-Frank] as I am, albeit with qualifications.”
Joining Stern at the podium, Chari agreed with the former Minneapolis Fed chief’s goal for reform but had a much different take on the current solution.
Declaring Dodd-Frank “an absolute disaster,” Chari argued that looking to regulation “is contradicted by every bit of historical experience we have.” He said that assuming “really smart regulators… get the balance between risk and reward just right is wishing for the tooth fairy.”
The ‘too big to fail’ problem
The roots of the problem go back to that earlier financial meltdown known as the Great Depression. Following a wave of bank collapses, the Federal Deposit Insurance Corp. was created in 1933 to prevent another financial panic by insuring depositors’ accounts and forestalling a run on banks.
That safety mechanism for depositors had another consequence. Stern described how investors in banks and other financial institutions, who are not themselves covered by deposit insurance, have learned to expect the government will step in to bail out the largest banks, those “too big to fail.” As a result, large, systemically important financial institutions are in effect encouraged to engage in risky behavior that their financial backers would not support if they thought they might lose their investment.
It happened in the 1980s savings-and-loan crisis, and it happened in 2008 with the subprime mortgage debacle.
As early as 2004, Stern and co-author Ron Feldman had highlighted the problem in their book, “Too Big to Fail: The Hazards of Bank Bailouts.” While still at the Fed in 2009, Stern had testified before Congress that effective financial reform should focus on limiting the spillover effect of any one institution’s failure on the entire system.
Stern described three elements of Dodd-Frank as potentially positive steps: creation of the Financial Stability Oversight Council and the Office of Financial Research, as well as “living wills” — the authority to wind down some ailing non-bank financial institutions.
While their actual roles have yet to be defined, Stern suggested that these reforms should focus on understanding the risk to the entire financial market — systemic risk — posed by a handful of key institutions and move to wall off the impact of their failure.
Chari said that the recent meltdown was not the result of “greedy CEOs or evil bankers” but market incentives that rewarded increasing risk, combined with an expectation of government bailouts.
“If you did not take on the same kinds of risk other financial institutions were taking on, you were being irresponsible to your shareholders. You were not doing what is proper, socially sanctioned behavior … The question is how you … introduce greater market discipline into the regulatory systems.”
Dodd-Frank also has exacerbated the economic slowdown, Chari said, by holding back commercial lending.
“I don’t think it is that much of a puzzle that banks are sitting on the sidelines. Twenty percent of commercial bank assets in the U.S. are sitting at the Fed earning 0.25 percent. There are no profitable risk-free opportunities [but there are] plenty of profitable and risky opportunities.”
Bankers are not lending because they “have no idea how regulators are going to second-guess [their] judgment,” he said. At the same time, newly empowered regulators “have every incentive to be excessively conservative and cautious. Do you want to be the regulator for the second financial crisis of the 21st century? I think not.”