Rebuilding Through Reform: How to Ensure Global Financial Stability

The current crisis is following much the same pattern of previous financial crises — an inability or unwillingness to see the warning signs and take preventive action, followed by massive damage, and then working through the emergency policy steps and the rebuilding of our financial system.

While we know we cannot prevent the next financial crisis, public policy and preventive steps play an important role in establishing the overall stability and resiliency of our financial system. Consequently, getting these steps right is essential if we are to avoid setting the stage for an even more severe crisis.

We must also recognize that our resolve in dealing with financial crises unfortunately tends to diminish after a crisis passes. Understandably, financial institutions want to get back quickly to a more profitable state, and the public wants a prompt and painless return to the prosperity they enjoyed before the crisis.

As a result of this substantial pressure, many policymakers and market participants become reluctant when it is time to make the hard judgments about effective reforms and instituting greater risk restraints. Signs of this are already occurring with the efforts by financial institutions and others to weaken or delay stronger capital standards and other provisions of the Dodd-Frank Act. That would be unwise.

Yes, the housing bubble was a major factor in bringing on the financial crisis. But there is something else that stands out to me as a banking supervisor: Both the private marketplace and regulators believed that they had new tools that could more accurately measure, price and control risk, even as financial instruments became far more complex and often were untested.

They had become convinced that we had entered a new era in which lower credit standards could simply be priced into the terms of a subprime loan, or that bank leverage ratios were a thing of the past because institutions and regulators could risk-weight assets and off-balance-sheet exposures and use quantitative risk models to come up with “better” and, invariably, lower measures of capital needs.

We also have had numerous changes in the structure of our financial markets over the past few decades, which have left us with a much different corporate culture in banking and finance. In fact, the new structure has brought with it a greater focus on short-term performance and more aggressive attitudes regarding risk-taking.

These changes include a rapidly rising concentration in the banking industry, the withering away of the Glass-Steagall constraints on banks engaging in securities activities and the growth of securitization and money and capital markets.

The outgrowth of all these changes was a complacency and false confidence in new risk-management practices and a substantial and largely unrecognized build-up in leverage and risk that laid the groundwork for this crisis.

Building a stronger financial system

If we are to construct a stronger financial system, we must address the significant problems and obvious shortcomings that led to the crisis. First and foremost is correcting the misaligned incentives and the improper expansion of the public safety net that encouraged and enabled institutions to take excessive risks.

The crisis has illustrated an ongoing pattern in which the response of public authorities is to expand the public safety net for too-big-to-fail institutions. This in turn facilitates even more risk-taking and sets the foundation for the next crisis to follow.

To break this cycle, it is crucial that we eliminate too-big-to-fail policies. The Dodd-Frank Act provides for the orderly liquidation of a large financial institution that has failed, but this is only a start — and there are other tools available.

Under the Gramm-Leach-Bliley Act, depository institutions in a financial holding company are required to remain well capitalized and well managed, or else face restructuring. It might be fair to ask whether all financial holding companies were in compliance with this requirement during the crisis.

In addition, we must return supervision to its traditional role of exercising sound judgment and making informed decisions.

In recent years, the supervisor’s role has become a more passive one, with examiners spending much time monitoring regulatory compliance and tracking the risk-management practices adopted by financial institutions. These demands will grow as examiners become more involved in stress tests, enhanced supervision, living wills and other features of the Dodd-Frank Act.

However, none of this should detract from the more traditional and time-tested efforts of examiners — to verify the quality of a bank’s assets, understand the bank’s business model, and evaluate lending standards and other factors that shape risk within a bank.

The judgments and decisions by examiners typically provide the earliest warning signal of problems at a bank, and we must continue to provide examiners with the independence and authority to fulfill this role.

As impartial observers, examiners are likely to be in the best position to identify the type of risk exposures and conditions that could lead to a crisis, particularly in the case of examiners who have dealt with previous crises. In fact, during my career in supervision, I have seen no substitute for the judgment of experienced examiners.

The breakdown of risk models and risk-management practices during the recent crisis tells me that we must not view the stress tests and other forms of quantitative analysis and models used by macroprudential supervisors as being a substitute or replacement for examiners and on-site supervision.

We face a real challenge in rebuilding our financial system and its supervisory framework. The steps we take today will either serve us well in the inevitable future financial shock, or they will sow the seeds of the next crisis. If we are to be successful, we must stop and ask ourselves what really went wrong this time and what we can do to construct a more stable and resilient financial system.

Editor’s note: This article was adapted from the author’s remarks at the 21st Annual Hyman P. Minsky Conference in New York City, on April 11, 2012. The conference was organized by the Levy Economics Institute of Bard College with support from the Ford Foundation.