The Next Financial Crisis – How Good Rules Go Bad

Karen Shaw Petrou’s Federalist Society speech titled, The Next Financial Crisis How Good Rules Go Bad

It is an honor to speak here today with Senator Gramm, a man whose name graces many of the most important banking and budgetary bills enacted during the decades he represented Texas voters – I know they miss him still. He has just spoken about the macroeconomic risks he believes result from Federal Reserve accommodative-monetary policy. But, there’s an even greater danger than misfiring monetary policy: none at all. The new, radically-different structure of the US financial-services market means that the Fed can’t tell the economy what to do anymore because banks don’t matter anywhere near as much as they used to. You may well say good riddance given the cost of the financial crisis, but a country without a functioning monetary-policy delivery channel where systemic risks increasingly arise outside the reach of prudential regulation is one putting itself at great and unnecessary risk.

Is this alarmist? I sure hope so. I’m not the only one, though, worrying a lot about the FRB’s growing inability to use interest rates and bank reserves to set the economy on its preferred course – a conference held yesterday and today at the Federal Reserve Board itself on precisely this issue shows that the FRB knows it has a problem even though it has yet, sadly, to broach any solutions. The global Financial Stability Board yesterday counted up all the US financial assets housed in most non-banks, logging them in at $14.2 trillion at year-end 2014.1 That’s not small and neither is the risk they pose.

Although describing the conference as a research session, Chair Yellen yesterday said that she would like to better understand how changes in the way US financial intermediation affects monetary-policy transmission. Let me today offer my own thoughts on this critical question and, given how urgent it is, also a few things the FRB can and should do ASAP to save not only its ability to conduct monetary policy, but also the rest of us from preventable systemic crises.

Maybe we could manage without monetary policy if there was another way to short-circuit boom-bust crises – what we’ve come to call macroprudential regulation. But macropru doesn’t work any better than monetary policy. In the real world in which financial institutions live or die, rules have costs and costs have consequences. Regulators believe that costs are manageable and consequences are nothing but beneficial. However, the costs now are so great that combined with other market transformations, they pose significant second-order risks. We’ve probably corrected for all the causes of the last crisis, but I fear we’re sowing the seeds of the next one.

Where Needed Change Still Sows Systemic Seeds

Before I talk about specific regulatory actions and how they have changed the market, let me first point to one example of the best intentions that nonetheless pose grave risk. It epitomizes how even an unimpeachable policy action poses second-order dangers.

The policy actions I mean here aren’t so much a single rule, but rather the cumulative impact of all of the new rules and the current, way-tough enforcement environment. Many of these rules – stress-testing, for example – are essential and punishment for crisis-causing behavior was, if anything, too weak. But in practice the new rules and enforcement regime combine with newly-enhanced risk management and better boards to force banks to devote billions not to innovation and enhanced customer service, but rather to model-building, internal investigations, and new information systems.