Module 6
Regulating the Financial System Assignment
a. The Sources and Consequences of Runs, Panics, and Crises
In a market-based economy, the opportunity to succeed is also an opportunity
to fail. New restaurants open and others go out of business. Only 1 in 10 restaurants
survives as long as three years. In principle, banks should be no different from
restaurants: new ones should open and unpopular ones close. But few of us would
want to live in a world where banks fail at the same rate as restaurants. Banks serve
some essential functions in our economy: They provide access to the payments
system, and they screen and monitor borrowers to reduce information problems. If
your favorite restaurant closes suddenly, you can still eat, but if your bank closes, you
lose your ability to make purchases and pay your rent. So while no one suggests that
the government appoint officials to minimize restaurant closings, everyone expects
the government to safeguard banks.
Banks’ fragility arises from the fact that they provide liquidity to depositors.
That is, they allow depositors to withdraw their balances on demand. If you want the
entire amount in your checking account converted into cash, all you need to do is go
to your bank and ask for it; the teller is obligated to give it to you. If a bank cannot
meet this promise of withdrawal on demand because of insufficient liquid assets, it
will fail. Banks not only guarantee their depositors immediate cash on demand; they
promise to satisfy depositors’ withdrawal requests on a first-come, first-served basis.
This commitment has some important implications. Suppose depositors begin to lose
confidence in a bank’s ability to meet their withdrawal requests. They have heard a
rumor that one of the bank’s largest loans has defaulted, so that the bank’s assets may
no longer cover its liabilities. True or not, reports that a bank has become insolvent
can spread fear that it will run out of cash and close its doors. Mindful of the bank’s
firstcome, first-served policy, frenzied depositors may rush to the bank to convert
their balances to cash before other customers arrive.
A bank run is a critical event in the financial system that can have far-reaching
consequences for banks, depositors, and the broader economy. It occurs when a large
number of depositors simultaneously withdraw their funds from a bank due to
concerns about the bank's solvency or financial stability. This phenomenon is driven
by fear and panic, as depositors rush to withdraw their deposits in anticipation of the
bank's failure.
The mechanics of a bank run hinge on the perception of the bank's financial
health. If depositors believe that a bank may not be able to fulfill its obligations to
repay deposits, they seek to withdraw their funds before other depositors, fearing that
the bank may run out of cash or become insolvent. This collective action can quickly
escalate into a full-scale run if the initial withdrawals reinforce the belief that the bank
is in trouble, prompting more depositors to withdraw their funds.
Bank runs pose significant challenges to banks because they typically do not
hold enough cash on hand to satisfy the withdrawal demands of all depositors
simultaneously. Banks rely on a fractional reserve system, where only a fraction of
deposits is held as cash reserves, with the remainder invested or loaned out to
generate income. Therefore, a sudden and large-scale withdrawal demand can quickly
deplete a bank's liquid reserves, exacerbating its financial instability.
The consequences of a bank run can be severe. If a bank fails to meet
depositors' withdrawal demands, it may be forced to declare insolvency and cease
operations. This not only results in financial losses for depositors but also undermines
confidence in the banking system as a whole. Bank runs can trigger a domino effect,
leading to systemic banking crises and economic downturns if not effectively
managed.
Governments and central banks play a crucial role in mitigating the impact of
bank runs and maintaining financial stability. They may intervene to provide liquidity
support to troubled banks, reassure depositors about the safety of their deposits, or
even guarantee deposits through deposit insurance schemes. Regulatory measures,
such as capital requirements and stress testing, are also implemented to strengthen
banks' resilience and reduce the likelihood of bank runs.
Moreover, advances in financial regulation and supervision aim to enhance
transparency and oversight within the banking sector, reducing systemic risks and
improving market confidence. These measures are designed to prevent excessive risk-
taking and ensure that banks maintain adequate capital buffers to withstand financial
shocks, including potential runs by depositors.
In summary, while bank runs are rare in well-regulated and stable financial
systems, their potential impact underscores the importance of robust banking
regulations, effective supervision, and crisis management frameworks. Maintaining
depositor confidence and financial stability is essential for safeguarding the integrity
and resilience of the banking sector, thereby supporting sustainable economic growth
and prosperity.
In short, a bank run can be the result of either real or imagined problems. No
bank is immune to the loss of depositors’ confidence just because it is profitable and
sound. In practice, runs often start with shakier banks and then spread to healthier
ones as confidence erodes. The financial crisis of 2007–2009 is replete with examples
of runs on banks and on the much less regulated shadow banks, which also provide
liquidity to the financial system. The United Kingdom faced its first run on a large
bank in more than a century when, in September 2007, depositors rushed to withdraw
funds from Northern Rock, a major housing lender (see neighboring photos).
Meanwhile, the largest savings bank in the United States, Washington Mutual, failed
when depositors fled in September 2008.
In the tumultuous landscape of financial crises, the events surrounding
Wachovia Bank in its final months before its emergency sale in 2008 stand as a
poignant example of the vulnerabilities within the banking sector during that period.
Wachovia Bank, once the fourth-largest commercial bank in the United States, faced a
confluence of challenges that ultimately precipitated its rapid decline and forced sale.
The origins of Wachovia's troubles can be traced back to its heavy exposure to
risky mortgage-backed securities and subprime mortgages. Like many other financial
institutions at the time, Wachovia had invested heavily in these assets, driven by the
allure of high returns during the housing boom. However, as the housing market
collapsed and mortgage defaults surged, the value of these securities plummeted,
severely impairing Wachovia's balance sheet and eroding investor confidence.
The deterioration of Wachovia's financial health became increasingly evident
as news of mounting losses and deteriorating asset quality surfaced. Depositors,
concerned about the bank's solvency and ability to honor their withdrawals, began
withdrawing their funds in large volumes. This sudden outflow of deposits
exacerbated Wachovia's liquidity crunch, making it increasingly difficult for the bank
to meet its short-term obligations.
Facing mounting pressure and a diminishing ability to access funding in the
interbank market, Wachovia's management and board were compelled to explore
strategic options to shore up its financial position. In September 2008, as the global
financial crisis intensified following the collapse of Lehman Brothers, Wachovia's
plight worsened. Efforts to find a buyer or secure a capital infusion to stabilize the
bank proved unsuccessful amid the prevailing market turmoil and uncertainty.
Ultimately, Wachovia found itself on the brink of failure. To prevent a
disorderly collapse that could have further destabilized the financial system,
regulators and policymakers intervened. The Federal Deposit Insurance Corporation
(FDIC) facilitated Wachovia's sale in a transaction that saw its banking operations
acquired by Citigroup. This emergency sale, arranged over a frantic weekend of
negotiations, marked the end of Wachovia as an independent entity and highlighted
the systemic risks posed by the interconnectedness of financial institutions during
times of crisis.
The fallout from Wachovia's demise reverberated across the financial industry
and broader economy. It underscored the vulnerabilities inherent in a financial system
overly reliant on complex financial instruments and exposed to excessive risk-taking.
The episode also prompted policymakers to reevaluate regulatory frameworks and
implement reforms aimed at strengthening oversight, enhancing transparency, and
bolstering the resilience of financial institutions to future shocks.
In hindsight, the case of Wachovia Bank serves as a stark reminder of the
critical importance of prudent risk management, robust regulatory oversight, and
effective crisis preparedness in safeguarding financial stability. It remains a pivotal in
the history of the 2008 financial crisis, shaping subsequent reforms and influencing
the evolution of global financial regulation to mitigate systemic risks and protect
against future banking sector crises.
Quiet, invisible runs on shadow banks were even more dramatic, as they
punctuated the peaks of the financial crisis. In March 2008, short-term lenders and
other creditors stopped lending to Bear Stearns, the fifth-largest U.S. investment bank.
The run halted only when the Federal Reserve Bank of New York stepped in to help
the then-second-largest U.S. commercial bank, JPMorgan Chase, acquire Bear. A
similar sudden stop in private lending led the U.S. government to take over Fannie
Mae and Freddie Mac in September 2008. The financial crisis peaked later that month
when a run on Lehman Brothers—the fourthlargest U.S. investment bank—
precipitated its bankruptcy. Shortly thereafter, losses on Lehman debt compelled a
money-market mutual fund (MMMF) to “break the buck”—that is, to lower its share
value below $1; that fixed value is traditionally promised by all MMMFs so that their
customers can treat their shares as if they were bank deposits.
The events surrounding the collapse of several Money Market Mutual Funds
(MMMFs) during the financial crisis of 2008 highlight significant vulnerabilities in
the financial intermediation process in the United States. MMMFs, traditionally
considered safe investments offering stable returns slightly above traditional bank
deposits, became a focal point of investor panic and systemic risk during this period.
Money Market Mutual Funds operate by investing in short-term, high-quality
assets such as government securities, commercial paper, and certificates of deposit.
They aim to maintain a stable net asset value (NAV) of $1 per share, allowing
investors to redeem their shares at this price. This stability and liquidity have made
MMMFs attractive to a wide range of investors, including individuals, corporations,
and institutional investors seeking cash management and short-term investment
options.
However, the financial crisis exposed vulnerabilities within MMMFs,
particularly regarding their susceptibility to runs by investors. The crisis triggered a
wave of fear and uncertainty in financial markets, exacerbated by the collapse of
Lehman Brothers and the broader turmoil in the banking and credit markets. As
confidence in the financial system eroded, investors in MMMFs became concerned
about the safety of their investments and the ability of these funds to maintain their $1
NAV.
The pivotal concern during the crisis was the potential for MMMFs to "break
the buck," meaning their NAV could fall below $1 per share. This scenario would
indicate that the fund's assets were worth less than its liabilities, implying losses for
investors. Fearful of such a scenario and eager to secure their investments at the
perceived stable $1 NAV, investors rushed to redeem their shares from MMMFs. This
collective action, known as a run, exacerbated the selling pressure on MMMFs and
strained their ability to maintain liquidity.
The runs on MMMFs during the crisis undermined a key component of the
U.S. financial intermediation mechanism. MMMFs traditionally served as a vital link
between savers and borrowers in the economy, providing liquidity to short-term
borrowers while offering a safe and liquid investment option for savers. The runs
destabilized this intermediation function, as withdrawals depleted the funds' liquid
assets, forced them to sell holdings at distressed prices, and in some cases, prompted
fund closures or interventions by regulators.
In response to the crisis, policymakers and regulators implemented measures
to stabilize MMMFs and restore investor confidence. The U.S. Treasury Department
temporarily guaranteed certain MMMF holdings, and the Securities and Exchange
Commission (SEC) introduced regulatory reforms to enhance transparency, improve
risk management practices, and strengthen the resilience of MMMFs to market
stresses.
The crisis also spurred broader discussions about the role of MMMFs in the
financial system and the need for additional safeguards to mitigate systemic risks.
Some proposals included further regulatory reforms, such as capital requirements,
liquidity buffers, and changes to the valuation and redemption practices of MMMFs,
to enhance their stability and reduce the likelihood of future runs.
In conclusion, the runs on Money Market Mutual Funds during the 2008
financial crisis underscored the fragility of financial intermediation mechanisms and
the interconnectedness of financial markets. They prompted significant regulatory
responses aimed at enhancing stability, restoring investor confidence, and
safeguarding the critical role of MMMFs in the broader financial system.
What matters during a bank run is not whether a bank is solvent, but whether it
is liquid. Solvency means that the value of the bank’s assets exceeds the value of its
liabilities—that is, the bank has a positive net worth. Liquidity means that the bank
has sufficient reserves and immediately marketable assets to meet depositors’ demand
for withdrawals. False rumors that a bank is insolvent can lead to a run that renders a
bank illiquid. If people believe that a bank is in trouble, that belief alone can make it
so. When a bank fails, depositors may lose some or all of their deposits, and
information about borrowers’ creditworthiness may disappear. For these reasons
alone, government officials work to ensure that all banks are operated in a way that
minimizes their chance of failure. But that is not their main worry. The primary
concern is that a single bank’s failure might cause a small-scale bank run that could
turn into a systemwide bank panic. This phenomenon of spreading panic on the part
of depositors in banks (or of creditors to shadow banks like MMMFs) is called
contagion.
During the peak of the 2007–2009 financial crisis, contagion spread rapidly
across global financial markets, fueled by mounting fears and uncertainties
surrounding the stability of financial intermediaries worldwide. The crisis, which
originated in the United States housing market and spread globally, underscored the
interconnectedness and interdependencies within the international financial system.
At the heart of the crisis were complex financial products linked to subprime
mortgages, which began to unravel as housing prices declined and mortgage defaults
soared. These products were widely held by financial institutions globally, leading to
substantial losses and impairments to balance sheets. As losses mounted, confidence
in the financial health of banks and other financial intermediaries eroded, triggering
widespread panic among depositors, creditors, and investors.
Governments and central banks responded with unprecedented interventions to
stabilize financial markets and restore confidence. These measures included interest
rate cuts, liquidity injections, bank recapitalizations, and guarantees on deposits and
bank debt. International cooperation and coordination among central banks and
financial regulators were crucial in containing the crisis and preventing a complete
collapse of the financial system.
The crisis also prompted significant regulatory reforms aimed at strengthening
the resilience of financial institutions and improving the oversight of financial
markets. These reforms included stricter capital requirements, enhanced risk
management practices, and greater transparency in financial reporting. The goal was
to reduce the likelihood and severity of future financial crises and enhance the ability
of the financial system to absorb shocks.
In conclusion, the powerful contagion effects during the 2007–2009 financial
crisis underscored the vulnerabilities and interconnectedness of global financial
markets. The crisis served as a stark reminder of the importance of robust risk
management, effective regulation, and international cooperation in safeguarding
financial stability and mitigating systemic risks in the future.
Information asymmetries are the reason that a run on a single bank can turn
into a bank panic that threatens the entire financial system. What is true for cars is
even truer for banks. Most of us are not in a position to assess the quality of a bank’s
balance sheet. In fact, because banks often make loans based on sophisticated
statistical models, only an expert with knowledge of market conditions and access to
all details about a bank’s assets can estimate their worth. Depositors, then, are in the
same position as uninformed buyers in the used-car market: They can’t tell the
difference between a good bank and a bad bank. And if the cost of withdrawal is tiny,
who wants to keep a deposit in a bank if there is even a small chance that it could be
insolvent? So when rumors spread that a certain bank is in trouble, depositors and
other creditors begin to worry about their own banks’ financial condition.
The concern about the stability of a single bank and its potential to trigger a
broader panic and systemic collapse of the banking system is rooted in the complex
dynamics of confidence, interconnectedness, and contagion within financial markets.
Throughout history, instances of bank failures and financial crises have demonstrated
how fear and uncertainty can rapidly escalate, undermining trust in the entire banking
system and leading to widespread repercussions.
Bank runs and financial panics are often driven by psychological factors such
as fear, uncertainty, and herd behavior. If depositors lose confidence in the ability of a
bank to safeguard their deposits or meet withdrawal demands, they may rush to
withdraw their funds in a self-fulfilling prophecy. This behavior can quickly spread to
other banks as depositors seek to protect their savings, potentially triggering a domino
effect of bank failures.
Banks are interconnected through various channels, including interbank
lending, payment systems, and derivative contracts. A failure or distress at one
institution can transmit financial stress to others with direct or indirect exposures.
This interconnectedness can amplify the impact of a single bank's troubles, leading to
contagion effects that spread throughout the financial system.
Banks rely on confidence and liquidity to operate effectively. A loss of
confidence can lead to liquidity shortages as depositors withdraw funds and creditors
withhold financing. This liquidity squeeze can impair a bank's ability to meet its
obligations, forcing it to sell assets at distressed prices or seek emergency funding. In
extreme cases, liquidity pressures can escalate into solvency concerns, further
undermining market confidence.
The collapse of one or more major banks can pose systemic risks to the
broader economy. Banks play a critical role in intermediating funds between savers
and borrowers, facilitating credit creation, and supporting economic activity. A
widespread loss of confidence in the banking system can disrupt credit flows, impair
corporate financing, and undermine consumer confidence, potentially leading to a
severe economic downturn. Governments and central banks play a crucial role in
mitigating systemic risks and restoring confidence during financial crises. They may
intervene with measures such as deposit insurance, liquidity support, capital
injections, and guarantees to stabilize troubled banks and prevent contagion.
Regulatory reforms aimed at enhancing transparency, improving risk management
practices, and strengthening capital buffers also aim to bolster the resilience of the
banking system against future shocks.
Historical episodes of banking crises, such as the Great Depression in the
1930s or the Savings and Loan Crisis in the 1980s, provide valuable lessons on the
consequences of banking system collapses. These experiences have informed policy
responses and regulatory frameworks designed to prevent or mitigate systemic risks
and safeguard financial stability. In summary, while concerns about individual banks
can escalate into broader financial panics and systemic collapses, proactive regulatory
oversight, effective crisis management frameworks, and measures to enhance market
confidence are essential in safeguarding the resilience and stability of the banking
system. Understanding the dynamics of panic and contagion is crucial for
policymakers, regulators, and market participants in managing financial crises and
maintaining the trust and functionality of the financial system.
While banking panics and financial crises can easily result from false rumors,
they can also occur for more concrete reasons. Because a bank’s assets are a
combination of loans and securities, anything that affects borrowers’ ability to make
their loan payments or drives down the market value of securities has the potential to
imperil the bank’s finances. The decline of U.S. housing prices and the resulting wave
of mortgage defaults that began in 2006 set the stage for the crisis of 2007–2009 by
lowering the value of assets on the balance sheets of intermediaries around the world.
Recessions— widespread downturns in business activity—have a clear negative
impact on a bank’s balance sheet. When business slows, firms have a harder time
paying their debts. People lose their jobs and suddenly can’t make their loan
payments. As default rates rise, bank assets lose value, and bank capital drops. With
less capital, banks are forced to contract their balance sheets, making fewer loans.
The decline in loans during economic downturns can have profound and
cascading effects on the broader economy, amplifying the severity of recessions and
contributing to the destabilization of financial institutions, including both traditional
banks and shadow banks.
When economic conditions deteriorate, businesses typically reduce their
borrowing and investment activities. This cautious approach stems from reduced
consumer demand, uncertainty about future economic prospects, and tighter credit
conditions imposed by lenders. As businesses scale back on borrowing for expansion,
capital expenditure, and inventory financing, the overall volume of loans extended by
banks and other financial intermediaries declines.
The reduction in business investment has significant implications for
economic growth. Business investment drives productivity improvements, innovation,
and job creation, laying the foundation for sustainable economic expansion. When
businesses curtail investment due to economic uncertainty or limited access to credit,
it stifles growth prospects and weakens the overall resilience of the economy.
Simultaneously, economic downturns often trigger large declines in asset prices across
various markets, including stocks, bonds, and real estate. These asset price declines
reflect investor pessimism, heightened risk aversion, and forced selling to raise
liquidity. Plummeting asset prices can erode household wealth and business balance
sheets, further dampening consumer spending and investment confidence.
The combination of reduced lending activity and asset price declines poses
significant challenges to financial institutions. Traditional banks, which rely on
lending as a primary revenue source, face shrinking interest income and potential loan
losses as borrowers struggle to repay debts amid economic hardship. This strain on
banks' balance sheets can weaken their capital adequacy and liquidity positions,
making them more vulnerable to financial distress or failure.
Shadow banks, or non-bank financial intermediaries, also face heightened
risks during economic downturns. These entities, which include investment funds,
mortgage lenders, and finance companies, provide credit and liquidity services outside
the traditional banking sector. They often rely on short-term funding markets and
leverage to finance their operations. When market liquidity dries up or asset prices
plummet, shadow banks may experience funding pressures and asset value declines,
potentially leading to destabilization or failure.
The widespread failure of banks and shadow banks during deep recessions
poses systemic risks to the financial system and the broader economy. Such failures
can disrupt credit intermediation, impair access to financing for households and
businesses, and exacerbate economic downturns. In response, policymakers and
central banks often implement measures to stabilize financial markets, restore
liquidity, and support the capitalization of troubled financial institutions.
Historical financial crises, such as the 2008 global financial crisis and the
Great Depression, underscore the consequences of widespread bank failures and asset
price collapses. These episodes have prompted regulatory reforms aimed at enhancing
financial stability, improving risk management practices, and reducing the likelihood
of future crises. Measures such as enhanced capital requirements, stress testing of
financial institutions, and greater transparency in financial markets aim to mitigate
systemic risks and strengthen the resilience of the financial system.
In conclusion, the interplay between declining loans, reduced business
investment, asset price declines, and the failure of financial institutions during
economic downturns illustrates the interconnectedness and vulnerabilities within the
global financial system. Understanding these dynamics is crucial for policymakers,
regulators, and market participants in formulating effective responses to mitigate
risks, stabilize financial markets, and support sustainable economic growth.
The history of banking in the United States shows clear evidence that
downturns in the business cycle put pressure on banks, substantially increasing the
risk of panics. To see this, we can look at the period from 1871 to 1914, prior to the
creation of the Federal Reserve System. Over those four-plus decades, there were 11
business cycles— booms followed by recessions. Bank panics occurred during seven
of them, five of which were very severe. They often started near the business cycle
peak, when investors began to anticipate a downturn. The next series of severe bank
panics occurred during the Great Depression of the 1930s, when output fell by
roughly one-third.
Bank panics, often triggered by real economic events or their anticipated
impact, represent critical junctures in financial history where systemic confidence in
the banking system is severely tested. These events typically stem from underlying
economic factors rather than mere speculation or rumors, highlighting the complex
interplay between economic fundamentals, market psychology, and financial stability.
Bank panics frequently coincide with or follow periods of economic
contraction, recession, or financial distress. During economic downturns, businesses
may experience declining revenues, rising defaults on loans, and reduced ability to
service debt. This strain on borrowers' financial health can weaken the quality of
banks' loan portfolios, erode their capital reserves, and heighten concerns among
depositors about the safety of their funds. Sharp declines in asset prices, such as real
estate, stocks, or commodities, can destabilize financial markets and undermine
investor confidence. When asset values plummet, investors and financial institutions
holding these assets may face significant losses, prompting liquidity pressures and
exacerbating fears of insolvency. This scenario can trigger depositor withdrawals and
investor redemptions, amplifying the panic and accelerating the deterioration of
financial institutions' balance sheets.
Disruptions in credit markets, including liquidity shortages, rising borrowing
costs, and reduced availability of financing, can exacerbate financial stress for banks.
Tighter credit conditions constrain banks' ability to lend and refinance maturing
obligations, forcing them to liquidate assets or seek emergency funding. These
challenges can intensify perceptions of systemic risk and trigger depositor runs as
stakeholders seek to safeguard their assets amid growing uncertainty.
Bank panics are often driven by a loss of confidence among depositors,
creditors, and investors in the ability of financial institutions to honor their
obligations. Negative news about a bank's financial health, high-profile defaults, or
regulatory interventions can erode trust and spark fear of widespread financial
instability. This loss of confidence can quickly escalate into a self-fulfilling prophecy
as depositors rush to withdraw funds, further straining banks' liquidity and solvency.
Herd behavior plays a significant role in amplifying bank panics. When depositors
observe others withdrawing their funds from a bank perceived as vulnerable, they
may follow suit to avoid potential losses or being left without access to their savings.
This collective action, driven by fear and uncertainty, can intensify liquidity pressures
on banks and exacerbate the severity of the panic.
Historical episodes of bank panics, such as the Great Depression in the 1930s
and the global financial crisis in 2008, have informed policymakers and regulators
about the importance of preemptive measures and coordinated responses to financial
instability. These experiences underscore the need for robust financial regulation,
effective crisis management frameworks, and measures to promote transparency and
stability in financial markets.
In conclusion, while bank panics often have roots in real economic events or
their anticipation, the psychological and behavioral dynamics of fear and uncertainty
play a pivotal role in their escalation. Understanding these factors is essential for
designing proactive policies and strategies to safeguard the resilience and integrity of
the banking system against future crises.
Financial disruptions can also occur whenever borrowers’ net worth falls, as it
does during a deflation. Companies borrow a fixed number of dollars to invest in real
assets like buildings and machines, whose values fall with deflation. The same applies
to households acquiring houses. So a drop inMprices reduces companies’ and
households’ net worth (but not their loan payments). This decline in net worth
aggravates the adverse selection and moral hazard problems caused by information
asymmetries, making loans more difficult to obtain. If borrowers cannot get new
financing, business and residential investment will fall, reducing overall economic
activity and raising the number of defaults on loans. As more and more borrowers
default, banks’ balance sheets deteriorate, compounding information problems and
creating a full-blown crisis.
The adverse feedback loop between financial and economic activity is a
fundamental characteristic that exacerbates the severity and duration of deep crises.
This interconnected relationship underscores how disruptions in the financial sector
can amplify economic downturns, leading to a vicious cycle of worsening conditions
for businesses, households, and financial institutions.
During periods of financial distress, banks and other lenders may tighten credit
conditions by reducing lending, increasing interest rates, or imposing stricter
borrowing requirements. This credit contraction limits businesses' ability to invest in
expansion, purchase inventory, or finance operations. Reduced access to credit can
stifle economic growth, weaken consumer spending, and exacerbate unemployment,
further straining household incomes and increasing loan defaults. Financial crises
often precipitate sharp declines in asset prices, including stocks, bonds, real estate,
and commodities. These asset price corrections erode household wealth, reduce
corporate valuations, and impair financial institutions' balance sheets. As asset values
plummet, investors and institutions may experience significant losses, prompting
further asset sales and liquidity pressures. The resulting wealth effects contribute to
reduced consumer confidence and spending, prolonging the economic downturn.
Financial crises frequently lead to banking sector distress, with some
institutions facing solvency concerns, liquidity shortages, or depositor withdrawals.
Weak banks may curtail lending, liquidate assets, or seek government intervention to
shore up their capital positions. Banking sector distress undermines financial
intermediation, disrupts credit flows to businesses and consumers, and impedes
economic recovery efforts. The resulting uncertainty and risk aversion exacerbate
market volatility and hinder investment and growth.
Central banks typically respond to deep crises by lowering interest rates,
providing liquidity to financial markets, and implementing unconventional monetary
policies such as quantitative easing. These measures aim to stimulate borrowing,
support asset prices, and restore confidence in the financial system. However, the
effectiveness of monetary policy may be limited during severe downturns when
interest rates are near zero or when financial markets are dysfunctional.
Governments often implement fiscal stimulus measures, including increased
government spending, tax cuts, and targeted economic relief programs, to boost
demand, support employment, and mitigate the adverse effects of the crisis on
households and businesses. Fiscal interventions can provide immediate economic
support, bridge funding gaps, and stimulate recovery in sectors adversely affected by
the downturn.
Deep crises underscore the need for regulatory reforms aimed at enhancing the
resilience and stability of the financial sector. Reforms may include strengthening
capital and liquidity requirements for banks, improving risk management practices,
enhancing transparency in financial markets, and establishing mechanisms for early
intervention and resolution of financial institutions in distress.
Historical examples, such as the Great Depression of the 1930s and the global
financial crisis of 2007–2009, highlight the enduring impact of adverse feedback
loops between financial and economic activity. These crises have shaped
policymakers' understanding of systemic risks, informed the development of crisis
management frameworks, and underscored the importance of coordinated
international responses to global economic challenges.
Addressing the adverse feedback between financial and economic activity
requires a multifaceted approach that integrates monetary policy, fiscal measures, and
regulatory reforms. Proactive risk management, enhanced financial oversight, and
international cooperation are essential for identifying emerging threats, strengthening
financial resilience, and promoting sustainable economic growth in an interconnected
global economy.
In conclusion, the adverse feedback loop between financial and economic
activity amplifies the severity and duration of deep crises, underscoring the
importance of preemptive policy measures, robust regulatory frameworks, and
effective crisis management strategies to safeguard financial stability and promote
resilient economic growth.
b. The Government Safety Net
First, the government is obligated to protect small investors, many of whom
are unable to judge the soundness of their financial institutions. While competition is
supposed to discipline all the institutions in the industry, in practice only the force of
law can ensure a bank’s integrity. As small investors, we rely on the government to
protect us from mismanagement and malfeasance. Second, the tendency for small
firms to merge into large ones reduces competition, ultimately ending in monopolies.
In general, monopolies exploit their customers, raising prices to earn unwarranted
profits. Because monopolies are inefficient, the government intervenes to prevent the
firms in an industry from becoming too large. In the financial system, that means
ensuring that even large banks face competition. Third, the combustible mix of
liquidity risk and information asymmetries means that the financial system is
inherently unstable. A financial firm can collapse much more quickly than an
industrial company. For a steel corporation, an electronics manufacturer, or an
automobile maker, failure occurs slowly as customers disappear one by one. But a
financial institution can create and destroy the value of its assets in an astonishingly
short period, and a single firm’s failure can bring down the entire system.
Government officials employ a combination of strategies to protect investors
and ensure the stability of the financial system. First, they provide the safety net to
insure small depositors. Authorities both operate as the lender of last resort, making
loans to banks that face sudden deposit outflows, and provide deposit insurance,
guaranteeing that depositors receive the full value of their accounts should an
institution fail. But this safety net causes bank managers to take on too much risk,
leading to the regulation and supervision. This section will examine the unique role of
depository institutions in our financial system. The point is that we need banks. While
they are essential, they are also fragile. This leads to a discussion of the components
of the safety net and the problems it creates. The next section will look at the
government’s responses to these problems.
As the key providers of liquidity, banks ensure a sufficient supply of the
means of payment for the economy to operate smoothly and efficiently. This critical
role and the problems associated with it make banks a key focus of attention for
government regulators. Shadow banks are also major providers of liquidity, and
following their role in the financial crisis of 2007–2009, they also have attracted
intense attention from regulators around the world. We all rely heavily on these
intermediaries for access to the payments system. If banks, MMMFs, and securities
brokers were to disappear, we would no longer be able to transfer funds—at least not
until someone stepped forward to take their place. Other financial institutions—
insurance companies, pension funds, and the like—do not have this essential day-to-
day function of facilitating payments.
Furthermore, because of their role in liquidity provision, banks and shadow
banks are prone to runs. These intermediaries hold illiquid assets to back their liquid
liabilities. In the case of banks, their promise of full and constant value to depositors
is based on assets of uncertain value. The fixed-value shares of MMMFs are like bank
deposits in all but name. The liabilities of other shadow banks are less similar but
have important deposit-like characteristics. For example, repurchase agreements are
usually overnight contracts, so a repo lender can refuse to roll over the loan to a
securities broker at virtually any time, an action similar to a deposit withdrawal. In
contrast, pension funds and insurance companies (and even some hedge funds) may
hold illiquid assets, but their liability holders cannot withdraw funds whenever they
want. Moreover, banks and shadow banks are linked to one another both on their
balance sheets and in their customers’ minds.
Commercial banking system assets—which was less than 1 percent of all bank
capital. Prior to the crisis, interbank lending had been substantially greater and
represented roughly one-third of all bank capital. If a bank begins to fail, it will
default on its loan payments to other banks and thereby transmit its financial distress
to them. Similarly, MMMFs hold large volumes of commercial paper, most of which
was issued by banks. And (shadow) banks are among the key repo lenders to
securities brokers and hedge funds. Banks and shadow banks are so interdependent
that they are capable of initiating contagion throughout the financial system. Other
financial institutions also may pose such risks, but these intermediaries typically are
very large and few in number (see footnote 4 regarding the derivatives exposure of
AIG, the largest U.S. insurer when the crisis of 2007–2009 hit). While the
ramifications of a financial crisis outside the system of banks and shadow banks may
be more limited, they are still damaging. As a result, the government also protects
individuals who do business with finance companies, pension funds, and insurance
companies. For example, government regulations require insurance companies to
provide proper information to policyholders and restrict the ways the companies
manage their assets. The same is true for securities firms and pension funds, whose
assets must be structured to ensure that they will be able to meet their obligations
many years into the future.
The best way to stop a bank failure from turning into a bank panic is to make
sure solvent institutions can meet their depositors’ withdrawal demands. In 1873 the
British economist Walter Bagehot suggested the need for a lender of last resort to
perform this function. Such an institution could make loans to prevent the failure of
solvent banks and could provide liquidity in sufficient quantity to prevent or end a
financial panic. Specifically, Bagehot proposed that Britain’s central bank should lend
freely on good collateral at a high rate of interest. By lending freely he meant
providing liquidity on demand to any intermediary that asked for it. Good collateral
would provide assurance of the borrowing institution’s solvency, and the high interest
rate would penalize the borrower for failing to hold enough reserves or easily salable
assets to meet deposit outflows and would promote rapid repayment when funding
conditions normalized.
The existence of a lender of last resort significantly reduces, but does not
eliminate, contagion. The series of three bank panics that occurred during the Great
Depression of the 1930s is one example of the failure of a lender of last resort. While
the Federal Reserve had the capacity and the mandate to operate as a lender of last
resort in the 1930s, it chose not to do so. In effect, policymakers acted as if the “fire”
would burn itself out. Instead, the conflagration spread and intensified. The result was
the worst financial disaster in the 100-plus-year history of the Federal Reserve. There
is another flaw in the concept of a lender of last resort. For the system to work, central
bank officials who approve the loan applications must be able to distinguish an
illiquid from an insolvent institution. But during a crisis, computing the market value
of a bank’s assets is almost impossible, because there are no market prices. (If a bank
could sell its marketable assets in the financial markets, it wouldn’t need a loan from
the central bank.) Because a bank will go to the central bank for a direct loan only
after having exhausted all opportunities to sell its assets and borrow from other banks
without collateral, its illiquidity and its need to seek a loan from the government raise
the question of its solvency. Officials, anxious to keep the crisis from deepening, are
likely to be generous in evaluating the bank’s assets and to grant a loan even if they
suspect the bank may be insolvent. Knowing this, bank managers will tend to take too
many risks.
In other words, the central bank’s difficulty in distinguishing a bank’s
insolvency from its illiquidity creates moral hazard for bank managers. It is important
for a lender of last resort to operate in a manner that minimizes the tendency for
bankers to take too much risk in their operations. Finally, as we learned in the crisis of
2007–2009, the U.S. lender-of-last-resort mechanism has not kept pace with the
evolution of the financial system. Like many government practices in the financial
arena, the conventional rules for Fed discount lending were (and remain) based on the
legal form of the borrower rather than on its economic function. Some intermediaries
facing sudden flight by their very short-term creditors were not banks—to whom the
Fed usually lends—but shadow banks, which do not normally have access to Fed
loans. Only by using its emergency lending authority—something last done in the
Great Depression of the 1930s—was the Fed able to lend to such nonbank
intermediaries to stem the crisis.
During the turmoil, the Fed utilized this emergency authority repeatedly when
it needed to lend to securities brokers, MMMFs, insurers, other nonbank
intermediaries, and even to nonfinancial firms. Based on this emergency authority, it
developed a variety of new policy tools—including the Primary Dealer Credit Facility
through which the authorities lent directly to nonbank securities dealers—to deliver
liquidity where and when it was needed. While this ad hoc, reactive approach helped
both stem runs and counter their impact, it had limited value in preventing them in the
first place. Lending to nonbank intermediaries also added massively to the moral
hazard usually associated with the lender of last resort. These intermediaries generally
are not subject to regulation or supervision by the Federal Reserve, and the level of
oversight they received from other agencies was typically less intense and intrusive
than that applied to banks. Accordingly, in the absence of new oversight, the access to
central bank loans granted by the Fed in the crisis will encourage these borrowers to
take greater risks in the future.
Congress’s response to the Federal Reserve’s failure to stem the bank panics of
the 1930s was to create nationwide deposit insurance. The Federal Deposit Insurance
Corporation guarantees that a depositor will receive the full account balance up to
some maximum amount even if a bank fails. Bank failures, in effect, become the
problem of the insurer; bank customers need not concern themselves with their bank’s
risk taking. So long as a bank has deposit insurance, customers’ deposits are safe,
even in the event of a run or bank failure. Here’s how the system works. When a bank
fails, the FDIC resolves the insolvency either by closing the institution or by finding a
buyer. The first approach, closing the bank, is called the payoff method. The FDIC
pays off all the bank’s depositors and then sells all the bank’s assets in an attempt to
recover the amount paid out. Under the payoff method, depositors whose balances
exceed the insurance limit, currently $250,000, suffer some losses.
The second approach, called the purchase-and-assumption method, is more
commonly applied than the payoff method. In a “P&A” transaction, the FDIC finds a
firm that is willing to take over the failed bank. Because the failed institution is
insolvent— on the balance sheet, its liabilities exceed its assets—no purchaser will do
so for free. In fact, the FDIC has to pay banks to purchase failed institutions. That is,
the FDIC sells the failed bank at a negative price. Depositors prefer the P&A method
to the payoff method because the transition is typically seamless, with the bank
closing as usual at the end of the week and reopening on Monday morning under new
ownership. In a purchase and assumption, no depositors, even those whose account
balances exceed the deposit insurance limit, suffer a loss. No private or small public-
sector insurance fund would be able to withstand a run on all the banks it insures—but
the FDIC can. Because the U.S. Treasury backs the FDIC, it can withstand any crisis
that does not undermine the nation’s sovereign credit standing.
Since its inception, deposit insurance clearly helped prevent runs on
commercial banks. Even so, it did not prevent the crisis of 2007–2009 and the runs
associated with it. The prime reason is that deposit insurance covers only depository
institutions. But as the financial system developed, shadow banks—money market
funds, securities brokers, and the like—gained importance. Those entities are
sufficiently like banks that they, too, face the risk of runs by their short-term creditors.
However, these nonbanks lack the benefits of deposit insurance, and, until the latter
part of the crisis, they had no access to a lender of last resort. Although some
traditional banks suffered runs during the crisis—mostly by large depositors with
balances in excess of the insurance limit—most of the runs were against shadow
banks that bid for funds in the competitive (“wholesale”) money markets.
We know that insurance changes people’s behavior. Protected depositors have
no incentive to monitor their bankers. Knowing this, bankers take on more risk than
they would normally, because they get the benefits while the government assumes the
costs. In protecting depositors, then, the government creates moral hazard. This is not
just a theory. We can find evidence for this assertion by comparing bank balance
sheets before and after the implementation of deposit insurance. In the 1920s, before
the deposit insurance system was created, banks’ ratio of assets to capital was about 4
to 1. Most economic and financial historians believe that government insurance led
directly to the rise in risk.
And that is not the only problem. Government officials are especially worried
about the largest institutions because they can pose a threat to the entire financial
system. Although the failure of a community bank is unfortunate, the prospect of a
large financial conglomerate going under is a regulator’s worst nightmare. The
financial havoc that could be caused by the collapse of an institution holding more
than a trillion dollars in assets is too much for most people even to contemplate. What
this means is that some intermediaries are treated as too big to fail or too
interconnected to fail. Putting such an institution through the usual mechanism for
resolving a business failure—bankruptcy court—may force the bankruptcy of many
households, firms, and other intermediaries that have contracted with the failed
institution. Thus, too big to fail really means too big or too complex to shut down or
sell in an orderly fashion without large and painful spillovers. Regulators call such an
institution too big to resolve, and the Dodd-Frank law gave rise to a special legal
designation for such a firm: systemically important financial institution (SIFI).
Experience has led the managers of these too-big-to-fail intermediaries to
expect thatMif their institutions begin to founder, the government will find a way to
bail them out. Regulators allowed Lehman Brothers to fail in September 2008, but the
painful financial and economic disruptions that ensued served only to reinforce the
widespread expectation that government will bail out the largest and most
interconnected financial institutions. A bailout of a failed bank can take many forms.
In most cases, the deposit insurer quickly finds a buyer; otherwise, the government, as
lender of last resort, usually makes a loan to buy time to fashion a solution.
Depositors whose balances do not exceed the insurance limit will be made whole. But
in the crisis of 2007–2009, most of the creditors to banks were protected, not just the
insured depositors. Following the Lehman failure, governments in Europe and the
United States guaranteed all of the liabilities of their largest banks. In particular, they
promised that the holders of new bonds issued by the banks would not incur losses.
Without these guarantees, the evaporation of funding liquidity probably would have
led to a rapid cascade of failures because banks would be unable to fund themselves.
In a number of cases, unlike in a normal bankruptcy, the managers of failing banks
also kept their jobs.
During the crisis, governments also recapitalized some intermediaries—that is,
gave them public money in return for partial ownership rights—to prevent a run by
their creditors. In effect, governments declared recapitalized intermediaries to be too
big to fail while they allowed many smaller institutions to go under. In the United
States, for example, the FDIC shut down 297 banks in 2009 and 2010, the largest
number in a two-year period since 1991–1992. In these ways, the government, not the
market, chose the winners and the losers. Because it undermines the market discipline
that depositors and creditors impose on banks and shadow banks, this too-big-to-fail
policy is ripe for reform. Given the $250,000 insurance limit, a corporation with
millions of dollars to deposit would normally be concerned about the quality and
riskiness of the assets a bank holds. If the bank or MMMF were to fail, the
corporation would face significant losses. Thus, the threat of withdrawal of these large
balances restrains the bank or MMMF from taking on too much risk.7 But for very
large banks, the too-big-to-fail policy renders the deposit insurance ceiling
meaningless. In the aftermath of the crisis of 2007–2009, everyone knew which banks
were too big to fail and that the authorities would support them. With little threat that
depositors will flee, bank managers are inclined to take greater risk than they
otherwise would. The too-big-to-fail policy compounds the problem of moral hazard,
encouraging managers of large banks to engage in extremely risky behavior (and
putting small banks at a competitive disadvantage).
During the financial crisis, many shadow banks also received government
bailouts and guarantees that foster moral hazard. Like their bank brethren, some of the
largest shadow banks obtained government support because their failure was
perceived as too costly in a crisis. And the problem is not limited to the too-big-to-fail
class. The U.S. government guaranteed the liabilities of all MMMFs—most of which
are small—in order to halt a run. Whenever the government provides such a safety net
without charging an appropriate fee for it in advance of the protection, the
government creates an incentive for financial institutions to take risks that can
threaten the system as a whole. Why do government authorities provide this free
safety net in a crisis? After all, they know that some quick-fix policies create bad
incentives and impose large burdens on taxpayers. In the midst of a crisis, however,
they must balance the often-conflicting goals of crisis mitigation and crisis
prevention. Frequently, there are no good choices. Like an emergency room doctor
trying to save a dying patient, a government official will occasionally act to rescue the
financial system from urgent threats that, if left to play out on their own, would lead
to an economic catastrophe. Of course, the taxpayer foots the bill.
Naturally, in the aftermath of a crisis, limiting the unintended consequences of
the government safety net is the leading problem facing regulators. Some argue that
toobig-to-fail institutions are simply too big to exist and that they need to be broken
up, removing certain business activities from them in ways that limit incentives for
risk taking. However, that approach does not eliminate the bad incentives arising from
deposit insurance and from the government guarantees provided to smaller institutions
during the crisis. Dodd-Frank law addresses these challenges, and we will assess its
shortcomings. We’ll also discuss how, through a variety of fees and charges,
governments could discourage certain kinds of risk taking, thereby limiting systemic
threats. The conflict between crisis prevention and crisis mitigation exemplifies the
problem of time consistency (see pageM27). In good times, governments and central
banks typically promise not to bail out financial behemoths and other intermediaries,
hoping to limit their risk taking and thus prevent a crisis. But these intermediaries
know that, in bad times, policymakers will have an overwhelming incentive to bail
them out to limit a crisis. If these policymakers also have the tools to implement a
bailout, their good-times promises will lack credibility. When it is not feasible to
make a credible commitment, policy cannot be time consistent.
One approach to this problem is to remove the policy tools entirely—to
substitute legal rules for discretionary bailouts. Following the crisis of 2007–2009,
bankruptcy lawyers proposed to modify the bankruptcy code to make it safely
applicable to the resolutionMof large financial intermediaries.8 In 2017, the House
passed the Financial Institution Bankruptcy Act that incorporated these ideas.
However, the Senate did not, so it remains to be seen whether such reform will
become law. Another approach—which characterizes the postcrisis regulatory reform
in the United States—is to make bailouts more difficult, but not impossible, for
policymakers to implement. The more difficult a bailout, the less likely a crisis, but
the more dangerous an actual crisis will be. There is no costless way to overcome the
time-consistency challenge.MAs you think about the Dodd-Frank legislation, consider
the extent to which it reduces this time-consistency problem, and the cost at which it
does so.
c. Regulation and Supervision of the Financial System
Government officials employ three strategies to ensure that the risks created
by theMsafety net are contained. Government regulation establishes a set of specific
rules for intermediaries to follow. Government supervision provides general oversight
of financial institutions. And formal examination of an institution’s books by
specialists provides detailed information on the firm’s operation. As we look at each
of these, keep in mind that the goal of government regulation is not to remove all the
risk that investors face. Financial intermediaries themselves facilitate the transfer and
allocation of risk, improving economic efficiency in the process. Regulating risk out
of existence would eliminate one of the purposes of financial institutions. Consider
also that efforts to tighten regulations on banks may push risk taking somewhere
outside the view of the authorities. The result may not be a safer financial system.
Wary of asking taxpayers to pick up the bill for bank insolvencies, officials
created regulatory requirements that are designed to minimize the cost of such failures
to the public. The first screen, put in place to make sure the people who own and run
banks are not criminals, is for a new bank to obtain a charter. Once a bank has been
chartered and has opened for business, a complex web of detailed regulations restricts
competition, specifies what assets the bank can and cannot hold, requires the bank to
hold a minimum level of capital, and makes public information about the bank’s
balance sheet. As we all know, rules are one thing; enforcement is another. Posting a
speed limit on an interstate highway is just the first step in preventing people from
driving too fast. Unless the police patrol the highways and penalize speeding drivers,
such laws are worthless. The same is true of banking regulations. The best-designed
regulatory structure in the world won’t be worth the paper it’s written on unless
someone monitors banks’ compliance. Government supervisors are the highway patrol
of the banking world. They monitor, inspect, and examine banks and other
intermediaries to make sure their business practices conform to regulatory
requirements.
Banks are regulated and supervised by a combination of the U.S. Treasury, the
Federal Reserve, the FDIC, and state banking authorities. The overlapping nature of
this regulatory structure means that more than one agency works to safeguard the
soundness of each bank. A bank can effectively choose its regulators by choosing
whether to be a state or national bank and whether or not to belong to the Federal
Reserve System. Banks can also change their legal form––say, to become a securities
broker-dealer—leading to yet a different regulator (the Securities and Exchange
Commission) and regulatory framework. If one regulator allows an activity that
another prohibits, a bank’s managers can threaten to switch, or argue that a competitor
who answers to a more permissive regulator has an unfair advantage. The
consequences of such regulatory competition are twofold. First, regulators force each
other to innovate, improving the quality of the regulations they write. But regulatory
competition has a less desirable outcome: It allows bank managers to shop for the
most lenient regulator—the one whose rules and enforcement are the least stringent.
Especially since the repeal of the ban on interstate branching, regulatory agencies
have tried to prevent this outcome. Today state authorities usually defer to the Federal
Reserve, whose supervisors impose uniform regulations on all state-chartered banks.
The Comptroller of the Currency cooperates with the Fed to ensure that national
banks receive similar treatment.
However, the financial crisis of 2007–2009 highlighted cases of “regulator
shopping” that resulted in ineffective oversight. One example was the supervision of
AIG—then the largest U.S. insurer—by the small U.S. Office of Thrift Supervision
(OTS) that also had supervised failed savings banks like Countrywide, IndyMac, and
Washington Mutual. OTS naturally had less experience than other supervisors with
the insurance business—especially with the complex derivatives that AIG sold and
with its business of lending securities. In effect, AIG had chosen its supervisor by
purchasing a small savings bank years earlier. In 2010, the Dodd-Frank Act closed the
OTS—the only regulatory agency that was shut down following the crisis—and
merged it with the Office of the Comptroller of the Currency. The arbitrary and
complex structure of U.S. financial regulators does not stop with the banks. Some
shadow banks—such as securities brokers—are subject to regulation by both the
Securities and Exchange Commission (SEC) and the Commodity Futures Trading
Commission (CFTC). The SEC also regulates MMMFs. Even after the DoddFrank
Act, hedge funds remain lightly regulated: Aside from registering with the SEC, and
fulfilling reporting requirements, they need only act with care (i.e., as a fiduciary).
One long-standing goal of financial regulators has been to prevent banks from
growing too big and powerful, both because their failure might threaten the financial
system and because banks that have no real competition exploit their customers. And
until 1999, banks could not own securities firms or insurance companies. While recent
legislation has changed the banking industry, restrictions on bank size remain. Bank
mergers still require government approval. Before granting it, officials must be
convinced on two points. First, the new bank must not constitute a monopoly in any
geographic region. Second, if a small community bank is to be taken over by a large
regional bank, the small bank’s customers must be well served by the merger. But
government officials also worry that the greater the competition among banks, the
more difficulty banks will have making a profit. Competition reduces the prices
customers must pay and forces companies to innovate in order to survive. These
effects are as true of the market for deposits and loans as they are of the markets for
cars and computers. Competition raises the interest rate bankers pay on deposits and
lowers the interest rate they receive on loans; it spurs them to improve the quality of
the services they provide. Normally we think of these effects of competition as being
positive, but there is a negative side as well. Lower interest margins and reduced fee
income cause bankers to look for other ways to turn a profit. Some may be tempted to
assume more risk—that is, to make loans and purchase securities that are riskier than
advisable, to increase leverage, or to rely excessively on short-term funding.
There are two ways to avoid this type of moral hazard. First, government
officials can explicitly restrict competition. That is the solution regulators have chosen
in a number of countries; it was also one of the purposes of branching restrictions.9
(Branching restrictions create networks of small, geographically separated
independent banks that face very little competition in their regions.) A second way to
combat bankers’ tendency to take on too much risk is to prohibit them from making
certain types of loans and from purchasing particular securities. The financial crisis of
2007–2009 accelerated the ongoing concentration in the U.S. financial system. When
banks and shadow banks weakened or failed during the crisis, regulators encouraged
other institutions to buy them. JPMorgan Chase, already the second-largest U.S. bank,
acquired both Bear Stearns, the fifth-largest broker, and Washington Mutual, the
largest savings bank. Bank of America, the number one bank in the country,
purchased both Merrill Lynch, the largest broker, and Countrywide, the biggest
housing lender. And Wells Fargo, the fifth-largest commercial bank, took over
Wachovia, the fourth-largest. As of 2018, 36 percent of deposits at U.S. commercial
banks were held in only four banks—Bank of America, Citi, JPMorgan Chase, and
Wells Fargo.
One way to prevent bankers from exploiting their safety net is to restrict
banks’ balance sheets. Such regulations take two forms: restrictions on the types of
asset banks can hold and requirements that they maintain minimum levels of capital.
While banks are allowed to build big office buildings and buy corporate jets for top
executives, their financial assets are heavily restricted. U.S. banks cannot hold
common stock.10 Regulations also restrict both the grade and quantity of bonds a
bank can hold. For example, banks are generally prohibited from purchasing bonds
that are below investment grade, and their holdings from any single private issuer
cannot exceed 25 percent of their capital. The size of the loans they can make to
particular borrowers is also limited. For example, the Federal Reserve requires that
one bank’s exposure to another not exceed 25 percent of the bank’s capital. While
these restrictions on asset holdings are quite detailed, they are really just a matter of
common sense and sound risk management. In effect, regulators are telling bankers to
do what they should be doing already: holding a well-diversified portfolio of liquid,
high-grade bonds and loans.
Minimum capital requirements complement these limitations on bank assets.
Recall that bank capital represents the net worth of the bank to its owners. Capital
serves as both a cushion against declines in the value of the bank’s assets, lowering
the likelihood of the bank’s failure, and a way to reduce the problem of moral hazard.
Capital requirements take two basic forms. The first requires most banks to keep their
ratio of capital to assets above some minimum level, regardless of the structure of
their balance sheets. This approach is equivalent to capping leverage, which is a key
means of taking risk. The second requires banks to finance their activities with capital
in proportion to the riskiness of their operations. The computation is extremely
complicated and the rules change frequently, but basically a bank must first compute
the risk-adjusted level of its assets given the likelihood of a loan or bond default. Then
a capital charge is assessed against that level. Of course, banks face a multitude of
other risks, including trading risk, operational risk, and the risk associated with their
off-balance sheet operations. Regulators require banks to finance their activities with
capital based on assessments of those risks as well. (See Tools of the Trade for a
description of recent changes in capital requirements.)
