The financial crisis that consumed our nation a decade ago caused a great recession that led to unemployment for millions and lost savings in the trillions. Between 2007 and 2010, the unemployment rate rose from 4¾ percent to 9½ percent, the net worth of America’s median household declined $50,000, and GDP fell 5 percent, or $600 billion. That experience serves as a continuing reminder of the importance of getting financial regulation right.
While the popping of the housing bubble was the match that lit the conflagration, the tinder was a financial system with insufficient capital to weather losses, and dependent for funding on short-term, non-deposit borrowing that could not survive an evaporation of liquidity in money markets. Going into the crisis, only 3½ percent of bank assets were highly liquid. Perhaps more importantly, a large share of intermediation between depositors and lenders had moved to the non-bank sector, supported by little to no capital or liquidity resources at all.
Banks were rightly chastened from the financial crisis and have taken significant steps to ensure that they are both resilient and resolvable. Under post-crisis regulation, the average ratio of common equity to risk-weighted assets has risen from 6 percent to 12 percent, corresponding to a $1.03 trillion increase in the strongest form of capital – common equity tier 1 capital. (For perspective, note that total net expected losses in the most recent round of Federal Reserve stress tests for the largest banks – applying a scenario far worse than the financial crisis and great recession — totaled approximately $140 billion.) Those larger banks also now carry so-called bail-in debt that shields taxpayers from loss, to the tune of an additional $1 trillion in loss absorbency. Meanwhile, the percentage of bank assets that are highly liquid – and thus can be sold in the event of crisis — has risen from 3½ percent to 18 percent, and banks have significantly cut their reliance on short-term wholesale funding.
Not surprisingly, then, official assessments of financial stability now consistently find that banks in the United States are a bulwark against, not a source of, financial stability risks. In its July report to Congress, the Federal Reserve noted that large banks “would be able to lend to households and businesses even during a severe global recession.”
One major concern, though, is how much bank resilience will matter in the next crisis – and there will always be a next crisis. It seems quite likely that large banks will serve as a modern-day Maginot Line, a heavily fortified structure that does not prove useful when the action occurs elsewhere. For example, based on last year’s data on mortgage originations, approximately 55 percent of mortgage lending is conducted by non-banks. Regulation has imposed significant constraints on the ability of banks to make small business and some consumer loans, and that business is increasingly conducted by lenders who are short-term, non-deposit funded. (As a result, while economic growth in general has been strong, small businesses have lagged; similarly, capital and supervisory constraints have deterred banks from serving lower-income Americans, a significant proportion of whom continue to turn to payday lenders and check cashers.)
Thus, part of any reform of post-crisis regulations need to emphasize the resilience and resolvability of banks but also their relevance. A strong deposit base makes them durable, and able to lend in a crisis, while regulations focused disproportionately on banks pose a substantial risk of putting loans and other important assets into the hands of firms that will not be able to continue operating in an economic downturn or a crisis. Further increases in bank capital and liquidity requirements have low marginal benefits and push more activity to the shadows.
A new set of regulators has the opportunity to consider those difficult tradeoffs, and now a good occasion for doing so. Our members are committed to the core objectives of safety and soundness and economic growth and opportunity. We encourage policymakers to take a thoughtful and evidence-based approach to identifying ways that regulations can be better tailored and made less complex. Such improvements offer opportunities to promote innovation and growth for everyone and create a financial system – not just a banking system – able to weather a future crisis.
Mr. Baer is President and Chief Executive Officer of the Bank Policy Institute.
Disclaimer: The views expressed in this post are those of the author(s) and do not necessarily reflect the position of the Bank Policy Institute or its membership, and are not intended to be, and should not be construed as, legal advice of any kind.