Financial Regulatory Reform: A Progress Report
Hubbard, Glenn, Federal Reserve Bank of St. Louis Review
The 2007-09 financial and economic crisis was the result of a lack of effective regulation. The author addresses the problems with regulations in effect at the time of the crisis and offers proposals for regulation reform to address future crises. He notes that reforms should be based on solid principles, including reduction of system risk and contagion and increased transparency to promote investor protection. Any new financial regulatory structure must be able to achieve these goals, while acknowledging and managing trade-offs between enhancing accountability and mitigating systemic risk from contagion. (JEL G01, G18, G28)
The conventional assessment of the 2007-09 financial and economic crisis places blame on a dearth of regulation. That assessment is simplistic at best and entirely inaccurate at worst. The truth is that the financial crisis is the result of a lack of effective regulation.
Several themes emerge from the crisis. First, we need more effective regulation. Although we need new regulation in some previously unregulated areas, the crisis has shown that the most precarious sectors of our financial system are those already subject to a great deal of regulation--regulation that has proved woefully ineffective. Any call for further reform means that new or revised regulations should be based on solid principles, chief among them the reduction of systemic risk and contagion. Second, we must increase transparency in the financial system to promote investor protection. More information enables the market to price assets, risk, and other relevant inputs more accurately. Much of the recent crisis can be attributed to a lack of critical information (and perhaps, in some cases, misinformation). Third, we must build a financial regulatory structure able to achieve these goals. Finally, we need to acknowledge and manage trade-offs between enhancing accountability for individual institutions and mitigating systemic risk from contagion.
THE CRISIS AND THE REGULATORY RESPONSE
Severity of the Crisis
The 2007-09 financial crisis was the most serious such event since the Great Depression. The crisis manifested itself in credit losses, write-downs, liquidity shocks, deflated property values, and a contraction of the real economy. The sharp contraction in U.S. gross domestic product in 2009 can be traced to the adverse effects of the crisis on household consumption and business investments. Costs directly attributable to the crisis include outlays by the federal government, including the Troubled Assets Relief Program (TARP) and the stimulus package passed in February 2009.
In the housing sector, banks took advantage of low interest rates and securitization opportunities to institute relaxed lending standards that drove the boom in mortgage lending from 2001 to 2006. Although the number of households in the United States increased only marginally between 1990 and 2008, the aggregate mortgage debt outstanding more than quadrupled during that same period. Increased borrowing by U.S. households was partially offset by climbing asset prices. However, the period of rising property values came to a close after the second quarter of 2006, with home prices eventually falling by a third by the end of 2008. The burst of the housing bubble virtually eliminated construction and sales activity for a while. The percentage of delinquent mortgages is at an all-time high, and more than 20 percent of all mortgages are in a negative equity position.
The financial crisis of 2007-09 and its continuing aftermath have complex origins, but those origins share a four-letter word: risk. The mispricing of risk--with inflationary consequences for asset prices in the boom, a downward spiral of collapsing asset prices and economic activity in the bust, and contagion in the unwinding--must be central to economic analysis of and policy responses to the crisis. Underlying factors include (i) global saving and investment imbalances that contributed to low real interest rates and risk premia in international capital markets for many years, (ii) excessively expansionary U. …