In the first chapter of “Across the Great Divide: New Perspectives on the Financial Crisis,” Sheila Bair and Ricardo Delfin argue that regulatory responses to past crises sow the seeds of the next ones:
- The “Greenspan put” fostered risk-taking and overconfidence.
- Low interest rates and the search for yield led to a lowering of lending standards and stronger demand for mortgages; a rise in housing wealth accompanied falling household incomes. The Fed’s strong policy response to the Great Recession may create new risks.
- The 1980s savings and loans crisis led to stronger reliance on the originate to distribute model and securitisation of mortgages. Market participants lost sight of the risks. Regulatory incentives led banks to take the securitised loans back on their balance sheets and additional sources of maturity mismatch arose from strong reliance on short-term funding.
- The “self-correcting markets myth” led Congress to deregulate financial services. The Gramm-Leach-Bliley Act fostered competition and consolidation; the Commodity Futures Modernization Act loosened oversight over the OTC derivatives market. Financial regulators also relaxed restrictions; Basel II replaced standardised regulator-set capital charges with internal models of banks.The Dodd-Frank Act reversed this trend, allowing for more discretion and micro-management.
- The pre-crisis incentives led to large, “too-big-to-fail” institutions and bred moral hazard. Dodd-Frank improve things, by establishing consolidated oversight, living will requirements, enhanced prudential standards and enabling the FDIC to resolve systemic entities that cannot be resolved safely in bankruptcy. Clearing houses may require more regulation.