How to Make Banks Too Safe to Fail

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There is widespread consensus that the Great Recession did not have to be as Great: Had regulators acted earlier and more aggressively to stem the financial panic, its consequences would have been less severe. Instead, the average American household lost nearly a third of its net worth; two-and-a-half million businesses closed their doors; and nine million families lost their homes. Why was more not done? And are we better prepared to weather the next storm?

Two explanations are typically offered for the lack of aggressive response at the onset of the Great Recession. The first is that financial crises occur unexpectedly, offering little time for intervention by even nimble and alert regulators. The second is that even those who realized that a downturn was on the horizon were constrained by their lack of legal authority to fortify large financial institutions.

This Article disputes both these myths. First, there was significant time between the onset of the crisis and its peak: Between the summer of 2007 and the collapse of Lehman Brothers in September 2008, warning signs appeared in financial markets and many commentators sounded the alarms. Second, regulators had at their disposal significant legal authority to bolster banks and prevent failures. In fact, they used this authority with respect to small banks, but not large systemically important firms.

There is an alternative explanation for the tepid early response to the crisis. Regulators’ default is inaction until regulatory measures of bank health signal distress. These measures are slow to update—in many cases, the day before banks failed, their regulatory capital measures suggested no cause for concern. In the absence of significant change, regulators will inevitably be fire-fighting future financial crises ex-post; rather than successfully policing financial markets ex-ante.

This Article recommends a way forward. It advocates for automatic recapitalization of financial firms when markets indicate that distress is likely. Such an approach would have forced large banks to stop paying dividends and to raise new capital between the summer of 2007 and the fall of 2008, helping to forestall the worst of the Recession. The stress-testing regime, with minor modifications, is a potential tool to dynamically monitor the financial sector and respond to crises at their onset.

Unfortunately, those who lead the Federal Reserve today are not learning from the mistakes of the Great Recession; they are forgetting them. Recent dilution of the stress tests and moves toward more static capital requirements go in the exact opposite direction of this Article’s recommendations. These changes are catastrophic. Unless policymakers are quick to course correct, the next financial crisis is becoming increasingly inevitable. Successful firefighting and good fortune prevented the Great Recession from being a Great Depression. It is unclear whether we will be so lucky next time.


Law and economics, banking & financial regulation, large institutions, Great Recession, 2007-2008 financial crisis, risk, exposure, capital reserve requirements, Federal Reserve, stress testing, leverage ratios, dynamic recapitalization, Supervisory Capital Adequacy Program, SCAP

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