SOURCE: Center for American Progress
CAPAF’s Michael S. Barr testifies before the House Subcommittee on Financial Institutions and Consumer Credit
Over two years ago, the United States and the global economy faced the worst economic crisis since the Great Depression. The crisis was rooted in years of unconstrained excess on Wall Street, and prolonged complacency in Washington and in major financial capitals around the world. The crisis made painfully clear what we should have always known–that finance cannot be left to regulate itself; that consumer markets permitted to profit on the basis of tricks and traps rather than to compete on the basis of price and quality will, ultimately, put us all at risk; that financial markets function best where there are clear rules, transparency and accountability; and that markets break down, sometimes catastrophically, where there are not.
For many years, a core strength of the U.S. financial system had been a regulatory structure that sought a careful balance between incentives for innovation and competition, on the one hand, and protections from abuse and excessive risk-taking, on the other. When that balance was properly struck, the U.S. financial system worked at its best. The American financial system often surpassed other major developed economies in innovation and productivity growth. It was generally good at directing investment towards the companies and industries where the returns would be the highest. Its regulatory checks and balances helped create a remarkably long period of relative economic stability which, in turn, gave rise to extraordinary national wealth. And it did so while providing investors and consumers with strong protections. It endured crises and recessions, including the costly bank and thrift failures of the late 1980s and early 1990s; these, however, did not threaten the foundations of the financial system.
Over time those great strengths were undermined. The careful mix of protections we created eventually eroded with the development of new products and markets for which those protections had not been designed. And our regulatory system found itself outgrown and outmaneuvered by the institutions and markets it was responsible for regulating and constraining.
In particular, the growth of the “shadow banking” system permitted financial institutions to engage in maturity transformation with too little transparency, capital, or oversight. The years leading up to the recent crisis saw the significant growth of large, short-funded, and substantially interconnected financial firms. Huge amounts of risk moved outside the more regulated parts of the banking system to where it was easier to increase leverage. Legal loopholes and regulatory gaps allowed large parts of the financial industry to operate without oversight, transparency, or restraint. Entities performing the same market functions as banks escaped meaningful regulation on the basis of their corporate form, and banks could move activities off balance sheet and outside the reach of more stringent regulation. Derivatives were traded in the shadows with insufficient capital to back the trades. “Repo” markets became riskier as collateral shifted from Treasuries to poorer quality asset-backed securities. The lack of transparency in securitization hid the growing wedge in incentives facing different players in the system and failed to require sufficient responsibility or risk retention from those who made loans, or packaged them into complex instruments to be sold to investors. Synthetic products multiplied risks in the securitization system. The financial sector, under the guise of innovation, piled ill-considered risk upon risk.
As the shadow banking system grew, our system failed to require real transparency, sufficient capital or meaningful oversight. Rapid growth in key markets hid misaligned incentives and underlying risk. Financial innovation often outpaced the capacity of managers, regulators and markets to understand new risks and adjust. Throughout our system we had increasingly inadequate capital buffers – as both market participants and regulators failed to account for new risks appropriately. Short-term rewards in new financial products and rapidly growing markets overwhelmed or blinded private sector gatekeepers, and swamped those parts of the system that were supposed to mitigate risk. Consumer and investor protections were weakened and households took on risks that they often did not fully understand and could ill-afford.
Rising home and other asset prices had helped to feed the financial system’s rapid growth, and to hide declining underwriting standards and other underlying problems in the origination and securitization of mortgage loans. When home prices began to flatten, and then to decline, fault lines were revealed. The asset implosion in housing led to cascades throughout the financial system, and then to contagion from weaker firms to stronger ones. Failures in the shadow banking system fed failures in the more regulated parts of the banking system. And then, in the fall of 2008, credit markets froze. The over-reliance on short-term financing, opaque markets and excessive-risk taking that had been the source of significant profit on Wall Street and in financial capitals globally, fanned a panic that nearly collapsed the global financial system.
The major U.S. investment banks merged, failed, or sought a life-line from the Federal Reserve as newly converted bank holding companies. The federal government injected capital into major commercial banks shaken in the aftermath of the collapse of Lehman Brothers. The FDIC put in place guarantees across the entire banking system. The Federal Reserve pumped liquidity into the financial system to halt further economic collapse. A dangerous run on money market mutual funds was halted by guarantee and liquidity programs set up by Treasury and the Federal Reserve. Congress enacted a major stimulus plan to keep the economy from cratering.
Yet stabilizing the financial sector did not address the failures that led to the crisis. Further action was necessary to restore discipline to our financial markets, adequate protections to consumers and investors, and the market’s long-term ability to generate economic growth for future generations of Americans. The test of whether a financial system works is whether it does a reasonable job of channeling savings to finance future innovation and growth. The test is whether it protects consumers and investors. And the test is also whether it can do so while supporting, not harming, the economy. In the lead up to 2008, our system failed that test.