A Macroprudential Perspective on the Regulatory Boundaries of US Financial Assets

This paper uses data from the Financial Accounts of the United States to map out the regulatory boundaries of assets held by US financial institutions from a macroprudential perspective. We provide a quantitative measure of the macroprudential regulatory boundary—the perimeter between the part of the financial sector that is subject to some form of macroprudential regulatory oversight and that which is not—and show how it has evolved over the past 40 years. Additionally, we measure the boundaries between different regulatory agencies and financial institutions that operate within the regulatory perimeter and illustrate how these boundaries potentially become blurred in the face of regulatory overlap. Quantifying the macroprudential regulatory boundary and the boundaries for different regulators within the perimeter is informative for assessing financial stability risks over the credit cycle

Too Big to Fool: Moral Hazard, Bailouts, and Corporate Responsibility

Domestic and international regulatory efforts to prevent another financial crisis have been converging on the idea of trying to end the problem of “too big to fail”—that systemically important financial firms take excessive risks because they profit from success and are (or at least, expect to be) bailed out by government money to avoid failure. The legal solutions being advanced to control this morally hazardous behavior tend, however, to be inefficient, ineffective, or even dangerous—such as breaking up firms and limiting their size, which can reduce economies of scale and scope; or restricting central bank authority to bail out failing firms, which (ironically) exacerbates the risk that an uncontrolled banking failure will trigger another crisis. This article contends that the too-big-to-fail problem is exaggerated. It shows that the evidence for this problem is weak, conflating correlation and causation. It also shows that managerial incentives should mitigate the problem because managers who cause their firms to engage in excessive risk-taking, in the expectation of a government bailout, are taking serious personal risks. That begs the question why systemically important firms sometimes do take excessive risks. The article argues that such risk-taking is more likely to be caused by other factors, including a legally embedded conflict between corporate governance and the public interest that allows managers of those firms to ignore the costs of systemic externalities. To address this, the law should—and the article shows that it realistically could—control excessive risk-taking more directly by requiring managers to account for systemic externalities in their governance decisions. It also argues for the creation of a privatized fund to minimize the public cost of bailing out systemically important firms that might fail (because of exogenous shocks, for example) notwithstanding reduced risk-taking

The Macroprudential Turn: From Institutional \u27Safety and Soundness\u27 to Systematic \u27Financial Stability\u27 in Financial Supervision

Since the global financial dramas of 2008-09, authorities on financial regulation have come increasingly to counsel the inclusion of macroprudential policy instruments in the standard ‘toolkit’ of finance-regulatory measures employed by financial supervisors. The hallmark of this perspective is its focus not simply on the safety and soundness of individual financial institutions, as is characteristic of the traditional ‘microprudential’ perspective, but also on certain structural features of financial systems that can imperil such systems as wholes. Systemic ‘financial stability’ thus comes to supplement, though not to supplant, institutional ‘safety and soundness’ as a regulatory desideratum. The move from primarily micro- to combined micro- and macroprudential finance-regulatory regimes is surely to be welcomed, for reasons that this author and others have elaborated in many earlier articles. The old ‘lean versus clean’ debate is resolved once again now in favor of leaning – this time not only in the realm of monetary policy, but in that of its cousin finance-regulatory policy as well. The victory does, however, raise certain new legal challenges to which predominantly microprudential finance-regulatory regimes are not typically subject – challenges of which legal scholars, regulators, policymakers and other financially-oriented lawyers will wish to remain mindful. This Article aims to assist that endeavor by exhaustively anticipating, cataloguing, and provisionally addressing all of the mentioned challenges, in order that interested parties might thereby be able to find comprehensive treatment of the subject in one place. The hope is that this will ultimately make for both better theory and better practice where finance and its regulation are concerned

The \u27Too Big To Fail\u27 Problem

“Too big to fail” – or “TBTF” – is a popular metaphor for a core dysfunction of today’s financial system: the recurrent pattern of government bailouts of large, systemically important financial institutions. The financial crisis of 2008 made TBTF a household term, a powerful rhetorical device for expressing the widely shared discontent with the pernicious pattern of “privatizing gains and socializing losses” it came to represent in the public’s eye. Ten years after the crisis, TBTF continues to frame much of the public policy debate on financial regulation. Yet, the analytical content of this term remains remarkably unclear. Taking a fresh look at the nature of the TBTF problem in finance, this article offers a coherent framework for understanding the cluster of closely related, but conceptually distinct, regulatory and policy challenges this label actually denotes. It identifies the fundamental paradox at the heart of the TBTF metaphor: TBTF is an entity-centric, micro-level metaphor for a complex of interrelated systemic, macro-level problems. While largely unacknowledged, this inherent tension between the micro and the macro, the entity and the system, critically shapes the design and implementation of the key post-2008 regulatory reforms in the financial sector. To trace these dynamics, the article deconstructs the TBTF metaphor into its two basic components: (1) the “F” factor focused on the “failure” of individual financial firms; and (2) the “B” factor focused on their “bigness” (i.e., relative size and structural significance). Analyzing post-crisis legislative and regulatory efforts to solve the TBTF problem through this simplifying lens reveals critical gaps in that process, which consistently favors the inherently micro-level “F” factor solutions over the more explicitly macro-level “B” factor ones. It also suggests potential ways of rebalancing and expanding the TBTF policy toolkit to encompass a wider range of measures targeting the relevant systemic dynamics in a more direct and assertive manner

The \u27Too Big To Fail\u27 Problem

“Too big to fail” – or “TBTF” – is a popular metaphor for a core dysfunction of today’s financial system: the recurrent pattern of government bailouts of large, systemically important financial institutions. The financial crisis of 2008 made TBTF a household term, a powerful rhetorical device for expressing the widely shared discontent with the pernicious pattern of “privatizing gains and socializing losses” it came to represent in the public’s eye. Ten years after the crisis, TBTF continues to frame much of the public policy debate on financial regulation. Yet, the analytical content of this term remains remarkably unclear. Taking a fresh look at the nature of the TBTF problem in finance, this article offers a coherent framework for understanding the cluster of closely related, but conceptually distinct, regulatory and policy challenges this label actually denotes. It identifies the fundamental paradox at the heart of the TBTF metaphor: TBTF is an entity-centric, micro-level metaphor for a complex of interrelated systemic, macro-level problems. While largely unacknowledged, this inherent tension between the micro and the macro, the entity and the system, critically shapes the design and implementation of the key post-2008 regulatory reforms in the financial sector. To trace these dynamics, the article deconstructs the TBTF metaphor into its two basic components: (1) the “F” factor focused on the “failure” of individual financial firms; and (2) the “B” factor focused on their “bigness” (i.e., relative size and structural significance). Analyzing post-crisis legislative and regulatory efforts to solve the TBTF problem through this simplifying lens reveals critical gaps in that process, which consistently favors the inherently micro-level “F” factor solutions over the more explicitly macro-level “B” factor ones. It also suggests potential ways of rebalancing and expanding the TBTF policy toolkit to encompass a wider range of measures targeting the relevant systemic dynamics in a more direct and assertive manner

Do Labyrinthine Legal Limits on Leverage Lessen the Likelihood of Losses? An Analytical Framework

A common theme in the regulation of financial institutions and transactions is leverage constraints. Although such constraints are implemented in various ways—from minimum net capital rules to margin requirements to credit limits—the basic motivation is the same: to limit the potential losses of certain counterparties. However, the emergence of dynamic trading strategies, derivative securities, and other financial innovations poses new challenges to these constraints. We propose a simple analytical framework for specifying leverage constraints that addresses this challenge by explicitly linking the likelihood of financial loss to the behavior of the financial entity under supervision and prevailing market conditions. An immediate implication of this framework is that not all leverage is created equal, and any fixed numerical limit can lead to dramatically different loss probabilities over time and across assets and investment styles. This framework can also be used to investigate the macroprudential policy implications of microprudential regulations through the general-equilibrium impact of leverage constraints on market parameters such as volatility and tail probabilities.Massachusetts Institute of Technology. Laboratory for Financial EngineeringNorthwestern University School of Law (Faculty Research Program

The New Global Financial Regulatory Order: Can Macroprudential Regulation Prevent Another Global Financial Disaster?

This Article posits that the success of macroprudential regulation will depend on four factors. First, the economic philosophy of the central banker in charge of the domestic institution with jurisdiction over macroprudential regulation will prove crucial in the implementation of adopted regulation. If, like Chairman Greenspan, the banker is averse to the exercise of the Central Bank\u27s regulatory oversight authority, then no amount or volume of policy or regulation will prevent or mitigate systemic risks and the accompanying shocks. Second, a sufficiently deep level of international cooperation is required to mitigate regulatory arbitrage, without being so broad that the ensuing harmonization of regulatory regimes will result in a homogenized global regulatory system that will possibly give rise to a productization of risk and therefore a far more rapid spread of systemic risk and shock. Third, the acceptance of macroprudential regulation by disparate domestic regulators will require a new guiding philosophy for the financial industry that will allow the macroprudential regulator the opportunity to meet its mandate and provide a foundation for system-wide success. Fourth, there needs to be a sufficient level of political willpower on the part of domestic legislatures and regulators in the face of what may be fierce opposition to macroprudential regulation by the largest and most politically powerful institutions the policy aims to supervise. To counter this, macroprudential regulation is primarily under the purview of the Central Bank, and therefore less prone to regulatory or political turbulence. To explore the present and possible future impact of macroprudential regulation, one must recognize the possible implications of the current regulatory proposals. One way to ascertain such information is to examine the strengths and weaknesses of macroprudential regulation as it is currently proposed and implemented. As such, this Article considers the possible opportunities and threats that lay ahead within a policy and regulatory framework that considers the economic, political, and international implications of macroprudential regulation proposals

Too Many to Fail: Against Community Bank Deregulation

Since the 2008 financial crisis, policymakers and scholars have fixated on the problem of “too-big-to-fail” banks. This fixation, however, overlooks the historically dominant pattern in banking crises: the contemporaneous failure of many small institutions. We call this blind spot the “too-many-to-fail” problem and document how its neglect has skewed the past decade of financial regulation. In particular, we argue that, for so- called community banks, there has been a pronounced and unjustifiable shift toward deregulation, culminating in sweeping regulatory rollbacks in the Economic Growth, Regulatory Relief, and Consumer Protection Act of 2018. As this Article demonstrates, this deregulatory trend rests on three myths. First, that community banks do not contribute to systemic risk and were not central to the 2008 crisis. Second, that the Dodd-Frank Act imposed regulatory burdens that threaten the survival of the community bank sector. And third, that community banks cannot remain viable without special subsidies or regulatory advantages. While these claims have gained near- universal acceptance among legal scholars and policymakers, none of them withstands scrutiny. Contrary to the conventional wisdom, community banks were key participants in the 2008 crisis, were not uniquely burdened by postcrisis reforms, and continue to thrive economically. Dispelling these myths about the community bank sector leads to the conclusion that diligent oversight of community banks is necessary to preserve financial stability. Accordingly, this Article recommends a reversal of the community bank deregulatory trend and proposes affirmative reforms, including enhanced supervision and macroprudential stress tests, that would help mitigate systemic risks in the community bank sector