Financial Policy After the Crisis

Abstract

Jon Danielsson discusses the use of capital ratios and macroprudential regulation and describes the limitations of each policy: How banks can inflate capital ratios, how capital requirements fail to reduce the risk of aggregate shocks and how Basel III regulations burden smaller banks relative to larger banks. Moreover, Danielsson discusses the pros and cons of putting macroprudential regulations in the hands of a central bank, the possibility that this policy may turn out to be procyclical and the dangers faced to the credibility of a central bank that attempts to assess the economic risk of political decisions.

Over the past decade, G20 financial reforms have fixed the faultlines that caused the global financial crisis.

Mark Carney, Chairman of the Financial Stability Board, and Governor of the Bank of England (FSB [2017] Annual Report)

Discussion of Chapters 12–14

In discussing Johnsen’s paper, Dooley recalled Jeff Schafer’s question, “What did the banks do that was illegal?” He noted that the banks’ loaning themselves money to buy their own stock was indeed illegal. He also suggested that had they not been found guilty of such a clearly illegal act; the government might have had virtually no leverage against them.

In discussing post-crisis financial policy, Jón Danielsson noted that the 2008 financial crisis did not result from policy decisions made in the three years immediately preceding it. He suggested evaluating policy from the standpoint of the 2003 political environment instead. He also suggested rethinking risk and recognising that it increases during upswings (as imbalances build) and materialises during recessions. He likened a financial crisis to the bursting of a dam: the risk is greatest right before the dam bursts, and after it bursts and all the water goes out, there’s no more risk to be had. The least risk in the system is right after a crisis, and the greatest is right before. Measured risk goes away. Danielsson argued that the policy reaction to the crisis was wrong: de-risking shouldn’t take place post-crisis; risk should be increased post-crisis. De-risking should be done before the crisis, whereas it is often done at the wrong time in the cycle. Actual risk goes up along with the bubble and down with the bubble.

Danielsson posited as well that the most dangerous risks are not those that are known and can be prepared for but the “unknown unknowns”. The trick, then, is to figure out what those are. He also emphasised that macroprudential policy would not help mitigate the cycle because perceived risk peaks right after the crisis, whereas actual risk peaks just beforehand.

Dooley agreed with Danielson’s conclusions but stressed that the unknown unknowns will never be identifiable. Knowing that they exist is all well and good but doesn’t offer a roadmap for further action.