The Regulatory Confidence Cycle

We can already see the cycle repeating. After the 2010 was enacted in the US, and after financial firms’ capital requirements were raised and some of their riskiest activities limited, industry leaders announced that the battle had largely been won. The financial sector had been made safe for the twenty-first century. Further regulation would be punitive and ill-considered, for it would prevent banks from doing their job – lending to the real economy.

Meanwhile, regulators will have reason to believe that they have achieved a new safety paradigm: tighter rules that prevent banks from failing, and new ways to resolve any banks that fall through the cracks and fail anyway. A half-dozen years after the financial crisis, regulators will find it discouraging to conclude anything other than that they have solved the problem or are close to doing so. Fatigued by years of effort and beset by criticism from the industry, regulators will ease up.

And that is when things become dangerous. For example, because many view the Lehman Brothers collapse as sparking, or exacerbating, the financial crisis, much of the regulatory focus has been on developing the means to handle the failure of a similarly large financial firm. New regulatory authority from Congress has encouraged the view that regulators will soon be able to handle a Lehman-size failure smoothly.

But, if regulators become too confident too soon, they could consider the financial system safe from collapse, just as many did in 2008. Like generals fighting the last war, regulators, academics, and industry observers will be confident that regulators can handle and defuse another Lehman explosion before it happens. The financial industry itself will believe that finance has been made safe; indeed, it has already started down this road. And fatigued regulators, eager to declare victory, may concur. Yet finance can fail in many ways; the Lehman collapse is only one.

If this cycle is even approximately right, regulatory fatigue from battling to make finance safer will soon turn into regulatory confidence that the last war has now been won. In a strong economy, finance will look stronger and existing regulation will appear to be effective. It is common for people to update their views of the world with what they have last seen; if what they last see is a strong economy and a stable financial system, they will conclude that they have stabilized the system. The Fed’s 2008 transcripts reveal that its leaders saw such a world.

It will be easy to interpret future looming crises as minor road bumps that can be absorbed. But at some point, what looked like a bump will turn out to be a landmine, unseen because it was not the one perceived as having caused the last explosion.

The question is not whether it will happen again. The question is where and how. And when.

Mark Roe is a professor at Harvard Law School.

Copyright: Project Syndicate, 2014.