We can’t eliminate crises, but we can limit their severity.
- November 29, 2017
- CBR - Finance
There are several narratives, but no consensus on the “reason” for the crisis. One narrative is that the system was too interconnected—too many people relied on other people who bought insurance, credit default swaps, and so on. Another narrative says people panicked, and there was a run on the financial system that had to do with short-term debt. A third narrative is too big to fail (TBTF).
TBTF is a problem, but it wasn’t the reason the crisis occurred. Who caused the most trouble? Investment banks such as Lehman Brothers. I don’t think anyone thought Lehman was too big to fail. The things at the center were not the traditional TBTF institutions.
I gave a speech before 2007 saying financial crises are everywhere and always caused by problems related to short-term debt. It looks to me like what happened was a run.
There’s no great evidence yet about whether Dodd-Frank has been good or bad. Probably more than 40 percent of the bill is good, and nothing is a disaster. But we haven’t had another big financial crisis, so we can’t say which of the hundreds of requirements in it were good, unnecessary, or bad.
The big banks don’t like the capital requirements or the Volcker Rule, which says you can’t do this (proprietary trading) and that (lending). I like capital requirements better than the Volcker Rule, because a lot of things look like proprietary trading, including market making. The Volcker Rule seems to have cut the amount of bonds that market makers hold, and there’s controversy about whether the bond market has become less liquid.
When you don’t know what caused the crisis, it’s hard to write a law to treat it. It’s almost as if people couldn’t decide whether we had cancer, or maybe a fungal infection. We tried to treat them both, and the problem went away, but maybe that going away had nothing to do with the treatment. Maybe it went away on its own.
Yes, I think Dodd-Frank did make things safer, although we’d be safer even if we hadn’t passed any laws at all. We don’t tend to have two crises in a row. Memories are still fresh. People say, “I made that mistake yesterday. I’ll make a different one today.”
Dodd-Frank didn’t outlaw every risky practice that could cause a crisis. No law could or should. Something’s going to happen, and at that point, we’ll see how well it works.
But one stated intent, I think, in writing the law was to make sure there would be no bailouts ever again. And if that’s how the law were to ever actually be interpreted, that would be a huge problem. The ability to prop up the financial system in a crisis is essential. That’s what central banks and governments are about. We don’t want to rely on their help too much, but we don’t want to make that help impossible.
We will have another crisis. We’re not going to get rid of them, but we can certainly cut down on the severity of them. But you’re not going to get crises down to zero.
Douglas W. Diamond is Merton H. Miller Distinguished Service Professor of Finance at Chicago Booth.
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