Reforming the Macroprudential Regulatory Architecture in the United States

When the COVID-19 pandemic shuttered major economies in March 2020, it also wreaked havoc on financial markets. In the first few weeks of March, investment-grade corporate bonds lost roughly a fifth of their value, on par with the declines in equity and high-yield debt. (Haddad et al., 2020; Falato, Goldstein & Hortaçsu (forthcoming)). Contrary to the usual flight to quality, in mid-March, U.S. Treasury yields began rising and only stabilized after the Federal Reserve initiated a massive purchase program. (Vissing-Jorgensen, 2020). The distress in the Treasury market accentuated distress in other markets and liquidity challenges for firms. Nonbanks that service … Read more

Stress Testing During a Pandemic

Yesterday, the Federal Reserve announced the results of its annual stress tests. This was the first time since 2009 that the Fed had stress tested large banks during a period of systemic distress. In a new paper, Stress Testing During Times of War, forthcoming in The Stress Test Handbook (Cambridge University Press) and available here, I explain why stress testing after a negative shock is both more important and more fraught than stress testing during times of peace. I further address why time-limited government backstops may be critical to ensuring the tests are robust, relevant and disclosed – … Read more

How Banks and Fintechs Can Help Small Businesses Survive COVID-19

Small business assistance has been a central focus of the government’s response to the COVID-19 crisis, and for good reason. Small businesses underlie the vitality of our neighborhoods, spark innovation, and employ almost one-half of the U.S. workforce. In a new working paper, “How to Help Small Businesses Survive COVID-19,” available here, we explain why finding better ways to harness banks and fintechs is critical if this vital part of the economy is to emerge without too much harm on the far side of this crisis.

There is no easy way for the government to readily provide the perfect … Read more

Congress Should Endorse the Federal Reserve’s Extraordinary Measures

The rapid spread of Covid-19 and massive change in behavior required to curb it have transformed the trajectory of the world’s economy.  Just a few short weeks ago, the United States was basking in the longest period of sustained economic growth on record.  The country now faces what could be the steepest decline in economic activity in its history.  The long-term health of the country and the economy remain fluid and will be determined in part by how policymakers respond.  The Federal Reserve quickly recognized the unprecedented nature of the threat and has intervened aggressively to stem the pain this … Read more

Coronavirus, Systemic Risk, and Lessons from 2008

The greatest single-day decline in the stock market this century, widespread fear and uncertainty, shuttered schools, an end to large gatherings everywhere from NBA games to the South by Southwest festival – these are just a few of the signs that the United States and the rest of the world will face some very tough economic times in the months and years ahead. The prospect of another crisis, and the increasing probability of another worldwide recession, have many looking back to 2008. A brief comparison of the two crises brings the lessons of the past into focus, in addition to … Read more

Why Financial Regulation Keeps Falling Short

Modern finance is fast moving, extremely complex, and contributes to pervasive unknowns. Yet the processes governing how finance is regulated are typically slow, highly deliberative, and often reflect deeply ingrained and incredibly optimistic assumptions about our ability to understand the financial system and the potential impact of regulatory intervention. In our new paper, “Why Financial Regulation Keeps Falling Short,” we identify the key drivers of this fundamental mismatch between finance and financial regulation, demonstrate how this mismatch contributes to undesirable policy outcomes, and lay the conceptual foundations for understanding how the processes governing the creation of financial regulations … Read more

Why We Need a Guarantor of Last Resort

More than a decade has passed since the worst of the 2007-2009 financial crisis.  In that time, we have learned that some of the gravest consequences of the crisis were not the economic fallout, but the political backlash it triggered.  After the panic that followed the failure of Lehman Brothers, the Federal Reserve and other regulators understandably concluded that they needed to do everything in their power to prevent the failure of another systemically important financial institution. The very next day, the Federal Reserve stretched the bounds of its legal authority to provide a record amount of liquidity support to … Read more

The Deregulation Debate: The Challenge of Using Static Rules to Govern a Dynamic System

In their lively disagreement about the role of deregulation in contributing to the 2007-2009 financial crisis, professors Arthur Wilmarth and Paul Mahoney inadvertently illuminate why the processes through which finance is regulated are so ill-suited to that purpose.  Finance is dynamic.  Today’s financial system bears only a coarse resemblance to the financial system of the 1950s.  Tomorrow, the system will evolve yet further and in ways we may not be able to imagine today.   In contrast, the legal regime is designed to stagnate. Frictions make statutes and regulations difficult to change, even when market changes have already altered the substantive … Read more

Lehman Brothers: How Good Policy Can Make Bad Law

As we approach the 10-year anniversary of the failure of Lehman Brothers, the news is again awash in a debate about whether policymakers could have saved the investment bank.  That the issue remains so deeply contested reflects how fundamentally flawed the current legal regime is.  Although embodying ideas that are sensible in the abstract, the regime makes the authority to act contingent on facts that policy makers cannot readily discern during periods of systemic distress.  Making matters worse, subsequent events, including other actions by those same policy makers, can further skew the critical facts on which legal authority rests.  This … Read more

Taking Investor Preferences Seriously

Over the last half century, finance has made remarkable progress explaining the pricing of financial assets.  In relying on portfolio theory, however, mainstream pricing models tend to ignore investor preferences for certain asset types.  This is a mistake.  In a new paper forthcoming in Harvard Business Law Review and available here, I weave recent empirical findings on the demand for “safe assets” with an institutional account of how financial intermediaries increase the effective supply of such assets to demonstrate how investor preferences can drive financial innovation and radically alter the structure of the financial system.  By moving beyond abstract … Read more

Visionaries and Pragmatism in Financial Regulation

In a world of “alternative facts” and political rhetoric crafted to mislead, it is easy to forget that idealized visions can at times illuminate more than they obfuscate.  In a book review recently published in Harvard Law Review and available here, I attempt to separate fact from fiction in the debate about how best to regulate short-term debt.  Although coming down in favor of pragmatism in financial policymaking, the review recognizes the ways that imaginative alternatives can reveal often-obscured choices and help lay the foundation for a better path forward.

The thought-provoking book that motivates the review is The Read more

Understanding Runs in the Shadow Banking System

There are two established explanations for bank runs: coordination problems among depositors and information asymmetries between bank managers and depositors.  In a new paper, “Information Gaps and Shadow Banking,” forthcoming in the Virginia Law Review and available here, I offer a novel, complementary explanation for why short-term creditors run: information nobody possesses.

Both the banking and shadow banking systems use short-term debt to fund longer-term, less liquid assets.  That short-term debt is designed to pose sufficiently minimal credit, liquidity, and duration risk that holders can treat the claims as close substitutes for money.  This reduces funding costs and has … Read more

Putting the Fall of LendingClub in Perspective

On Monday, LendingClub Corp., a leader in the growing online lending space, announced the surprise resignation of its founder and CEO, Renaud Laplanche.  Laplanche resigned in response to a board investigation that revealed a number of internal control failures, including the sale of more than $20 million in loans that failed to conform to the requirements imposed by the acquiring investors and the doctoring of dates on loan applications to cover up noncompliance with respect to $3 million in loans sold.  These developments triggered a massive decline in LendingClub’s stock price, but also contribute to a growing cacophony of questions … Read more

Intermediary Influence in Action: Focusing on the Core

Is “intermediary influence” all that unique? Can it be isolated? And how much harm really results? These are among the questions Professor Lawrence Cunningham poses in his thoughtful essay and recent post responding to my work on how intermediaries alter institutional arrangements in self-serving and socially costly ways. In the essay, Professor Cunningham also examines the acquisition market to provide additional evidence of intermediary influence while simultaneously introducing the question of how competition limits intermediary influence and the welfare losses that emanate from it.

Professor Cunningham concludes that “far from constituting criticism of Judge’s work, [the] questions [he raises] warrant … Read more

Was Bernanke Courageous?

As reflected in the title of the new memoir by Former Federal Reserve Chairman Ben Bernanke, The Courage to Act: A Memoir of a Crisis and Its Aftermath, Bernanke clearly believes that he and other Fed policymakers demonstrated exceptional courage in their handling of the 2007-2009 financial crisis.[1] In a new paper forthcoming in Columbia Law Review and available here, I suggest otherwise. I agree with Bernanke that if one narrows the lens to the Fed’s actions after Lehman Brothers failed in September 2008, the Fed and other financial regulators often displayed great courage and creativity and … Read more

A Different Take on the AIG Case: The Dangers of Invoking 19th Century Principles to solve 21st Century Problems

Bagehot, as in Walter Bagehot, was mentioned no less than seven times in the decision splitting the baby in the AIG trial.[1]   A nineteenth century British commentator, Bagehot was among the first to recognize that too little liquidity could wreak havoc on a financial system. [2]  In a series of admonitions, known today as Bagehot’s dictum, he admonished central banks to lend freely to any solvent institution with good collateral, but at a penalty rate to minimize the attendant moral hazard.[3] In invoking Bagehot, Judge Wheeler was in good company.   Ben Bernanke and other leading policymakers regularly invoked … Read more

Just How Scary is the Fed?

“There is an old saw that the Fed chair is the second most powerful person in government. In the aftermath of the financial crisis, that may actually be an understatement.” Nicholas Lemann, The New Yorker:

America has a long and conflicted relationship with central banking. The controversial actions taken by the Federal Reserve during and since the 2007-2009 financial crisis reignited longstanding concerns about vesting so much authority in the hands of a few unelected officials. The Fed’s creative and aggressive use of its authority likely helped to reduce the size of the financial crisis and the magnitude of … Read more

The Long Arm of Financial Intermediaries

Why haven’t the significant financial and technological innovations of the past thirty years substantially decreased the cost of financial intermediation?  What explains the ever-increasing complexity of financial products and markets?  Why do so many investors hold actively managed mutual funds despite evidence that their costs typically exceed their benefits? How is it that real estate brokers remain able to charge such high fees despite the rise of the Internet and the increasing capacity of buyers and sellers to connect without their services?  These are just a few of the questions that I address in a new article forthcoming in the … Read more

The Crisis: The More We Know, The Less We Understand

With the stock market regularly surpassing record highs, housing prices surging 13.6 percent in 2013 alone, and unemployment down to 6.7 percent, it is easy to forget just how dire the economic outlook appeared just five years ago. It is also tempting to assume that we have figured out what went wrong and have made the changes necessary to address the fragilities the crisis revealed. After all, academics, policymakers, and other commentators have produced seemingly endless articles and books about the crisis. Congress also passed the Dodd-Frank Act, the most sweeping financial reform bill since the 1930s. A closer look … Read more

The Fed’s Competition: The Real Lenders of Last Resort

It is well known that the Fed injected massive amounts of liquidity into the financial system during the 2007-2009 financial crisis.   Far less well known is that the Fed was not the only place banks obtained government-backed liquidity when market sources first ran dry.  Moreover, during the early stages of the Crisis, the Fed was not even the primary source of government-backed liquidity.  As I reveal in a new paper forthcoming in the Cornell Law Review, and available here, instead of going to the Fed’s discount window, banks increased their reliance on two other forms of government-backed liquidity.  … Read more