The financial crisis flared in an era of invisible high risk. Has the system been reformed?

Up until 2008’s global financial meltdown, economist Andrew Metrick studied a broad range of topics within finance. But the financial crisis was, he jokes, also his own “midlife (financial) crisis,” a turning point that set his research, which had been focused on venture capital and innovation, in a new direction.

Metrick, director of the Yale Program on Financial Stability, now studies financial crises, almost exclusively.

Of interest to any economist: The crisis, which began in 2007, sparked an 18-month recession that would become the worst US economic downturn since the Great Depression. Between 2007 and 2009, the US gross domestic product fell 4.2 percent. The unemployment rate reached 10 percent, with more than 8 million Americans losing jobs. Foreclosed homes sat empty, coast to coast.

Of interest to Metrick, on a more personal level: His father had been a senior executive at Bear Stearns, a venerable Wall Street firm that unraveled in spectacular fashion early in the crisis. “Watching that firm go away in a week was a profound intellectual challenge for me,” Metrick says today. “I’ve been trying to sort it out ever since.”

Ten years later, Metrick and other financial economists are still looking back at the crisis and the efforts regulators made to rein it in. They’re investigating the best ways to gauge risk in the financial system, the better to sound an alarm before the next time things run amok. They’re also examining how regulatory reforms fared post-recession, and whether the safeguards put in place will be strong enough to ward off another major crash.

There’s a lot more of this kind of work going on today than scholars did in the past, says Metrick. Along with his Yale colleague June Rhee, Metrick coauthored a recent review in the Annual Review of Financial Economics that surveys the “resurgence of research on financial regulation” that sprang forth after the crisis. The emerging body of work includes new economic models, new approaches to monitoring the economy and new analyses of what went wrong and what went right a decade ago.

The hope, they say, is that having a new trove of evidence and analysis at decision makers’ fingertips will put regulators in a better position the next time around. Since the crisis, Metrick and Rhee say, regulators’ tools to foresee, prevent and mop up a future crisis have improved. But the emergency powers needed to manage a meltdown as it unfolds have actually weakened.

A new kind of run on the bank

The financial crisis was a worldwide event, sparking major downturns in North America and Europe, and hardship elsewhere too. In the United States, the conditions that led to the crash started percolating in the early 2000s, in neighborhoods throughout the country. Overoptimistic homebuyers took out large-but-risky mortgages, driving prices higher and higher. But then the housing bubble burst. Property values plummeted, and many borrowers walked away from homes whose values had fallen below what was owed to pay them off. According to a Federal Reserve report from 2008, around 1.2 million foreclosures were initiated in the first half of that year, 79 percent more than the 650,000 initiated in the first half of 2007.

Those defaults rippled out of neighborhoods and into the financial markets. People and companies around the world bought and traded securities built on sliced-and-diced pieces of this housing debt, which had been cobbled together by a vast web of financial firms. When the mortgages went into default, investors scrambled to take their money out of the system, in an amplified, digital version of the classic run on the bank, à la It’s a Wonderful Life.

Casualties in the world of “shadow banking”

The fallout was severe for investment banks such as Bear Stearns and Lehman Brothers, and for other types of firms such as the insurer American International Group. AIG and others conducted a lot of business in this mortgage-backed financial ecosystem, and ended up scrambling for cash to keep their companies in operation. Some, including Bear Stearns and Lehman, disappeared, swallowed up by other firms or left to wither. Others, like AIG, survived after receiving multibillion-dollar lifelines from the US federal government.

“We had a run on the bank, except the bank wasn’t the bank,” Metrick explains. “It was this market-based financial system that had replaced banks for a big chunk of what was going on.”  Scholars sometimes refer to this diffuse financial system as “shadow banking,” a set of services outside the traditional banking sector that allowed investors to store vast amounts of cash far beyond what traditional banks could insure. Investors believed — wrongly, it turns out — that these financial instruments were very safe.

Hidden financial risks

The crash came as a complete surprise to economists, says Michael Barr, dean of the Gerald R. Ford School of Public Policy at the University of Michigan and a former Treasury official in the Obama administration. “People had kind of forgotten that you could have that kind of risk,” he says. “If you had asked economists in the years before the crisis, they would say, ‘You can’t have bank runs in the financial system anymore. We solved that problem in the 1930s.’” Barr says economists didn’t think a nationwide housing downturn was possible, either.

Western financial institutions and government regulators were equally taken aback. As recently as May 2007, Federal Reserve Chair Ben Bernanke had reassured audiences that “we believe the effect of the troubles in the subprime sector on the broader housing market will likely be limited, and we do not expect significant spillovers from the subprime market to the rest of the economy or to the financial system.” But then banks in the US and abroad started reporting staggering losses associated with subprime mortgage holdings. In August of that year, the European Central Bank injected 95 billion euros into the banking market to keep firms operating. Central banks in the US, Canada and Japan stepped up interventions, too.

By October 2008, several banks had failed, and the George W. Bush administration had responded with the Troubled Asset Relief Program, through which $700 billion was initially allocated for the government to purchase distressed investments from struggling financial firms whose collapse could upend the economy. Efforts to stanch the bleeding continued during the Obama administration, culminating in the 2010 passage of the Dodd-Frank Wall Street Reform and Consumer Protection Act, designed to strengthen regulation and prevent another meltdown.

Reforms triggered by the recession

Barr, who worked on Dodd-Frank and other regulatory reforms, divides efforts to regulate the post-crisis financial system in the US into five categories.

The first big step came when regulators increased the “cushion” that financial firms of various shapes and sizes were required to maintain, forcing them to keep a higher level of capital — liquid assets — on hand and to rely less heavily on short-term financing, as Bear Stearns and Lehman had in 2008.

Regulators also expanded what’s known as the “regulatory perimeter — who’s in and who’s out of regulation,” as Barr puts it. Before the crisis, government efforts focused narrowly on banks: firms that take deposits from customers. By casting a wider net and keeping tabs on the entire gamut of large outfits conducting bank-like activities, including investment banks like Lehman and insurance companies like AIG, Dodd-Frank sought to minimize the chances of another run on the bank-that-isn’t-the-bank. “If you’re a large institution that might be important to the economy, you’re going to get regulated for the risk you take regardless of your corporate form,” Barr explains.

Third, regulators created better systems for dealing with failing firms at the moment of crisis — an approach called “orderly liquidation” that would help financial companies unwind existing deals without causing a panic in the market.

Fourth, they increased controls over the markets for derivatives, complex financial instruments often thought to hedge risk, that were wrapped into the mortgage-backed securities that played such a crucial role in 2007 and 2008. The new law required derivatives trades, which used to take place directly between a seller and a buyer, to go through third parties. Known as central clearing houses, these third parties can help monitor risk accumulated in the system — and, ideally, contain it. “It gives you a clear view,” says Yale’s Rhee.

And fifth, regulators set up new consumer and investor protections including the Consumer Financial Protection Bureau, a federal agency tasked with protecting consumers from deceptive marketing in financial markets.  

The worst averted, but at a political cost

As soon as 2010, Metrick says, the US economy was already in “recovery mode,” with the interest rates banks charged each other normalizing, and job growth resuming; by 2011, US GDP had surpassed its previous peak. Still, the recovery from the crisis has been slow and incomplete, economists say, with GDP languishing below where it should be, based on historic trends.

Some European countries — most famously Greece, most recently Italy — are still suffering from the recession’s effects. The European system was “a bit less flexible, both in terms of adjusting to the shock and being able to react aggressively on the policy side,” Metrick says. “They’re a whole lot of sovereign nations as opposed to just one.”

Most scholars have shed any notion that a run on the banks could never happen again. Soon after new regulations went into effect, they began to study the crisis and response in depth — devising new analytical methods to help understand what happened, and new risk-assessment tools to sniff out emerging crises in the future.

In the aftermath of the crisis, many economists viewed the bailout as a major success, stopping the worse disaster of a depression. But many critics view TARP assistance as a reward given to companies who had acted irresponsibly, creating a skewed set of incentives for bad behavior, known as moral hazard. In response, politicians rolled back the government’s ability to bail out the firms economists considered “too big to fail.”

Metrick, who likens the regulatory system to a fire department, worries that this spells danger. “We had some fires, and we passed some much stronger laws about how you build fireproof houses,” he explains. “But we also reduced the size of our fire department … we’ve put a lot more pressure on ourselves to catch things early and to prevent them from happening, because we’ve reduced our ability to fight them when they occur.”

Measuring and improving reforms will take data

In their review, Metrick and Rhee argue that economists have a lot of work ahead of them when it comes to helping policy makers, who debate the extent to which the government should control the economy but don’t have much evidence upon which to rest their arguments. “The political argument suffers from a lack of agreement on the academic side,” Metrick says. Unlike the case of global warming, he adds, here “we don’t have the science solved … so the politics goes on and has its standard arguments that are not based on facts. But we can’t really blame them.”

He and Rhee urge scholars to take another look at emergency powers, which received a lot of attention in the immediate aftermath of the crisis but have fallen out of favor as a subject of study. They argue for better understanding of the impacts of shadow banking, and for rethinking ways to help out distressed firms without creating stigma and moral hazard. “You can’t link to one paper or even one set of papers,” Metrick says, “and say, oh, somebody has solved these problems.”

Concern about regulation rollback

Former Treasury official Barr says that the new proliferation of regulation research represents a “dramatic shift,” and that he thinks the financial system is “a lot safer and fairer than it was 10 years ago.” He’s very close to the issue, of course, and has concerns in the face of new calls in Congress to roll back Dodd-Frank, and a tendency in the Trump administration to go easy on enforcement.

“I worry that we’re putting ourselves on the path to recreate the conditions that led to the last financial crisis,” Barr says. “At least in Washington, there’s a collective amnesia that has descended that has led some people to call for deregulation and rolling back a number of the reforms we put in place.”

Not quite, says Metrick, who sees the current backlash to reform as fairly typical of Republican administrations, which have been concerned about overregulating American business for decades.

What’s more, it always takes a crisis to overcome financial industry opposition to new restrictions and oversight, he believes, noting that the last major push took place after the Great Depression, and a smaller wave of reform followed the savings and loan crisis of the 1980s and 1990s. “You pass these laws and then you spend the next few decades defending them,” he says. “That’s just the reality … it’s unlikely we’ll be able to write new rules until there’s another crisis.”

At least next time around, when the crisis hits — and Metrick says it inevitably will — policy makers might be able to make better-informed decisions.

“If we end up in a crisis and we need to go to Congress to get more powers,” he says, this time we will have done “research and rigorous thinking in the background, so we’re not caught flat-footed.”

Work that began in crisis has turned into a fertile area for intellectual discovery for Metrick. But his goal would be for others to use evidence to avoid any more crises — midlife or otherwise.