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It’s been 10 years since Lehman Brothers collapsed, setting off a global financial meltdown that would take years to correct. A decade later, there are some guardrails in place to prevent a Great Recession 2.0 — but another crisis at some point is essentially inevitable.
The 2008 financial crisis wreaked havoc on global markets and the world. In the United States, the S&P 500 fell by 28 percent in the 22 trading days after Lehman filed for bankruptcy in September 2008. Over the next six months, it would lose nearly half its value. The unemployment rate jumped from 6.1 percent in August 2008 to 9.5 percent two years later in August 2010. Millions of Americans lost their homes, their jobs, or both.
A decade later, there’s been a lot of reflection on what happened in the financial crisis — and whether a repeat could be on the horizon. I reached out to eight experts to ask how far we’ve come, specifically in terms of government policy, in guarding against another financial and economic calamity. Simply put, are the guardrails in place to prevent another financial crisis like what happened in 2008?
They told me there have been efforts to increase oversight, such as the Dodd-Frank financial reform, which created entities such as the Consumer Financial Protection Bureau (CFPB) and put in place new regulations and tools for banking supervision and oversight by entities such as the Federal Reserve and Federal Deposit Insurance Deposit Corporation (FDIC). But there are still risks in the system, and some suggested regulators hadn’t gone far enough. Moreover, financial crises are sometimes inevitable.
“Regardless of improvements in law and regulation, every financial system is vulnerable to a possible crisis,” Aaron Klein, a fellow in economic studies at the Washington, DC–based think tank the Brookings Institution, told me. “Throughout history, financial crises have emerged from many types of assets, from Dutch tulips to US subprime mortgages.”
Klein’s full response and the responses of the seven other experts I asked are below, edited for length and clarity.
Bill Emmons, assistant vice president and economist at the Federal Reserve Bank of St. Louis
The guardrails are not in place to prevent another crisis like 2008. However, I don’t think another crisis like that is likely anytime soon. The underlying conditions in the economy and financial markets are very different today, in large part because the crisis occurred and left lots of damage in its wake.
My understanding of the financial crisis is that it resulted from the reversal of “dual leverage cycles,” in the words of economist John Geanakoplos.
The first leverage cycle was an explosion of mortgages collateralized by houses; this was the debt-financed housing bubble. The second leverage cycle was in the financial markets, comprising new debt securities collateralized by mortgages. This was the world of collateralized debt obligations (CDOs) and credit default swaps (CDS).
The bursting of the housing bubble alone would not have been sufficient to create the financial crisis, in my view. Nor would a collapse of the markets for securitized mortgages itself have resulted in the crisis we saw.
What happened was the collapse of both bubbles. The housing bubble began to deflate first, followed by the financial markets bubble.
The guardrails that would prevent a recurrence would include hardwired, across-the-board mortgage underwriting standards, verified income, and, in an ideal world, shorter mortgage amortization schedules. All would reduce the incentive and ability to lever up the housing stock.
In the financial markets, guardrails would include much more stringent disclosure requirements for securitized debt (mortgage-backed securities), truly independent credit rating agencies (S&P, Moody’s, Fitch, others), and real power granted (and used) by the Securities and Exchange Commission and the Federal Reserve to regulate the over-the-counter derivatives markets, including the CDS market.
Another unrealized reform that touches on both retail and wholesale markets would be scaling back Fannie Mae and Freddie Mac, the housing government-sponsored enterprises. They pumped huge amounts of air into the housing bubble and participated in the credit market mania. If they were eliminated or drastically cut back, they would not be in a position to contribute to future leverage cycles in the housing and financial markets.
Very little of this reform agenda has taken place. Thus, I conclude that there is no reason why another financial crisis in housing and related financial markets could not occur. However, the damage resulting from the collapse of the last financial crisis was so severe that I don’t think we’re likely to experience another one any time soon.
Kristina Hooper, global markets strategist at Invesco
We have certainly put out a number of regulations following the global financial crisis intended to prevent a similar crisis. For example, the reforms we have seen around the mortgage industry — and keep in mind that housing was at the epicenter of the crisis in the US — were an appropriate response to the crisis and are likely to prevent a similar housing bubble and bust. And so it is unlikely that the exact same crisis will occur.
However, in the process, we may have made ourselves more vulnerable to another type of crisis. For example, one component of Dodd-Frank, the Volcker Rule — which essentially prevents banks from speculation in markets — may have increased the likelihood of a crisis because it removes important market makers, thereby reducing liquidity.
And, of course, we don’t have many tools available at our disposal, either fiscal or monetary, to combat another crisis it if does occur. With such a high level of government debt, we may find Congress unwilling to spend a lot to stimulate the US economy in the event of a crisis. And the Fed has only just begun normalizing monetary policy, so it doesn’t have a lot of “dry powder” to tackle a new crisis.
The Fed has an enormous balance sheet as a result of three phases of quantitative easing, and while it has started to unwind it, it is still incredibly bloated — much bigger than it was a decade ago when the global financial crisis started. And so it’s unclear how much the Fed would be willing to expand its balance sheet in the event of another crisis. The Fed has hiked rates seven times and is very likely to hike them again in September, but the federal funds rate is still relatively low, so there are only so many rate cuts the Fed could do to stimulate the economy in the event of a crisis. (The federal funds rate was over 5 percent at the start of 2007, so the Fed had the ability to dramatically drop rates in order to combat that crisis.)
Aaron Klein, policy director of the Center on Regulation and Markets at the Brookings Institution and former chief economist for the Senate Banking Committee
We have made substantial progress in building a safer and more resilient financial system since the crisis. Changes in law like Dodd-Frank created a stronger regulatory system and gave regulators new tools to detect, prevent, and contain future problems. These reforms can make future crises less likely to occur and mitigate the impact when they do.
Specifically, higher capital requirements for the largest, most systemically connected financial institutions reduce their chances of distress, and, coupled with restructuring requiring significantly more long-term debt, reduces the potential for devastating creditor runs. New tools that allow the FDIC to close any failed, systematically important financial institution should give policymakers a way out of the box they found themselves in in 2008, when the options were unjust bailouts or collapse of the financial institution. The establishment of the CFPB, the first financial regulator charged with putting consumers first, can help avoid creating the very type of toxic instruments that were at the core of the crisis.
However, regardless of improvements in law and regulation, every financial system is vulnerable to a possible crisis. Throughout history, financial crises have emerged from many types of assets, from Dutch tulips to US subprime mortgages.
Protecting against a crisis will always rely on the judgment, courage, and wisdom of those in charge. It is why changes to leadership, regulation, and enforcement actions in what were, and may once again, not be headline-grabbing financial regulators are the most important guardrails against another crisis.
Mark Zandi, chief economist at Moody’s Analytics
The financial system is on much sounder ground than it was a decade ago, prior to the financial crisis, and much less likely to suffer another crisis, at least on the same scale.
As a result of Dodd-Frank, the banking system now has much more capital — the cushion required to absorb losses the system suffers on its lending. The system also has much stiffer liquidity requirements and better risk management practices, including a stress-testing process that requires large financial institutions to be prepared for events similar to the financial crisis.
There is also now in place a clear process for resolving failing financial institutions that pose a threat to the entire financial system. There was no such process in place prior to the financial crisis, and policymakers resolved each failing institution, from Bear Stearns and Lehman Brothers to Fannie Mae and Freddie Mac, differently. This spooked investors in these institutions, causing them to run for the proverbial doors, precipitating the crisis.
The Federal Reserve and other regulators are willing and able to use so-called “macroprudential” tools to address problems that are developing in the financial system. Not too long ago, for example, regulators issued guidance to banks to be more cautious in their lending on multifamily projects, as there was growing evidence of overbuilding. This is something regulators would not have done prior to the financial crisis.
The CFPB is now looking out for consumer and mortgage lending practices. When combined with new rules making it more difficult to extend loans to households that can’t financially support them — the qualified mortgage rule is a good example — it is now more difficult to make bad consumer lending decisions.
To be sure, despite all these efforts and others, there will still be missteps by the financial system, and even crises. There are already problems brewing in so-called leveraged lending to non-financial businesses. These highly indebted companies will likely navigate the next recession, and the resulting bankruptcies and losses will stress the economy and financial system. Regulators appear to be on increasing alert to this problem, and may utilize macroprudential steps to address it. The sooner, the better.
More broadly, by requiring banks to hold more capital and be more liquid, risk-taking is shifting to the less regulated and more opaque part of the financial system known as the “shadow system.” The next financial event or crisis will likely emanate from here.
The financial system is in a much better place than it was 10 years ago, and the next crisis appears a long way off, but regulators will need to be vigilant as the nightmare of the financial crisis fades and risk-taking increases.
Richard Sylla, financial historian at New York University’s Stern School of Business
In a word, no.
In two years, we mark the 300th anniversary of the connected Mississippi bubble in France and South Sea bubble in England, perhaps the first great international financial crisis. From then to now, there have been a great number of similar crises.
In response to the 2007–2009 crisis, we have not done a lot to prevent excessive credit and debt creation — the common feature of nearly all financial crises. And even what we did, such as the Dodd-Frank reforms, is now being watered down.
That’s another feature of financial history, i.e., taking tough measures in the wake of a crisis and then watering them down over time. What’s different this time is that the watering-down began almost immediately instead of waiting a bit. That makes me think that we will not again have to wait half a century or more before the next large-scale financial crisis arrives.
Kathryn Judge, law professor at Columbia University
Despite a decade of reform, we still do not have the guardrails needed to ensure a healthy and resilient financial system. Banks today are stronger than they were in 2008, and there have been meaningful steps taken to prevent a precise replay of the last crisis. But the next crisis will inevitably look different than the last, and the structural deficiencies revealed in the last crisis have not gone away.
One core challenge is an excessively fragmented regulatory structure. The United States still has three federal bank regulators (the FDIC, OCC, and Federal Reserve) and two federal market regulators (the SEC and CFTC), in addition to a host of other state and federal financial regulators. These regulators sometimes compete when they need to cooperate, and they are limited in the information that they share with one another. No regulator has responsibility for understanding, much less addressing, the health of the financial system as a whole.
Dodd-Frank attempted to mitigate these challenges by requiring the heads of the major financial regulators to also serve as members of the Financial Stability Oversight Council (FSOC). But the FSOC’s powers are limited, and the agency heads remain far more concerned with furthering their individual missions than addressing systemic risk.
A second core challenge is complexity. Financial institutions, instruments, and market structures are increasingly complex and interconnected. The largest banking organizations continue to consist of hundreds, and sometimes thousands, of separate legal entities. New financial instruments with untested features are popping up daily and often trading in ever-changing market structures. As we learned the hard way with securitization, even useful financial innovations can pose unforeseen hazards. The rise of fintech only accentuates the rate of change and possibility of disruption. Post-crisis reforms have reduced the complexity of layering of securitization structures, but they have not halted the trend toward increasing complexity and the massive information gaps it creates.
The combination of a complex and constantly evolving financial system with a fragmented regulatory structure was at the core of the last crisis. These challenges remain, and could well lead to another crisis sooner than anyone would like.
Gregg Gelzinis, research associate for economic policy at the Center for American Progress
Reforms put in place following the financial crisis have improved the resiliency of the financial system. Big banks fund themselves with more shareholder capital and less debt than they did in 2008, enhancing their ability to sustain losses and avoid failure. They also rely on more stable forms of funding, face annual stress-testing, and file “living wills” with regulators to plan for their orderly failure. The previously unregulated derivatives market has been taken out of the shadows, regulators now have the authority to subject nonbank financial companies like Lehman Brothers to enhanced oversight, and consumers finally have a cop on the beat to police abuses in the financial marketplace.
These improvements have put our financial system on a more stable footing. But far more needs to be done to ensure that we protect workers, families, and savers from the economic devastation of another financial crisis.
Despite some improvement, the largest banks in the country still fund themselves with far too much debt and too little shareholder capital. Increasing the size of these loss-absorbing buffers would further limit the chances of a financial crisis and improve the outlook for long-term, sustainable economic growth.
Policymakers have also failed to meaningfully reform short-term funding markets that serve as a key source of funding for the shadow banking sector. The risk of destabilizing runs on these markets, similar to bank runs prior to deposit insurance, still poses a threat to the broader financial system.
Finally, the endless list of post-crisis scandals shows that policymakers have not adequately addressed Wall Street’s broken culture. Policymakers should advance rules that rein in excess risk-taking, misconduct, and conflicts of interest that still permeate Wall Street and that undermine trust in the financial system.
Diego Zuluaga, policy analyst at the Cato Institute’s Center for Monetary and Financial Alternatives
Using the term “guardrails” can be deceptive, because it implies more knowledge about the source of the next financial crisis than experience teaches us we can presume to have. But there is reason to believe that some of the causes of the 2008 meltdown remain unaddressed.
The crisis originated in the US mortgage market, where it had been long-standing government practice to encourage lending to risky borrowers on attractive terms. These loans were guaranteed by Fannie Mae and Freddie Mac. It was their government backing that caused much of the excessive risk-taking by banks.
Yet, a decade later, the GSEs like Fannie and Freddie hold more than 60 percent of US mortgage debt and are responsible for 97 percent of mortgage securitizations, the instruments whose mispricing caused so much pain 10 years ago. Indeed, America remains an outlier in the degree of control that the government exercises over the mortgage market.
Banks are in a better position to withstand shocks today than they were in 2008. Average bank capital as a share of assets, a key measure of resiliency, is around 10 percent. This compares to 7.5 percent at the dawn of the crash, and as low as 3 percent in the case of the failed Lehman Brothers. There is also greater awareness among regulators of the unreliability of complex models to appraise bank safety and soundness. Still, the Federal Reserve has 24 different capital measures, which it is now reducing to 14, to assess the health of banks. Supervision, therefore, is hardly more transparent than it was 10 years ago.
More significantly, taxpayers continue to be exposed through deposit insurance, guarantees on mortgage and student loans, and the government responsibility to resolve failed institutions. Such implicit underwriting of private risks encourages irresponsible behavior as much as it did a decade ago.
