Lessons from a retrospective regulation of the financial crisis

In a recent article in the Journal of Economic Perspectives, three economists from the British Macroprudential Strategy and Support Division and one member of the Financial Policy committee of the Bank of England analyze whether macroprudential regulation could prevent a rerun of the last crisis (Aikman et al., 2019 1).

To address this question, they study the literature that analyzes the financial vulnerabilities that lead to the crisis or exacerbated it. Then, they propose the thought experiment to see what macroprudential regulation could have helped to prevent the crisis or, at least, minimize its effects. Finally, they analyze whether the financial stability committees that now exist in over 40 countries have the means to do what it is required in a similar crisis. Of course, the next crisis may be different and contain new unforeseen elements, but the thought experiment still can tell us if the authority of these committees have the incentives and the power to make the necessary mandatory regulations. Next, I summarize the article using excerpts from it.

People queuing outside a Northern Rock branch in Golders Green, London, on 14 September 2007, to withdraw their savings due to fallout from the subprime crisis. Source: Alex Gunningham / Wikimedia Commons

Financial vulnerabilities in the US that lead to the 2008 crisis

Non-banks became an increasingly important source of credit for the real economy in the years preceding the crisis: between 2001 and 2007, non-bank financials accounted for over 70 percent of the total growth in home mortgage credit. This growth was accompanied by an increased reliance on debt financing of the non-bank system. Short-term borrowing became more important, with the belief that it could be rolled over continually.

As a second source of vulnerability, the years running up to the Great Recession saw an unprecedented surge in US household debt. That boom was accompanied and reinforced by soaring property prices. Aggressive credit supply expansion, compounded by financial innovation, provided the undercurrent for an unsustainable cycle. Household balance sheets became increasingly vulnerable to a shock as more credit was extended to highly indebted households.

Drawing from studies that identify the impact of the credit crunch on firms and consumers behavior, the authors estimate that the two factors identified above account for around two-thirds to three-quarters of the fall in the US GDP that followed the financial crisis.

What could a macroprudential regulator have done to address the build-up in these vulnerabilities?

Identifying the debt build-up in the household sector was relatively straightforward, and it was done as early as 2004 by the Bank of International Settlements (Borio and White, 2004, 2), and by the IMF (2005) 3. The house price bubble was also observed well ahead of the crisis. However, the extent to which the build-up in debt was being concentrated at riskier, heavily indebted borrowers was not being adequately picked up (Eichner et al., 2013) 4. It is striking that the word “subprime” was mentioned 314 times in the FOMC’s 2007 transcripts, but only 27 times in all the transcripts from 2000 to 2006. To reveal the full extent of the vulnerabilities that existed, stress tests would have had to cover the entire financial system: broker-dealers; commercial paper, repo, and derivative markets; specialized investment vehicles (SIVs); and other conduits. Building a complete map of funding interconnections between these markets and entities is challenging even today.

Among the actions to reduce leverage, the authorities may require that the banks increase the capital buffer. The authors estimate that a buffer of 4.7 percent would have ensured that banks would have had sufficient capital to avoid most of the problems. Nonbank financial institutions are not subject to these requirements. Thus, a macroprudential authority would have need to include these firms in the regulatory regime. In addition, they also estimate that a requirement to replace $1.5 trillion of short-term funding with longer-term debt would have reduced liquidity outflows in the crisis in a way that would have avoided a need for extraordinary central bank liquidity facilities.

Higher capital and liquidity requirements might also reduce household debt growth and house prices by increasing the cost of credit for borrowers. However, the impact of implementing such measures in a boom may be small (Bahaj et al., 2016 5). Thus, a macroprudential regulator determined to reduce a rapid build-up in household debt might wish to take additional actions, like loan-to-income limits and affordability criteria on new mortgages. A simple exercise by the authors shows that loans limited to four times annual income applied from 2003 to 2007 would have directly affected 10 percent of the mortgages. The economic impact is harder to calculate, especially, if the policy would have been well designed to account for second mortgages, refinancing, and induced change in consumers’ actions. Additional measures to exclude high risk borrowers and subprime loans should have taken along with the loan-to-income limits. According to the authors, all these measures would have meant an important reduction on the mortgage debt stock, especially on the riskier part.

The macroeconomic benefit of any limits would incorporate the fact that they would have targeted the most highly indebted borrowers. Several studies show a correlation between pre-crisis household leverage and subsequent negative consumption responses. Although these studies do not demonstrate causality, they suggest that limiting leverage of the most highly indebted households could have a stronger aggregate effect on spending in a downturn than reducing debt uniformly across households.

Could the macroprudential frameworks set up since the crisis implement such policies?

Out of 58 surveyed countries that created macroprudential frameworks since the crisis, 41 have set up multi-agency financial stability committees, and only 11 of these have the formal powers needed to have direct control over macroprudential policies or the right to issue “comply or explain” recommendations to which other authorities are formally obliged to respond. The remaining cases rely on the voluntary cooperation of other regulators to achieve their policy aims.

On one extreme they find the US Financial Stability Oversight Council, whose only binding tool is the power to designate nonbank financial institutions for enhanced supervision. The Council’s track record to date supports a pessimistic assessment about its capacity to implement policies. In several occasions its recommendations were rejected by the primary regulator or the government.

On the other extreme, the UK Financial Policy Committee is the most muscular macroprudential regulator in the world. It unilaterally sets the countercyclical capital buffer for all banks, building societies, and large investment firms operating in the United Kingdom, along with a countercyclical leverage buffer for large banks. In the past, it has made 18 recommendations to other regulators, all of which have been implemented. If confronted by a rerun of the events leading to the financial crisis, the Financial Policy Committee would have the direct power to increase the resilience of the banking system by raising capital requirements via the countercyclical capital buffer rate, sectoral capital requirements, and countercyclical leverage buffers. While it does not have powers to direct changes in banks’ liquidity or funding requirements, it could issue comply-or-explain recommendations to the macroprudential regulator to implement such changes. It seems plausible that it could have commissioned a stress test of the largest UK banking groups and recommend changes to the regulatory perimeter to include other parts of the financial system like stand-alone broker-dealers that were not part of wider banking groups.


  1. Aikman, D.; Bridges, J.; Kashyap, A., and Siegert, C. 2019. Would Macroprudential Regulation Have Prevented the Last Crisis? Journal of Economic Perspectives 33:1, 107–130.
  2. Borio, C., and White, W.R. 2004. Whither Monetary and Financial Stability? The Implications of Evolving Policy Regimes. BIS Working Paper 147.
  3. International Monetary Fund (IMF). 2005. Global Financial Stability Report, April 2005: Market Developments and Issues.
  4. Eichner, M.J.; Kohn, D.L., and Palumbo, M. 2013. Financial Statistics for the United States and the Crisis: What Did They Get Right, What Did They Miss, and How Could They Change? In Measuring Wealth and Financial Intermediation and Their Links to the Real Economy, edited by Charles R. Hulten and Marshall B. Reinsdorf, 39–66. University of Chicago Press.
  5. Bahaj, S.; Bridges, J.; Malherbe, F., and O’Neill, C.C. 2016. What Determines How Banks Respond to Changes in Capital Requirements? Bank of England Staff Working Paper 593.

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