Enhanced supervision: a new regime for regulating large, complex financial institutions

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Enhanced supervision: a new regime for regulating large, complex financial institutions

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Chairman Brown, Ranking Member Corker, and Members of the Committee, thank you for the opportunity to testify on the new regime for regulating large, complex financial institutions. I am a professor at the University of Maryland’s School of Public Policy and a faculty affiliate of the Center for Financial Policy at the Robert H. Smith School of Business at the University of Maryland. I am also a visiting scholar at the American Enterprise Institute and a senior fellow with the Milken Institute’s Center for Financial Market Understanding. I was previously Assistant Secretary for Economic Policy at the Treasury Department from December 2006 to January 2009.

Failures in the regulation of large complex financial institutions played an important role in the financial crisis. Many large American financial firms required substantial assistance from the federal government, including capital injections and asset guarantees through the TARP and access to a range of liquidity facilities from the Federal Reserve. At the same time, the main problems in subprime housing that gave rise to the crisis arose outside the most heavily regulated parts of the financial system among non-bank mortgage originators, Fannie Mae and Freddie Mac, and participants in the so-called shadow banking system.

Indeed, a broad view of the crisis shows failures by market participants at all levels of the financial system: sophisticated asset managers who bought sub-prime mortgage-backed securities (MBS) without understanding what was inside or demanding more information; securitizers who put those faulty securities together; rating agencies that stamped them as AAA; bond insurers who covered them; originators who made the bad loans in the first place; mortgage brokers who facilitated the process; and so on, including crucial deficiencies at the Government-Sponsored Enterprises (GSEs) of Fannie Mae and Freddie Mac. (Unfortunately one must also add to the list of failures the actions of some home buyers in providing inaccurate information on mortgage applications or in signing on the dotted line for a house they could not afford—though of course there was someone on the other side of each of these transactions willing to extend the loan.)

Moreover, the severe credit strains that ensued following the failure of Lehman Brothers in September 2008 were made considerably worse by problems in money market mutual funds—large, to be sure, but hardly a complex type of financial institution. The new regulatory regime for large, complex financial institutions is a vital part of lessening the likelihood of future crises, but it is important to keep in mind that there were many contributors to recent events beyond these firms and that an undue focus on this one element risks missing out on others.

Getting the right balance between financial market regulation and dynamism, including the possibility of failure and creative destruction, is an essential element of fostering a more robust economic recovery 2 and a strong U.S. economy into the future. The slow recovery from the recent recession reflects many factors, including the drag on demand from deleveraging by consumers and firms, the negative impact of policy and regulatory decisions, and the overhang of uncertainty about future taxes, health and energy costs, and so on. But drag from the financial system is likely playing a role as well, with many families and businesses still finding constrained access to credit. While loans were too readily available before the crisis, a danger today is that the pendulum has swung too far in the other direction. The caution of market participants in putting capital at risk could be exacerbated by uncertainty over the impact of ongoing financial regulatory changes. This uncertainty will weigh on the financial sector
and the economy.

Philip Swagel is a visiting scholar at AEI

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