How the Next Financial Crisis Will Happen
By Stephen A. Schwarzman
June 9, 2015 7:15 p.m. ET
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Photo: Getty Images After the financial crisis, a focus on safety and soundness was good medicine for the financial system. New bank liquidity and capital policies, among other initiatives, strengthened a debilitated patient. The banking system is now stronger, with more liquid assets and better underwriting standards.
Despite good intentions, however, politicians and regulators constructed an expansive and untested regulatory framework that will have unintended consequences for liquidity in our financial system. Taken together, these regulatory changes may well fuel the next financial crisis as well as slow U.S. economic growth.
The Volcker Rule, for example, bans proprietary trading by banks. The prohibition, when combined with enhanced capital and liquidity requirements, has led banks to avoid some market-making functions in certain key equity and debt markets. This has reduced liquidity in the trading markets, especially for debt. A warning flashed last October in the U.S. Treasury market with huge intraday moves, unrelated to external events. Deutsche Bank has reported that dealer inventories of corporate bonds are down 90% since 2001, despite outstanding corporate bonds almost doubling.
A liquidity drought can exacerbate, or even trigger, the next financial crisis. Sellers will offer securities, but there will be no buyers. Prices will drop sharply, causing large losses for investors, pension funds and financial institutions. Additional fire sales will aggravate the decline.
Why should we care? Because new capital, liquidity and trading rules are interrelated, and locked-up markets and rapidly falling securities prices will force banks to reduce assets and hoard liquidity in order to satisfy applicable regulatory tests. With individuals suffering losses and companies not able to raise capital, the economy will contract with layoffs, lower tax revenues and pain for middle- and lower-income Americans.
Small business owners will be particularly vulnerable because the number of community banks declined by 41% between 2007 and 2013. Recent studies by economists at the Richmond Federal Reserveand Harvard University both concluded that the 2010 Dodd-Frank financial law contributed to this decline. Dodd-Frank has disproportionately burdened community banks, despite their having no role in the financial crisis. We must revisit Dodd-Frank’s application to community banks because of their special relationship with borrowers in agriculture, small business and local real estate.
More generally, banks will not satisfy customers’ needs in a financial crisis as they have in the past. While many banks actively lent in 2008, the new capital requirements will cause banks to hoard capital with an eye toward satisfying the regulators, rather than meeting the needs of their customers.
The largest banks’ need to preserve capital will be intensified because of rules requiring them to revalue assets as they become riskier as well as decreasing their capital from unrealized securities losses. With respect to liquidity requirements, even if banks believed that regulators wanted them to drop below mandated levels, they will not want to lend because dipping below specified liquidity requirements would signal financial vulnerability to clients, investors and industry analysts.
If banks reduce their lending, customers will have little prospect of finding other funding in a declining market. While certain nonbank financial institutions would be a potential source of credit in a downturn, their overall lending capacity would not be sufficient to cover the shortfall. Indeed, corporate America’s fear that credit will not be available in times of financial distress has led many larger companies to retain unprecedented levels of cash. While certain companies have the scale and cash flow to be their own bankers, small and medium-size businesses, and the less sophisticated, do not have this luxury.
Indifference to the need for liquidity in a crisis has reached such a state that some legislators have proposed further limiting the Federal Reserve’s emergency lending powers. In a financial crisis, only the Fed, as the lender of last resort, might stand between our economy and financial catastrophe. We must leave the Fed with the flexibility to provide liquidity in order to stop a financial panic. While moral hazard is a legitimate risk, limiting the Fed’s ability to enhance systemic safety is, as former Fed Chairman Ben Bernanke has said, like shutting down the fire department to encourage fire safety.
Given the rapid expansion of bank regulation and growing liquidity concerns, regulators need to revisit whether they have overshot the mark. They need to assess the costs of liquidity regulation and take into account the perspective of consumers, businesses and other stakeholders who will depend upon access to the banking system in a crisis. This reassessment should explore countercyclical liquidity and capital strategies that encourage banks to support their customers in a crisis.
It is five years since Dodd-Frank became law, and time for a fresh look at its impact. We need a holistic regulatory review of the cumulative effect of postcrisis capital, liquidity and trading rules on the availability of credit and liquidity. Any review needs to be transparent, coordinated domestically and internationally and proactively engage a broad base of regulators, industry leaders, economists and consumers.
No one is looking to jettison the benefits of stronger capital and liquidity requirements. We just need to be careful that we don’t create bankers who, in words attributed to Mark Twain, take their lent umbrella back the minute it begins to rain.
Mr. Schwarzman is chairman, CEO and co-founder of Blackstone.
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