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Are we prepared for the next financial shock?

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Measures taken to strengthen the global financial system after the 2008 financial crisis have been effective, but they may be opening up new vulnerabilities, research from MIT Sloan shows.

“We’ve made substantial progress in devising tools and regulations to build up capital cushions, support the credit supply, and boost liquidity,” says MIT Sloan professor of management Kristin Forbes in a paper to be published in the American Economic Review. “But many risks remain.”

Forbes cautions, “It’s not yet clear that these tools can live up to their promise of reducing systemic financial weaknesses and preventing a future shock — from wherever it emerges — from becoming another costly crisis.”

One of the causes of the 2008 crisis was an insufficient understanding of macroprudential risks — that is, vulnerabilities in the wider financial system by which shocks can spread and become amplified. Before the crisis, most countries relied on central banks for price stability and microprudential regulators for the security of individual banks. The subsequent collapse of the financial system underscored the inherent problems with that approach, Forbes writes.

In the aftermath of the meltdown, most countries established some type of macroprudential authority and adopted new policies and tools, including regulations designed to fortify bank balance sheets and support financial institutions. “These rules have made banks safer, but risks are still there — in some cases they’ve just migrated to other sectors,” says Forbes.

The non-bank institutions that make up the “shadow” financial system — including hedge funds, pension funds, insurance companies, securitization vehicles, money market funds, and mortgage funds — are typically outside the regulatory perimeter or subject to oversight by less-powerful bodies, which means they could wind up being a source of broader financial vulnerabilities, she writes.

Calibration matters

Another issue, says Forbes, is how financial authorities calibrate new regulations. Very tight regulations often significantly reduce risks, but they could also harm economic growth. “Tighter regulations usually entail immediate costs — such as reducing a person’s access to credit to buy a home or start a company. Meanwhile, the benefits of tightening may not appear for years — or may be impossible to measure,” she says. “As a result, figuring out the right level of tightening is a politically tricky endeavor.”

More academic research is needed on macroprudential regulations, Forbes argues. In particular, the research ought to focus on better understanding how risks have shifted as investors and institutions find ways around the tighter regulations, as well as creative thinking about future risks.

“Macroprudential regulations today prioritize addressing the vulnerabilities behind the 2008 crisis. This makes sense, and there have been important steps forward,” she says. “But we simply don’t know whether changes in the global financial system — including those aimed at building bank resilience — are sowing the seeds of the next crisis.”

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