Sharyn O’Halloran is a professor of political economics and an administrator at Columbia University, where Thomas Groll is a lecturer. The two are editors of this collection of papers by academics, banking industry executives, and government officials on financial regulation in the wake of the 2008 financial crisis. “We hope,” the editors say, “the chapters shed light on how to think about the risky business that was the financial crisis, how ad hoc policy responses came about often in the depths of uncertainty and surrounded by controversy about effectiveness and fairness, and how we can do better in the future to manage risk and prevent crises that affect so many.”

Toxic securities / In the first chapter, O’Halloran, Groll, and Geraldine McCallister describe the events leading up to the Great Recession. Let me quote at length their view of the causes:

Exorbitant risk-taking by financial institutions inadequately overseen by regulators triggered the financial crisis. The housing market’s boom and bust underscores these lessons: permissive regulations allowed banks to offer mortgages with small down payments to buyers who had insufficient income to afford them. Compensation practices at financial firms rewarded volume and short-term performance over long-term sustainable returns. And credit rating agencies, laden with conflicts of interest, gave investment-grade ratings to subprime mortgages made [sic] them willing to designate tranches of subprime mortgages as investments-grade assets in exchange for a fee. As the housing bubble burst and prices declined, the underlying value of the mortgages that secured these assets fell into default. The subsequent mortgage crisis led to a liquidity crunch brought on by inadequate price discovery of asset valuations and uncertainty about credit risk. These highly leveraged mortgage-backed securities, assigned triple‑A ratings by credit agencies and with scant regulatory oversight, were exactly the funds that drove Bear Stearns into insolvency.

They blame both the market and government. Former House Financial Services Committee chair Barney Frank discusses “permissive regulations” in a later chapter. He argues that the market is mostly to blame because securitization and financial derivatives were inadequately regulated. He attempted to change the regulations before house prices crashed, but political opposition stopped him. According to Frank, “the reason for the flood of mortgages destined for foreclosure, the single biggest cause of the crash, was the self-interest of lenders in maximizing their profits.” If someone asked Frank why self-interest in other industries does not cause the economy to crash, I suppose he would say that lenders maximizing their profits plus financial innovation and inadequate regulations made the financial sector different.

Loans with low or no down payments were a problem. O’Halloran, Groll, and McCallister do not explain why banks abandoned the traditional practice of a 20% down payment. Russell Roberts, in his 2019 book Gambling with Other People’s Money, offers this: “With the encouragement of politicians from both parties, Fannie and Freddie relaxed their underwriting standards, the requirements they placed on originators before they would buy a loan.” That explanation is appealing. Banks would not make loans to borrowers who were poor credit risks without being able to sell the loans. If politicians permitted Fannie and Freddie to buy the loans, banks could be confident of selling them.

Frank minimizes the role of Fannie and Freddie in causing the crisis: they “did succumb to the fever and began outsourcing loans that should never have been made,” he admits, “but not until years after private entities had created the securitization pipeline.” He adds that “those of us on the proregulatory side” “took the lead in restructuring Fannie Mae and Freddie Mac to diminish the possibility of their becoming a drain on the federal budget, and we worked to preserve their role in providing backup housing finance for credit-worthy borrowers.” Taxpayers can appreciate the effort to protect them from the mistakes of Fannie and Freddie, but that effort was unsuccessful. The Federal Housing Finance Agency put the two government-sponsored enterprises under conservatorship in 2008 and they remain there today.

O’Halloran, Groll, and McCallister cite the role of compensation. In a later chapter, John Coffee elaborates:

Suppose a bank realizes that securitizations have become toxic and the mortgages it has assembled into portfolios are likely to default. Should it halt their sale? If senior bank officials handling these deals stand to make bonuses of $10 to $20 million when these deals close this year, those officers will push back hard at any such suggestion.

Investment bankers had more incentive to sell toxic securities than incentive to refrain. Incentives indirectly explain why there were buyers.

O’Halloran, Groll, and McCallister mention the “conflicts of interest” that weakened the judgment of bond rating agencies. They refer to the practice, encouraged by the Securities and Exchange Commission, in which sellers of bonds pay the rating agencies to rate the bonds. Rating agencies had more incentive to assign inaccurate high ratings to please the investment banks paying them than they had to assign accurate low ratings in the interest of the bond buyers.

To complete their summary of the cause of the financial crisis, O’Halloran, Groll, and McAllister describe the domino effect of falling house prices, defaults on mortgages, falling prices of mortgage-backed securities (MBS), and a liquidity crisis. Money market funds played a significant role in the liquidity crisis. One fund, the Reserve Primary Fund, had Lehman Brothers bonds on its balance sheet. Reserve Primary’s net asset value dipped below $1 per share, which prompted runs on it and other money market funds. Contributors Viktoria Baklanova and Joseph Tanega spell out the macroeconomic effect: “The run on these funds contributed to strains in the U.S. dollar short-term funding markets and led to a systemwide liquidity freeze.” The liquidity crisis became a credit crunch. O’Halloran, Groll, and McAllister report that “lending to large U.S. corporate borrowers” decreased by about 50% from the third quarter of 2008 to the fourth quarter. That substantial decrease in financing explains the simultaneous plunge in the private investment component of gross domestic product.

Regulatory reform / Contributors to After the Crash chronicle the history of government interventions in reaction to the financial crisis of 2008. Among the more familiar interventions were the acquisition of Bear Stearns by JPMorgan that was arranged by the Federal Reserve and Treasury, trillions of dollars of lending and open market purchases by the Fed, and bailouts of AIG, Citigroup, and the automakers. Among the less familiar is the Fed’s backstopping of money market mutual funds through loans. Coffee states: “The largest bailout commitment in 2008 was the government’s guarantee of money market funds.”

The authors devote more thinking to regulatory reform. This begins with setting goals. Take the chief goal to be financial stability. In his chapter, Glenn Hubbard puts it this way: “Regulation should reduce systemic risk,” which he defines as “the risk of collapse of an entire system or entire market.” He focuses on bank capital regulations and procedures for dealing with financial intermediaries near bankruptcy. He criticizes calls for simply requiring banks to increase their capital-to-asset ratios, arguing that selling more shares imposes costs on banks in terms of what they must give up to attract investors, as well as a “social cost” in terms of fewer bank loans.

Those are valid points, though I doubt that proponents of increasing capital requirements believe it is the “free lunch” he suggests they claim. As for reduced lending, if the result is fewer bad loans, that would be a good outcome. Hubbard endorses the efficacy of “contingent capital” such as bonds that become equity if bank capital decreases. Converting bonds into equity when asset values fall may prevent bank failure. Also, he approves of dealing with any type of financial intermediary near insolvency the way the Federal Deposit Insurance Act does: “It creates a flexible insolvency regime that provides for preresolution action, receivership and conservatorship, … liquidation, open bank assistance, purchase and assumption transactions, and the establishment of bridge banks.”

In his chapter, former treasury secretary Jack Lew defends the Dodd–Frank Act’s resolution process in the Orderly Liquidation Authority (OLA). The OLA does not, he maintains, perpetuate a policy of too big to fail.

Although it sounds sensible to insist that the benefits of a financial regulation exceed the costs, Jeffrey Gordon criticizes benefit–cost analysis. In his chapter, he tells of how a change in the Bankruptcy Abuse Protection and Consumer Protection Act of 2005 created a systemic risk. The change enabled MBS to be used as collateral in repo transactions. Gordon describes the Congressional Budget Office’s benefit–cost analysis as follows: “The benefits of greater systemic stability were assumed; the quantified assessment of costs focused on record keeping.” The change increased the demand for MBS, which fueled the house price bubble. When the bubble burst, a shortage of collateral in the repo market exacerbated the credit crunch. Instead of static benefit–cost analysis, Gordon recommends dynamic precaution “to observe the system as it evolves, and to observe the effects of new rules on the system as a whole.” That, according to him, is what the Financial Stability Oversight Council (FSOC) does.

Paul Tucker, chair of the Systemic Risk Council, explains “rules versus standards” in the regulation of banks. His example of a rule is that a bank’s capital-to-asset ratio should be a given percentage. His example of a standard is that bank managers should “manage their affairs prudently and maintain capital adequate to remain safe and sound.” Rules foster “predictability and generality.” For example, if the rule is to have a minimum capital-to-asset ratio of 10%, bankers know they can sell $1 billion of shares, borrow $9 billion, and buy $10 billion of assets. They know the competition can do that too.

The problem with standards is imprecision. How much capital is enough “to remain safe and sound”? Rules are clear, but they cause “regulatory arbitrage.” The simple rule of a minimum 10% capital ratio leaves a bank free to invest in the riskiest assets. Shadow banking is regulatory arbitrage as well. The advantage of a standard relates to the way in which a bank can comply with a rule yet promote systemic risk. Tucker puts it this way: “standards (or a rule for an objective) are preferred by those who regard the state of economic knowledge as insufficient for society to harness itself to a detailed rule book … and who place weight on the avoidance strategies likely to be adopted by regulated industries.” If one thinks of rules and standards more as complements than substitutes, effective bank regulation means enforcing rules using judgment guided by standards of financial stability.

Several contributors attest that more bank capital, resolution planning, and stress testing enhance the “resilience” of the financial system. Readers will not encounter details of measuring bank capital, specific resolution plans, or how the Fed conducts stress tests. However, readers will encounter some detailed analyses. O’Halloran and Nikolai Nowaczyk use data science to build a “systemic risk engine” that simulates the effects of regulatory changes. Baklanova and Tanega summarize the post-crisis regulations on money market funds such as liquidity requirements, disclosure of portfolio holdings, liquidity fees, and redemption gates. Mark Roe and Michael Tröge estimate that eliminating the deductibility of interest expense from corporate income would induce banks to increase their capital-to-asset ratios by 6 percentage points. Agostino Capponi explains how derivative clearinghouses work; understanding the intricacies he describes is challenging intellectual labor.

The blind side / To paraphrase Frank, the core of the Dodd–Frank Act pertains to over-the-counter swaps, subprime mortgages, bank capital, resolution of insolvent institutions, and the Consumer Financial Protection Bureau. Despite amendments to the act that increased the asset size of institutions falling under the authority of FSOC and relief for small banks, Frank insists that the core regulations are “essentially unscathed.” That, he says, is evidence of success.

Coffee’s observation that “crises always come from the blind side” proves to be prescient as COVID-19 stifles the economy. The shock of the pandemic will be the ultimate stress test on the financial system and the regulations that aim to ensure its resilience.