Part I: Global financial resilience in a time of uncertainty

The Brookings Institution is commencing a project on risk and resilience in Asia. This project will essentially investigate how well countries such as China, Japan, Korea, and the large emerging economies of Southeast Asia are set up to prevent or respond to an economic or financial crisis. We are looking to engage with policymakers and experts in the region to come up with practical policy recommendations that could increase economic security.

This first of four blogs ponders the question: Are we all safe yet? This is a variant of the question asked by former U.S. Treasury Secretary Timothy Geithner in a recent Foreign Affairs article.

Geithner asks what is the underlying fragility of the U.S. system today or how “dry is the tinder?” What is our ability to limit the intensity of any crisis especially via macroeconomic responses? How adequate are our emergency response mechanisms to prevent a crisis from spinning out of control?

These also seem the right three questions to organize thinking on Asia and the global economy, and I will explore preliminary perspectives on each question in subsequent blogs over the coming weeks. Let me start though with the U.S. given its essential role in the global system. This is timely given moves in the U.S. to roll back or curtail aspects of the Dodd-Frank Wall Street Reform and Consumer Protection Action, a sweeping piece of regulation ushered in by the Obama administration in 2010 in the wake of the 2008 financial crisis.

How risky is the U.S. financial system?

Geithner’s analysis of the current risks in the U.S. financial system is sober but not alarmist. He correctly notes that financial regulation has materially improved the capital and liquidity buffers in the U.S. system as a whole and expanded the supervisory perimeter to include most major institutions. He emphasizes the inherent risks in the maturity transformation at the heart of modern finance – that is the practice whereby financial institutions borrow money on shorter timeframes than when they lend money out, that leaves banks and other institutions vulnerable to ‘runs’ on deposits. As financial sector experts are acutely aware, we can never know risks to the financial system with any certainty. Hence the need to assess system preparedness to respond to shocks.

Liquidity risks appear to have risen in some U.S. financial markets. Some asset prices appear extended; in part, a result of the extended low interest rates that have been part of the macroeconomic response in the U.S. Non-bank financial activity is growing, in part in response to stronger regulation. However, strong memory of the 2008 crisis is probably placing some curb on the risk appetite of many players, assisted by the more intense prudential and macroprudential regulation brought forth by the crisis. As a result, the U.S. financial system risks did not figure prominently in the most recent International Monetary Fund’s survey of global financial risks. And the signs of strengthening demand and some welcome price pressures may reduce financial risks in the short term. The real risks in the U.S. will come in a time of prosperity and the seemingly inevitable complacency that sets in with investors and regulators.

Nevertheless, and this is a point underplayed by Geithner, there are near-term risks to the domestic U.S. financial system emanating from outside the U.S., adding urgency to his overall arguments for focusing on resilience in U.S. policy settings.

How available are U.S. macroeconomic policy tools in a crisis?

Beyond regulation, the larger risk at present is the limited firepower of macroeconomic policy to respond to any near-term shocks. Interest rates are still very low, and even with recent signs that they will soon rise, low long-term interest rates suggest that monetary policy will have less leeway in future to respond to shocks.

This suggests that more of the burden of response needs to be carried by fiscal policy in the event of a future shock. Yet fiscal policy is constrained on both economic and political grounds. Nevertheless, fiscal policy tools would need to be deployed earlier in a shock to support demand and soften the economic and financial disruption. This course would pose fewer risks if fiscal policy were on a sounder long-term footing. Indeed, forging such a pathway or framework is an important component of overall crisis readiness.

Pro-growth structural or productivity reforms could also help economic resilience, for example, by improving macroeconomic “speed limits” and fiscal sustainability.

Are ‘emergency powers’ sufficient?

Limited macroeconomic firepower would suggest even more focus than usual on the effectiveness of financial regulation in preventing or limiting the severity of crises. In particular, this suggests ongoing importance for higher capital and liquidity provisioning, intensive supervision of crisis risks and preparedness (stress tests and the like), and retaining a wider regulatory perimeter (encompassing more activity in the non-bank sector and more system‑wide monitoring), to make the system safer. One hopes that any “roll back” avoids watering down these important gains.

Geithner’s top priorities for reform to further increase the safety of the system go against the grain of most critics, right and left. They involve increasing the discretion of regulators to deal with systemic crisis events, though within clear accountability frameworks. In particular, he advocates increased flexibility, over that allowed for in Dodd-Frank, to lend to institutions in an emerging crisis, and to use judgment in imposing losses on creditors in a failing institution (bailing-in) in a situation where this could set off a chain of dominoes in the system.

Geithner’s analysis, though, gives scope to reform aspects of financial regulation while at least not further harming core crisis prevention goals. He says nothing (deliberately I suspect) of the Volker rule, which he has argued cogently elsewhere has less connection with the fragilities uncovered by the crisis. The extensive provisions covering conduct and other aspects of the finance industry’s operations involve policy tradeoffs which, while important, may not centrally affect the crisis mitigation goals of regulation. Not all reform of Dodd Frank is therefore synonymous with a return to crisis risk.

But the threat of roll back of central pillars of crisis resilience such as capital and liquidity buffers is real. If such a course were chosen, the answer to the question “are we safe yet?” would be a resounding no, for the U.S. and global economies. Indeed, when the other macroeconomic vulnerabilities are added, the U.S. economy would  be decidedly unsafe, and prone to even a relatively small shock having outsized consequences.

Geithner comments, “Financial crises cannot be forecast. They happen because of inevitable failures of imagination and memory.” It would be a great pity if a defective collective memory led to an increase in systemic risk in the U.S. regulatory system—with possible international implications—so soon after the crisis.

The next parts in this series will look at how the global economy stacks up against the organizing questions outlined above, to provide some initial perspectives on the question ‘are we all safe yet?’