ABSTRACT
If credit and leverage matter in bubbles, they played major roles in the most recent bubble which popped in the Panic of 2007-2008. Financial institution credit and leverage fueled the real estate and securities bubbles in the United States and Europe. These factors also made the crashes in both continents more severe and the ensuing financial crises more destructive, economically and socially. Following historical pattern, these latest debt bubbles proved far more dangerous than equity bubbles, not least because they became intertwined with a banking boom, bust, and crisis. This book has thus far largely skirted the current financial crisis. However, just as they played crucial roles in three centuries of bubbles, the dynamics outlined earlier in this book that destabilized financial regulation reappeared in spades as the current crisis brewed. Moreover, these dynamics – the regulatory stimulus cycle, compliance rot, regulatory arbitrage frenzies, and herd-promoting and procyclical regulations – worked to supercharge the lending and leverage of U.S. and European financial institutions. Regulatory stimulus and regulatory arbitrage came together to incubate massive real estate and capital markets bubbles in the United States and Europe. As the bubbles inflated, they, in turn, promoted more regulatory stimulus and arbitrage, as market participants sought both changes in legal rules and to use novel financial instruments to skirt those rules that endured. At the same time, regulation promoted herding by financial institutions into real estate and certain related capital markets and classes of financial instruments. The metastasizing growth of these markets and instruments fueled real estate and security prices. As the real estate and capital market bubbles inflated further, they promoted more herd behavior, as well as outbreaks of fraud and law-breaking. The story of how regulatory change sowed the seeds for these bubbles thus presents a master class in the Regulatory Instability Hypothesis. Indeed, the Regulatory Instability Hypothesis provides a unique lens through which to view the origins of the Panic of 2007-2008. This lens focuses attention on regulatory stimulus, compliance rot, regulatory arbitrage, and herding, not as abstract or disconnected phenomena. Rather, these dynamics had their most farreaching effects by midwifing the birth and suckling the growth of an alternative channel of credit in the economy called the shadow banking system. This system
formed from the fusion of disparate markets for financial instruments, each of which emerged in the last decades. These instruments include asset-backed securities, asset-backed commercial paper, money market mutual funds, credit derivatives, and repos. These separate markets later ultimately fused together to form an intricate system that connected borrowers to investors in capital markets. This system funneled credit to consumers and businesses and transferred and spread credit risk to investors. This system did not grow, however, in a vacuum, merely to meet the economic needs of borrowers and investors. Rather, it formed as a bypass around depository banking; it developed in the shadow of that heavily regulated traditional financial sector. Banking law and other financial regulation functioned as the dark matter that exerted a hidden gravitational pull on shadow banking markets. Regulation and the impulse to evade regulations gave the shadow banking system its contours. Moreover, the urge to use regulatory subsidies and lower regulatory taxes formed part of the system’s molecular structure, its DNA, and, to a large extent, its very reason for existence. The individual constituent parts of the shadow banking system developed and flourished because of deregulation, the creation of regulatory preferences, and regulatory arbitrage. When these individual markets fused together, they created an alternative system for credit and investment that, by the eve of the Panic, rivaled the size of the depository banking sector. The creation of an alternative credit system is critical because, as the last chapter explained, credit pours jet fuel onto the fire of an asset price bubble. Indeed, shadow banking instruments, together, funneled massive amounts of credit into inflating real estate markets. Moreover, as the twin bubbles in real estate and shadow banking markets expanded, they promoted further regulatory arbitrage and herding, as well as regulatory stimulus and law-breaking. Indeed, scholars argue that, in the later stages of the bubble, investments in the shadow banking sector boomed because financial institutions sought to use its component instruments to engage in a saturnalia of regulatory capital arbitrage. The formation of vicious feedback loops provide a time lapse film of the dynamics described in this book. Regulatory stimulus, increasing regulatory arbitrage, deteriorating legal compliance, and regulation-fueled herding created a credit system that turbocharged financial markets and sparked a bubble. This system enabled meteoric increases in financial institution leverage, which enlarged the effective money supply in financial markets. At the same time, this leverage rendered financial institutions extremely vulnerable to a crash. The risk of a crash worsened because of the herd behavior of financial institutions, who – driven in large part by regulatory preferences and subsidies – stampeded into shadow banking markets. The herd created dangerous correlations of risk, yet masked that risk with the illusion of safety and liquidity. Unfortunately, the Federal Reserve and bank regulators paid too little heed to the creation of this shadow banking system and to its consequences – in terms of both monetary impacts and systemic risk.
