Rethinking Countercyclical Financial Regulation

• Publication year: 2022

Rethinking Countercyclical Financial Regulation

Jeremy C. Kress
The University Of Michigan, kressj@umich.edu

Matthew C. Turk
Indiana University, turkmat@indiana.edu

Rethinking Countercyclical Financial Regulation

Cover Page Footnote
?Assistant Professor of Business Law, University of Michigan Ross School of Business. Kress was previously an attorney in the Federal Reserve Board's Legal Division. ?Associate Professor of Business Law, Indiana University - Kelley School of Business. For helpful comments and conversations, we thank Gregg Gelzinis, Patricia McCoy, Lev Menand, Graham Steele, David Zaring, and the participants in the Wharton Financial Regulation Conference. We also thank Jake Zaslow and Wei-Chung Lin for excellent research assistance.

RETHINKING COUNTERCYCLICAL FINANCIAL REGULATION

Jeremy C. Kress^* & Matthew C. Turk^?

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The 2008 financial crisis exposed a longstanding problem in financial regulation: traditional regulatory strategies tend to be procyclical. That is, regulatory tools—most notably, bank capital requirements—incentivize excessive credit growth during economic expansions and insufficient lending during contractions. The procyclicality of U.S. financial regulation was a key driver of the housing bubble in the mid-2000s and the massive credit crunch that followed. To combat this phenomenon, Congress and the federal banking agencies attempted to mitigate procyclical boom-and-bust cycles by implementing regulatory approaches that were explicitly countercyclical. The Dodd-Frank Act and related post-crisis reforms included several countercyclical features that were designed to become stricter during periods of economic growth and more lenient during contractions, with the goal of smoothing economic cycles.

Less than a decade later, however, these countercyclical tools failed to prevent unprecedented financial stress during the COVID-19 recession. This Article is the first legal scholarship to revisit the design of countercyclical rules in light of the COVID-19 pandemic. It reveals weaknesses in Dodd-Frank's countercyclical approach and the significant costs of failing to implement an effective countercyclical strategy. The Article also establishes a blueprint for strengthening the United States' countercyclical framework going forward. The Article identifies three principles—automaticity, portfolio strategy, and market-

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wide coverage—that should guide countercyclical policymaking. It then applies these principles to five specific areas in which financial regulators should bolster countercyclical oversight: bank capital requirements, accounting standards, securitization rules, early remediation guidelines, and margin requirements. Taken together, these reforms are critical to making countercyclical financial regulation work and creating a more stable and prosperous financial system.

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Table of Contents

I. Introduction....................................................................499

II. The 2008 Crisis and the Case for Countercyclical Financial Regulation...................................................505

III. Post-Crisis Countercyclical Regulation: Lessons (Almost) Learned.........................................................513

A. COUNTERCYCLICAL CAPITAL REQUIREMENTS...........513
B. CECL ACCOUNTING STANDARD..................................520
C. RISK RETENTION RULE..............................................524
D. EARLY REMEDIATION REQUIREMENTS......................529

IV. The Covid-19 Pandemic: Relearning the Lessons of 2008.................................................................................533

A. FINANCIAL SECTOR FRAGILITIES AND THE EMERGENCY RESPONSE................................................................533

1. Government Support for the Financial System ..........................................................................534
2. Relaxation of Regulatory Requirements .......... 538

B. LESSONS FOR COUNTERCYCLICAL REGULATION........543

1. Countercyclical Regulation's Unfulfilled Promise .......................................................................... 544
2. The Costs of Inadequate Countercyclical Adjustments......................................................547

V. Making Countercyclical Financial Regulation Work ..........................................................................................552

A. PRINCIPLES FOR EFFECTIVE COUNTERCYCLICAL REGULATION............................................................553

1. Automaticity......................................................553
2. Portfolio Strategy .............................................. 555
3. Market-wide Coverage......................................557

B. IMPLEMENTING EFFECTIVE COUNTERCYCLICAL REGULATION............................................................558

1. Automate and Expand the Countercyclical Buffer ..........................................................................559

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2. Enact the CECL Accounting Standard............563
3. Strengthen the Risk Retention Rule.................564
4. Finalize Early Remediation Requirements......566
5. Institute Countercyclical Margin and Haircut Requirements....................................................567

VI. Conclusion....................................................................571

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I. Introduction

Financial regulation has long suffered from a critical shortcoming: traditional regulatory approaches tend to be procyclical. That is, financial regulatory tools—most notably, bank capital requirements—exacerbate boom-and-bust cycles by incentivizing financial institutions to lend too much during economic expansions and not enough during contractions.¹ At no time has this dynamic been more apparent—or more harmful—than during the 2008 financial crisis. In the early 2000s, financial regulations encouraged institutions to create exotic new financial instruments and engage in excessive mortgage lending.² When the housing bubble burst a few years later, the same rules drove banks to all but stop extending credit to households, businesses, and the broader U.S. economy.³

In the aftermath of the 2008 crisis, a consensus began to emerge that in order to combat procyclicality, financial regulators should adopt approaches that are explicitly countercyclical. Scholars urged policymakers to counteract the boom-and-bust cycle by implementing rules that would become stricter during periods of economic expansion and more lenient in times of economic contraction.⁴ International financial regulators likewise endorsed a

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countercyclical approach. At an emergency summit shortly after the crisis, G20 leaders declared their intent to pursue strategies "to mitigate pro-cyclicality."⁵

The rationale for countercyclical regulation is two-fold. First, regulatory rules that become more stringent during expansionary cycles can prevent the economy from overheating and create a cushion in the financial system to absorb losses when the economy ultimately sours.⁶ Second, countercyclical rules allow policymakers to loosen financial regulations during contractionary periods in order to boost the economy without compromising financial stability.⁷ Thus, effective countercyclical financial regulation can help moderate extreme fluctuations in the economic cycle.

U.S. policymakers embraced this new approach by adopting several countercyclical reforms in the wake of the financial crisis. For example, the Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank) expressly directed the financial regulatory agencies to make bank capital "requirements countercyclical, so that the amount of capital required . . . increases in times of economic expansion and decreases in times of economic contraction."⁸ The federal banking agencies implemented this mandate by establishing a countercyclical capital buffer (CCyB)—a

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discretionary capital cushion the agencies may require systemically-important banks to maintain when macroeconomic conditions warrant.⁹ Other Dodd-Frank provisions—such as early remediation requirements for distressed banks and risk retention rules for securitizations—implicitly tracked a countercyclical logic, as well.¹⁰

Despite these countercyclical policies, however, the U.S. financial system remained vulnerable when the COVID-19 pandemic emerged in early 2020. At the time, the United States was in the midst of a decade-long expansion—the longest period of economic growth in the nation's history.¹¹ Yet, by the spring of 2020, policymakers had to inject unprecedented fiscal support and emergency liquidity to prevent financial markets from collapsing.¹² Meanwhile, the federal banking agencies rolled back regulations and enacted a slew of forbearance policies to prevent banks from breaching minimum requirements.¹³ Federal Reserve stress tests revealed that, despite these extraordinary accommodations, one-quarter of the United States' largest banks would be unable to maintain the required minimum level of capital in a double-dip recession.¹⁴

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The U.S. financial sector's fragility during the COVID-19 pandemic was due, in part, to the failure of the post-2008 countercyclical regulatory framework. Despite the historic economic expansion of the 2010s, policymakers neglected to use their countercyclical tools as intended. In some cases, the financial regulatory agencies failed to activate discretionary countercyclical policies.¹⁵ For example, the Federal Reserve never triggered the CCyB despite numerous economists and former regulators urging the central bank to do so.¹⁶ In other cases, the financial sector successfully pushed for delays or exemptions to countercyclical rules, such as Dodd-Frank's early remediation requirements.¹⁷ Thus, although Dodd-Frank and other post-2008 reforms established a countercyclical framework, the United States never fully realized the promise of countercyclical financial regulation.

This Article is the...