Longtime Bank Lawyer Predicts Where Next Financial Crisis Will Come From

The problem is that you can’t keep pumping cash into the system. You can’t keep putting assets on the Fed’s balance sheet without having long-term consequences. And that’s what we’re going to have to deal with next.

You argue that since the start of the regulatory era, “ever-larger financial panics” have occurred. Shouldn’t there have been fewer? 

The government has facilitated, caused or encouraged inadvertently much of the private sector’s abuses — like corporate fraud and unethical practices — that are [blamed for financial crises]. 

In 1913, when the Federal Reserve was created, [President Woodrow Wilson] and politicians were all saying that the Fed would end financial crises in America — only to have the Fed become part of the causation of the Great Depression of 1929.

That was followed by the savings and loan and banking crisis of the 1980s — only to be followed by the subprime lending crisis that erupted in 2008, which became a full-fledged global crisis.

So you have to ask yourself: Would we be better off without the Fed or with it?

What’s your answer?

We’re better off with it. But the Fed has to draw some lines somewhere about how much it gets integrated into the debate in the day-to-day transition of money and movement of the economy. 

You say we need to find the right type of government regulation, not eliminate regulation. Please explain “the right type.”

We need regulation because anytime somebody is handling somebody else’s money, somebody had better be watching. That’s No. 1. 

No. 2 is that regulation has to be smart. If not, it’s going to be counterproductive in the marketplace. The way we focus on regulation today isn’t smart. We’re not regulating all the right institutions in the right way at the right time.  

There’s no reason why regulation can’t be on a real-time basis. The system in use is backward-looking [after the fact].

There’s no reason why institutions can’t report their numbers in an automated way to financial regulators by using artificial intelligence to run algorithms that analyze the institutions daily and know where they’re going before they get there.  

Did the government fail to predict the 2008 financial crisis because this “backward-looking” system was in use?

We could have predicted and prevented some of the pain of 2008 if we were regulating smartly and if the government had been using artificial intelligence, big data and other technologies to predict what would happen and be there before it hit.

If we’re going to keep regulation the way it is now in this technologically oriented environment, we’ll continue to have financial crises over and over again.

Should being prepared for financial crises be the main job of the financial regulatory system?

This country has turned the pyramid of financial regulation on its head: Normally we should spend the most time thinking about predicting and trying to avert financial crises.

The regulators ought to be creating buffers for financial institutions to operate within so they don’t end up being in a crisis. They ought to micromanage institutions that can’t manage themselves.

But the way Congress has structured the regulatory system, these days the regulators spend the most time micromanaging institutions and the least time preparing for the next financial crisis.

What could the government have done to avoid the financial dislocation of 2020?

I’m not sure they could have done anything, because it was COVID-related. But every time we have a financial crisis, it’s like the first time, and [usually] there’s nothing in place to deal with it. 

The lucky part about 2020 is that it followed 2008 so quickly, and many of the people and processes were still there. So it didn’t hit in the same way it would have if 20 years had passed.

Every financial crisis since 1819 has been the result of “a collision of six different elements,” you write. What are the salient ones?

Government policies that are left unattended. Another is market fermentation: We tend to make laws and regulations in the financial area and leave them alone until we have a crisis.

A rule or requirement today has to be judged against the markets of tomorrow. If it’s no longer relevant or working properly, it’s going to cause distortions in the marketplace. 

Right now, do you see a stock market bubble? That’s always been a precursor to financial crises, you write.

I think we’re creating an enormous bubble in residential real estate and in the stock market. It’s a dynamic that will end up exploding.

We’re building toward assets losing value and credit evaporating. But it’s always hard to know what the one thing is that will kick over the can of confidence.

Markets will climb up the bubble, but no one will see that bubble. Even if they do, they’ll say, “I’m not jumping off, because I’m making a lot of money.” 

Nobody sees it as a ride up the roller coaster to the top, when you’re going to go down. But there’ll always be some point where you reach the top, and that’s the break-point at which confidence is lost in either a company, a group of assets or the government. 

But trying to figure out where that loss of confidence will come that causes the blow-up is the $64,000 question.