What If Regulation Helped Cause the Financial Crisis?

February 23, 2010

In much of the analysis of the causes of the financial crisis a frequent claim is that too little regulation of banks and financial institutions was a primary culprit. But what if instead of too little regulation, faulty regulation played an important role? That’s the view of Jeffrey Friedman and Wladimir Kraus, two scholars writing a book called Engineering the Perfect Storm: How Reasonable Regulations Caused the Financial Crisis” (University of Pennsylvania Press, forthcoming in 2011).

In a recent paper, Friedman and Kraus argue that regulatory rules were “designed to steer banks' funds into ‘safe’ assets, such as AAA mortgage-backed bonds” or those of government-sponsored enterprises (GSE) such as Fannie Mae and Freddie Mac. And on one level, these rules were successful, as “93 percent of the banks' mortgage-backed securities were either AAA rated or were issued by a GSE.” But as we now know, the regulators’ views of the safety of these securities were wrong.

And so the regulations themselves were problematic. Absent the regulations, they argue, “there is no reason for portfolios of American banks to have been so heavily concentrated in mortgage-backed bonds.” The dominant conventional narrative of the financial crisis says that too little regulation, excessive executive compensation, or other alleged ills caused the crisis

But these scholars have much data and evidence on their side as they make a different argument. And they deserve a hearing as policymakers chart a path forward.