Pursuing financial stability after the crisis: the unhappy consciousness of central bankers

Ideas about how to prevent instability in financial markets can be found already in the 17th and 18th century and formed part of a major statecraft by the British in the 19th century. There, the Bank of England was watchful of the boom-bust cycles in financial markets and sought to actively manage them by withdrawing credit when investments were becoming too speculative and inserting credit when there was a too high risk-aversion (Hotson 2017) (2). However, my book starts in the 1970s and traces how nation states in the West came to be concerned about financial stability in relation to banks and financial markets. 

At that time, the end of the Bretton Woods system not only made the US dollar free floating but also loosened controls over capital flows. Capital markets around the world became more integrated and banks increasingly started to borrow and interact more with capital market actors – in particular European banks with capital markets in the United States. Therefore, the central bankers that I am looking at started to fear an increased financial fragility. Although the world had just experienced 30 years without financial cycles, they understood that they in the end would have to bail the banks out if those banks got into trouble while interacting with financial markets. So they started to think: “What can we do to anticipate these dangers and actually mitigate them before they occur?” 

That was one of the first discoveries of this research: I thought the story started somewhere in the 2000s because that's when usually people start to tell the story, and I was very much surprised to find that already in the 1970s and 1980s this questioning, while marginal, already existed. And yet, the argument of the book is that it was at the time not powerful enough – because in those decades, we also observe the rise of scientised central banking, where evidence and scientific arguments play an ever bigger role. To speak the language of power, you need to be able to speak a language of models, formulas and metrics, and therefore be able to transform your intuitions into something that will be accepted as scientific. 

What I show is that macroprudential thinking – the acceptance that financial markets, if left unchecked, can really engage in booms that in the end can lead to busts – is an assumption that today is also deeply anchored, not only in central bankers’ but also in market regulators' thinking. (3) That was really not the case before the financial crisis. What I try to show in the book is all the epistemic battles the regulators had to go through with industry, with academia, in order to establish the fact that there actually is systemic risk in capital markets and that systemic regulation is required. 

On the one hand, people who were thinking about the financial system as a whole, linking banks and financial markets, were central to formulating the diagnosis of the 2008 crisis as a run on the shadow banking sector (4) and hence also for the first (failed) attempts to fix it. And yet, when the time came to enact reforms, they were often put aside, being told that they don't have any evidence, any models to justify the measures they promote. 

Everybody thought we had to learn from the crisis to avoid systemic risks, but the question of “What do we have to learn?” had no straightforward answer, not only with respect to banking regulation but also to the regulation of shadow banking. On this former battleground, the regulation of banks, there was a victory. Some very important macro-prudential ideas were inserted into what is called Basel III, a revision of the global banking regulation framework after the financial crisis. For example, the leverage ratio, i.e. the maximum indebtedness of banks, was introduced. But also the countercyclical capital buffer: when financial markets and banks start to become overly risk-taking, central banks require commercial banks to increase in a risk-dependent fashion the  share of their own capital among financial transactions, in order to increase the capacity of the system to deal with shocks. 

What was fascinating to me was not only that it sparked a lot of debate – including macroprudential measures in Basel III was a very tight decision – but also how embryonic the thinking was in terms of practical questions, such as:  “How do we measure the financial cycle?” “How do we know when financial markets start to take too much risk?” “When should we activate capital buffers?” There were mostly ideas with very limited models and metrics. What I then show in the book is how central bankers spent the next ten years working really hard on implementing and transforming these ideas into action. Therefore, another possible title for the book could have been “From ideas to action”. 

Well, this is the third aspect of the book, where I am trying to trace how metrics and tools are put into action. Most action has been taken where it is the least visible, which is why some analysts might come to the conclusion that nothing much has happened – but when we look at it in depth, we can see some action has been taken. What has changed, in particular, is the capacity to monitor the financial system – this is called “macro finance” in economics.  We do also see action towards trying to fix financial regulation by both regulating banks counter-cyclically, but also regulating financial markets. 

Even in the US, which, on the discursive level, is the country that has the least embraced these ideas, there have been very strong agents within the Federal Reserve (the US central bank) that have used “stress tests” (5) to impose some anti-cyclical measures. They used it to impose a greater resilience of the system between 2010-2013 as they thought that the financial system became overly exuberant. And yet at the same time these measures and their promoters in central banks face very strong resistance, from the banks themselves, and from politicians who often support the banks. 

Yes, and we saw that especially during the COVID crisis, which was the moment I had finished the first draft of this book and I still felt the need to take into account what was happening. 

In March 2020, when the Covid crisis really starts to hit, you get what is called a run on the shadow banking system in the USA: a lot of investors withdraw their money and therefore the whole financial system is about to tumble down. This is why central banks, in particular the Federal Reserve, decided to engage in emergency liquidity assistance to hedge funds (6), buying more than $600 billion worth of treasuries in a week, almost $100 billion every day. 

The irony of the situation is that to this day, we still have no restrictions on leverage for hedge funds – in other words how much money that is not their money they can invest to speculate. The United States of America only started in 2024 collecting reliable data on the leverage of these actors – this is why they are called the shadow banking system: until recently we haven't even collected data on them. And again, if you do not have the data, you cannot produce evidence. If you cannot produce evidence, you cannot regulate. This explains why it takes such a long time before regulating. But this also illustrates the asymmetry – and the absurdity – of the situation: in an emergency, central banks act, but afterwards, because they do not have the full evidence of the risks materialising (risks which they have prevented from happening), they do not have the arguments to regulate. The COVID crisis really has shown this contradiction. 

As we are speaking, the battle is raging in the US over how to regulate hedge funds and other actors in the shadow banking system. It's a battle that is currently fought mostly by democratic technocrats, for example Janet Yellen, US secretary of the treasury, and Gary Gensler, chair of the US Securities and Exchange Commission (SEC). They're making progress but there is a double temporality issue. First, it takes years to enact any kind of regulation and the market is growing very fast: the shadow banking system today is twice the size it was at the financial crisis. Second, progress in regulations is also slower than electoral cycles. As I show in the book, there was progress in shadow banking regulation until 2016 and when Trump came to power, who by the way is funded by hedge funds and other financial market actors, he has been deregulating. People like Janet Yellen and Gary Gensler are working on this since 2021, they only have some months left before the next election in November 2024 and will most likely not have finished by then. So either the Democrats gets another term and they can finish the job, or Trump wins, and then it's game over for them, as Trump will probably destroy any progress they might have made. (7)

In Europe the news is a little bit better. I think this has a lot to do with the fact that shadow banking is not so strongly developed in the European Union. This has enabled very strong regulation immediately after the crisis. It was further facilitated by the establishment of a European market regulator, the European Securities and Markets Authority (ESMA) in Paris, that has a very explicit financial stability mandate. ESMA enacts all kinds of supervisory measures, stress tests and so on, to regulate shadow banking. 

And yet they also do not manage to impose all their proposals, because there's a kind of competition between the US and Europe. As long as the US doesn't do anything, Europe will not do as much as they want to. We can see this most evidently with the United Kingdom because the UK has a huge shadow banking sector and is really concerned about the systemic risks that stem from it; and yet when it comes to regulating it, all they can do is point out that most of the money in the shadow banking sector is managed by US or EU entities and so escapes their regulating power. 

Another interesting finding on Europe is about the banking system. In the Eurozone, the European central bank monitors and gives advice but has very limited capacity to enact policies; therefore, most of the policies are actually taken at the national level, which allowed me to establish under which conditions we see more action. I show that this is when the central bank alone is in charge: independent central banks are more able to implement measures than when politicians are in control. I think it's important to highlight that because it also raises the issue of the political legitimacy of these decisions, when they are taken by unelected people. 

When you read the 2019 financial stability reports, you understand that before the COVID crisis, the world was already heading towards another boom that would inevitably end in a bust. In a sense, the COVID crisis papered over this boom and the possible negative consequences by acting as if a comet had hit planet Earth and the only thing that mattered was to save as many lives as possible. But there is a very important lesson that we risk not learning if we think that the COVID crisis was the problem, rather than the underlying tendency of financial markets to create euphorias and booms. Those problems don’t just go away and the very issues that were raised in 2019 are coming back to haunt us today in 2024: for example, commercial real estate is the major sector that causes problems due to an overvaluation which now translates into “troubled debt” (debt that might not be repaid) in the US and in Europe, just like what was written in 2019. 

Yet, do I expect another financial crisis soon? Not necessarily: what I actually expect to see is central banks immediately coming to the rescue whenever the slightest difficulties appear. They're not going to let commercial banks and other financial actors fail and risk another great financial crisis. That's the new reality we're living in: a system that is stabilised by central banks’ interventions, which in the end subsidise the rich who take the risks. I think that's also a very dangerous situation, because it adds to social inequality, it adds to the feeling of powerlessness, to a feeling of the system always being there for the ones above. 

I conclude the book by stating that although we now have a much greater awareness of the systemic risks from the financial system, it is coupled with a lack of tools, with a lack of power. As I argue in the final chapter, central bankers have become overly cautious firefighters: whenever they see the slightest problem, given the high awareness that they have of the financial system and its systemic risks, they immediately engage in major emergency activity, compensating risk-taking of the financial actors. And that, in a sense, takes away the capacity to discipline these actors. On a more abstract level, these technocrats are trying to fight a system that they're not powerful enough to change. I mean, those who really can are the politicians, because they have the backing of the people. Instead of political legitimacy, what technocrats can use is scientific legitimacy, but scientific legitimacy takes years and years to produce. This is what I call the unhappy consciousness of central bankers: they currently have the awareness of the risks but do not have the capacity to change the system.