NCPA - National Center for Policy Analysis

Is Another Financial Crisis On the Way?

June 11, 2015

After the financial crisis, a focus on safety and soundness was good medicine for the financial system. New bank liquidity and capital policies, among other initiatives, strengthened a debilitated patient. The banking system is now stronger, with more liquid assets and better underwriting standards.

Despite good intentions, however, politicians and regulators constructed an expansive and untested regulatory framework that will have unintended consequences for liquidity in our financial system. Taken together, these regulatory changes may well fuel the next financial crisis as well as slow U.S. economic growth.

The Volcker Rule, for example, bans proprietary trading by banks. The prohibition, when combined with enhanced capital and liquidity requirements, has led banks to avoid some market-making functions in certain key equity and debt markets. This has reduced liquidity in the trading markets, especially for debt.

A liquidity drought can exacerbate, or even trigger, the next financial crisis. Why should we care?

  • Because new capital, liquidity and trading rules are interrelated, and locked-up markets and rapidly falling securities prices will force banks to reduce assets and hoard liquidity in order to satisfy applicable regulatory tests. 
  • Small business owners will be particularly vulnerable because the number of community banks declined by 41 percent between 2007 and 2013. Recent studies by economists at the Richmond Federal Reserve and Harvard University both concluded that the 2010 Dodd-Frank financial law contributed to this decline.

It has been five years since Dodd-Frank became law, and time for a fresh look at its impact. We need a holistic regulatory review of the cumulative effect of post-crisis capital, liquidity and trading rules on the availability of credit and liquidity. Any review needs to be transparent, coordinated domestically and internationally and proactively engage a broad base of regulators, industry leaders, economists and consumers.

Source: Stephen A. Schwarzman, "How the Next Financial Crisis Will Happen," Wall Street Journal, June 9, 2015. 


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