Financial crises have occurred around the world for over two centuries. These crises have been so costly and frequent that one wonders why governments cannot prevent them from recurring despite repeated, wide-ranging attempts at legislation, regulation, supervision, and enforcement.
In an academic paper, researchers from the University of Michigan and Yale argue that lawmakers repeatedly act in two ways that may appear to be intuitive but are actually detrimental to system-wide stability. First, lawmakers fail to understand that banks — both traditional banks and shadow banks — produce runnable short-term debt, unlike other firms in the economy. To produce short-term debt, banks operate with opacity. Yet a regulatory framework based on secrecy is diametrically opposed to our dominant market-based paradigm that values transparency above all else. Second, lawmakers fail to understand the difference between a “systemic crisis” and the failure of individual banks. Aiming to enhance the safety and soundness of individual banks is not sufficient to produce system-wide stability. Committing these two errors leads to systemic risk and a recurrence of crises, according to the research.
Notably, the times when US lawmakers have succeeded in reducing systemic risk were by luck, not deliberate planning. In 1863, when Congress sought to finance the Civil War, it created a system of national banks and a uniform currency that inadvertently led to the creation of safer banks for a time. Similarly, in 1933, the Roosevelt Administration begrudgingly passed deposit insurance under political pressure, which led to decades of stability in the banking sector. Yet deliberate attempts at improving financial stability — including the GENIUS Act to regulate stablecoins — have fallen short because of the errors identified above. If lawmakers can correct these two errors, then modern economies may experience a long period of growth without crises.