Rethinking Countercyclical Financial Regulation

60 Pages Posted: 19 May 2021 Last revised: 18 Apr 2022

See all articles by Jeremy C. Kress

Jeremy C. Kress

University of Michigan, Stephen M. Ross School of Business

Matthew C. Turk

Indiana University - Kelley School of Business

Date Written: May 18, 2021

Abstract

The 2008 financial crisis exposed a longstanding problem in financial regulation: traditional regulatory strategies tend to be procyclical. That is, regulatory tools—most notably, bank capital requirements—incentivize excessive credit growth during economic expansions and insufficient lending during contractions. The procyclicality of U.S. financial regulation was a key driver of the housing bubble in the mid-2000s and the massive credit crunch that followed. To combat this phenomenon, Congress and the federal banking agencies attempted to mitigate procyclical boom-and-bust cycles by implementing regulatory approaches that were explicitly countercyclical. The Dodd-Frank Act and related post-crisis reforms included several countercyclical features that were designed to become stricter during periods of economic growth and more lenient during contractions, with the goal of smoothing economic cycles.

Less than a decade later, however, these countercyclical tools failed to prevent unprecedented financial stress during the COVID-19 recession. This Article is the first legal scholarship to revisit the design of countercyclical rules in light of the COVID-19 pandemic. It reveals weaknesses in Dodd-Frank’s countercyclical approach and the significant costs of failing to implement an effective countercyclical strategy. The Article also establishes a blueprint for strengthening the United States’ countercyclical framework going forward. The Article identifies three principles—automaticity, portfolio strategy, and market-wide coverage—that should guide countercyclical policymaking. It then applies these principles to five specific areas in which financial regulators should bolster countercyclical oversight: bank capital requirements, accounting standards, securitization rules, early remediation guidelines, and margin requirements. Taken together, these reforms are critical to making countercyclical financial regulation work and creating a more stable and prosperous financial system.

Keywords: financial regulation, financial crises, countercyclical regulation, banks, Dodd-Frank Act, procyclicality

Suggested Citation

Kress, Jeremy C. and Turk, Matthew C., Rethinking Countercyclical Financial Regulation (May 18, 2021). Georgia Law Review, Vol. 56, Forthcoming 2022, Available at SSRN: https://ssrn.com/abstract=3848990 or http://dx.doi.org/10.2139/ssrn.3848990

Jeremy C. Kress (Contact Author)

University of Michigan, Stephen M. Ross School of Business ( email )

701 Tappan Street
Ann Arbor, MI MI 48109
United States

Matthew C. Turk

Indiana University - Kelley School of Business ( email )

1309 E. 10th Street
Rm. HH4080
Bloomington, IA 47405
United States

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