Banking regulation failed to prevent the crisis that started in the summer of 2007. One reason is that it was based on a micro-prudential approach. This involved regulating the risk taken by individual banks. The idea was that if the risk taken by each individual bank was limited then the risk in the financial system as a whole would be limited as well. The problem is that this approach ignores systemic risk. This is the risk faced by the financial system as a whole.
Before 2005, many people went broke and many filed for bankruptcy. After 2005, many people still go broke, but not so many file for bankruptcy.
Why has the number of bankruptcies declined? Surely it is not the economy. All throughout the 2000s, families have been under increasing economic pressure. Median family incomes have declined, basic expenses have risen, and families are shouldering unprecedented debt loads. Defaults remain high for credit cards and car loans, while mortgage foreclosures have soared. By 2008, over half of all Americans reported that their incomes were falling behind their cost of living. These data all point in the same direction: people are still going broke in large numbers.
The crises of the 1990s in Asia, Europe, and Latin America have re-ignited the debate on the effects of financial liberalization. Many argue that the deregulation of financial markets was the main trigger of many of the crises observed since the 1970s. The evidence supports this claim. For example, Kaminsky and Reinhart (1999) find that the likelihood of banking crises increases by 40 percent following the deregulation of the domestic banking sector. They also find that crises are preceded by a sharp increase in the bank credit-to-GDP ratio and by a boom bust cycle in stock prices, about 50 percent higher than those observed in non-crisis times. A variety of models have been proposed to explain this link. For example, Allen and Gale (1999, 2000), Hellman et al. (2000), and Schneider and Tornell (2004), among others, show that financial liberalization leads to risky behavior by banks. Moreover, Tornell and Westermann (2005) argue that financial liberalization triggers lending boom-bust cycles in economies with credit restrictions and overall imperfections in financial markets. Allen and Gale (2000) further show that these lending booms can feed into stock market bubbles because agency problems generate an incentive for borrowers to use bank loans to buy risky assets, with these bubbles ending up in banking crises and recessions. Overall, these models rest on the idea that market failures and distortions pervade capital markets and are the sources of the boom-bust patterns.
Other authors, in contrast, highlight the benefits of financial liberalization. They claim that financial liberalization allows capital to move to its most attractive destination, increasing productivity and growth and fostering a better functioning of financial markets. For example, Bekaert et al. (2005a, b) find that liberalization leads to a one-percentage point increase in annual economic growth as well as to a decline in output volatility. Also, Henry (2000a, b) finds that liberalization triggers an increase in the investment rate and a substantial revaluation of equity prices in a large number of countries. Traditional neoclassical models provide the theoretical support for these findings. In these models, financial liberalization reduces the cost of capital and fuels a significant boom in lending and stock market prices, but does not trigger a financial crash.
