This article originally appeared in the Q1 2019 edition of Banking Perspectives, the quarterly journal of The Clearing House and Bank Policy Institute. You can find the original article here.
Bankers and regulators must carefully consider how the many changes in the financial system could affect us in the next recession. We should take actions now that would reduce those impacts.
When the next recession comes, how will banks and the wider economy be affected? This is a timely question, given fears in the financial markets that one of the longest U.S. expansions in history may soon come to an end. We know a lot about banks in previous recessions, but we’ve changed the financial system profoundly; will that change the relationship between banks and the economy?
America has transformed its financial system through government action and private sector innovation. Banks and their affiliates are now held to much tougher prudential standards – specifically, higher capital requirements and newly minted liquidity requirements, but also mandatory resolution and recovery plans and tougher supervision. For its part, the private sector responded to lessons from the global financial crisis and to opportunities offered by new technology to change the competitive landscape and transform business models.
In this piece we discuss two major shifts and consider how they may change the relationships between banks and the wider economy: Did new capital and liquidity standards reduce recession-related risks or add to them? And has market-based finance lowered recession risks by diversification or shifted business to more pro-cyclical “shadow banks”?