Financial Regulation: Lessson from the Recent Financial Crises

American Economic Association
Financial Regulation: Lessons from the Recent Financial Crises
Author(s): Takeo Hoshi
Source: Journal of Economic Literature, Vol. 49, No. 1 (MARCH 2011), pp. 120-128
Published by: American Economic Association
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Journal of Economic Literature 2011, 49:1, 120-128
http .www. aeaweb. org/articles.php ?doi=l 0.1257/jel. 49:1.120
Financial Regulation: Lessons
from the Recent Financial Crises
Takeo Hoshi*
The experiences of the financial crises in the United States recently and in Japan in
the 1990s suggest two lessons for future financial regulations. First, the lack of an
orderly resolution mechanism for large and complex financial institutions created
serious problems. Second, it is important to distinguish between individual financial
institutions' health and stability of the whole financial system. Policy recommenda?
tions in the Squam Lake Report address these issues well. The Dodd-Frank Act could
provide an effective regulatory framework to implement these recommendations, but
the success depends on the details of the regulations that have not been specified.
(JEL E44, E52, G01, G21, G28, L51)
1. Introduction
?he financial crisis that originally started
subprime loans in the United States devel?
oped into a global crisis and a near meltdown
of the entire global financial system, espe?
cially after the failure of Lehman Brothers
in September 2008. The crisis has moti?
vated policymakers around the world to try
to design better financial regulatory frame?
works in order to prevent catastrophic finan?
cial crises if possible and to contain the cost
when a crisis happens.
This paper reviews the experiences of two
recent financial crises?the global financial
crisis that started in the United States in 2007
as well as the banking crisis in Japan in the
1990s?and identifies two lessons that are
market for assets derived from
useful in designing future financial regulation.
One potential problem with designing a finan?
cial regulatory framework right after a crisis is
that regulators may focus too much on avoid?
ing the type of crisis that was just experienced.
They run a risk of creating a regulatory struc?
ture that could not respond to different types
of crises or worse, that imposes new problems.
Fortunately (from the point of view of improv?
ing regulation), the most recent financial cri?
sis is not the only financial crisis that we have
experienced in the last couple of decades. As
Carmen M. Reinhart and Kenneth S. Rogoff
(2009) point out, there are a lot of similari?
ties between the recent crises, although the
recent global financial crisis was certainly the
biggest in magnitude and coverage. Thus, by
looking at the experience of the most recent
crisis in a comparative perspective, we can
learn more general lessons.
Although the Japanese crisis and the
global financial crisis centered on different
* University of California, San Diego, NBER, and
TCER.
120

Hoshi: Financial Regulation 121
types of financial institutions and markets,
there were close similarities in the responses
of the governments, as Takeo Hoshi and Anil
K. Kashyap (2010) show. The Japanese crisis
happened in the traditional banking sector
and involved bank loans to real estate devel?
opers and other speculators who bet on ever
rising land prices. The crisis in the United
States started in the so called "shadow bank?
ing system" and in the markets for securitized
products. But the governments and the reg?
ulators in both cases found that the existing
regulatory structures were not suitable for
handling the crises and they had to impro?
vise. By looking at the common problems in
the Japanese crisis and the U.S. crisis, we can
better design a financial system to prepare
for the challenges governments and regula?
tors are likely to face in future crises, though
these crises will be different in many aspects.
There is already a large literature on what
happened in the global financial crisis. There
are also several proposals for financial reg?
ulatory reforms. A particularly useful one
is the Squam Lake Report by Kenneth R.
French et al. (2010). The report, authored
by fifteen economists, advances policy rec?
ommendations on many aspects of financial
regulation. This paper examines how the
report addresses the major lessons from the
U.S. and the Japanese crises. The paper also
studies how the actual financial regulatory
reform in the United States, represented
by efforts based on the Dodd-Frank Act,
reflects the recommendations of the Squam
Lake Report.
The paper is organized as follows. The
next section starts out by identifying two
important lessons from the two recent crises.
These are the importance of having a mech?
anism to resolve large financial institutions
without destroying the financial system as a
whole, and the importance of distinguishing
between the stability of individual financial
institutions and the stability of the financial
system as a whole. Section 3 examines how
recommendations from the Squam Lake
Report address these two lessons. Section 4
studies the current efforts for financial regu?
latory reform in the United States based on
the Dodd-Frank Act and asks if they are
consistent with the recommendations by the
Squam Lake Report. Section 5 concludes.
2. Lessons from the Japanese
and the U. S. Crises
There is a large literature on what happened
in the U.S. financial crisis. Descriptions of
the Japanese crisis in English are fewer but
do exist. This paper does not intend to pro?
vide a full description of the events. Instead,
some events that are especially relevant to
the lessons are briefly described.1
From the experiences of the two crises, we
can derive several lessons on many aspects
of how to cope with a financial crisis. Here I
focus on two lessons that are especially rel?
evant for future financial regulation.
First, in both cases, the lack of a mecha?
nism to deal with large failing financial
institutions imposed a serious constraint on
governments. The lack of such a mecha?
nism forced the governments to rescue fail?
ing banks and worsened the "too-big-to-fail"
problem.
In Japan, the traditional way to avoid the
failure of a bank was to ask a healthy bank
to take over the troubled bank. As Hoshi
(2002) showed, these so called "convoy res?
cues" worked quite well before the 1980s.
Regulators were able to convince healthy
lA detailed list of major events in the United States
is available at http://timeline.stlouisfed.org, for example.
French et al. (2010, chapter 1) contains a succinct descrip?
tion and analysis of the crisis. Other very useful descrip?
tions and analysis include Gary B. Gorton (2010), Michael
Lewis (2010), and David Wessel (2009). Descriptions
and analysis of the Japanese crisis in English are found in
Thomas F. Cargill, Michael M. Hutchison, and Takatoshi
Ito (2000), Hoshi and Kashyap (2001, chapter 8), and
Hiroshi Nakaso (2001). Hoshi and Kashyap (2010) com?
pare the policy responses to the crises in the two countries.

122 Journal of Economic Literature, Vol. XLIX (March 2011)
banks to acquire failing banks because, under
the heavy regulation that controlled many
interest rates and rationed bank branches,
acquiring a bank and expanding the deposit
base always helped the larger banks bottom
line. After the financial deregulation of the
1980s, absorbing a weak bank was no longer
such a profitable proposition. Moreover, by
the late 1990s, it had become hard to find
healthy banks in Japan to start with. The
mechanism was also designed for rescues of
relatively small banks. Thus, when some large
banks were suspected of being insolvent in the
late 1990s, Japanese regulators did not have
an effective way to deal with the insolvency.
The failure of Hokkaido Takushoku Bank
convinced the government that they could
not allow major banks to fail. The impact on
clients later turned out to be less than had
been feared (Masahiro Hori 2005), but the
interbank loan market froze and Japanese
banks had trouble securing funds. When the
Long-Term Credit Bank of Japan (LTCB)
was failing in 1998, the Japanese govern?
ment did not have an effective way to close
it down without repeating the chaos that
followed the failure of Hokkaido Takushoku
Bank. Only when the Diet passed new leg?
islation that established a way to resolve
failed banks through temporary national?
ization, was the government able to close
down LTCB.
The U.S. case was a little different from
the Japanese case. The United States had
a special bankruptcy regime for banks that
differed from the regime for general corpo?
rations well before the recent crisis. Robert
R. Bliss and George G. Kaufman (2007) dis?
cuss the evolution of these special resolution
mechanisms for banks over time and evalu?
ate their status as of 2007. The problem in
the recent crisis was that this resolution pro?
cess administered by the Federal Deposit
Insurance Corporation (FDIC) was not
applicable to nondepository financial institu?
tions such as investment banks.
Thus, when Bear-Stearns nearly failed
in March 2008, the Federal Reserve put
together an ad hoc rescue package and sub?
sidized JP Morgan to acquire Bear-Stearns.
The Federal Reserve also started the Primary
Dealer Credit Facility to provide liquidity to
investment banks. The Bear-Stearns case
set a certain expectation about how future
insolvencies of nonbank financial institutions
would be handled. Many expected the gov?
ernment to continue rescuing large troubled
financial institutions in order to avoid serious
crisis. This expectation probably dulled the
incentive for troubled financial institutions
to deal with the problem seriously.
When Lehman Brothers sought govern?
ment help in September 2008, the market
expected the government to put together
a rescue package similar to the one for
Bear-Stearns. The government refused and
Lehman Brothers was forced to file for
bankruptcy. This failure triggered a melt?
down of the financial system. The cost of
insuring the debt of many other financial
institutions jumped noticeably. Stock mar?
kets dropped sharply. A money market
mutual fund informed investors that it would
not be able to redeem claims at par value.
Financial firms' ability to issue commercial
paper for more than a week seems to have
disappeared. The bankruptcy process turned
out to be very difficult and chaotic because
Lehman Brother's bankruptcy involved
multiple jurisdictions, including the United
States and the United Kingdom.
The chaos in the financial markets that fol?
lowed the bankruptcy of Lehman Brothers
completely changed the stance of the U.S.
government. When a large troubled finan?
cial institution sought help, the government
could not now refuse. To save the financial
system, the government was forced to rescue
any large and important financial institution,
such as AIG Insurance. Thus, the failure to
resolve the Lehman Brother's bankruptcy
in an orderly fashion exacerbated the

"too-big-to-fail" problem. Expecting govern?
ment rescue in the end (hopefully before
it was too late), large financial institutions
had less incentive to clean up their balance
sheets on their own.
Recent experiences show that the lack
of a resolution mechanism for large fail?
ing financial institutions created a couple of
additional problems. First, it inevitably led
to intense political negotiation about who
should pay for the cost of the losses incurred
by the failed banks and delayed some useful
government responses to contain the crisis,
such as a careful examination of the health
of financial institutions and recapitalization
if necessary. Second, the lack of a resolution
mechanism aggravated uncertainty about the
financial system in general and about how
failures in the near future would be handled
in particular. This led to a serious disinter
mediation in the markets and credit dried up
for many financial institutions. Thus, the first
lesson from the two crises is the importance
of having a credible mechanism to resolve
failed financial institutions without disrupt?
ing the functioning of the financial system.
Both Japan and the United States suffered
from the lack of such a mechanism.
The second lesson is the importance of
systemic viewpoint. Both cases showed that
the health of individual financial institutions
is different from the stability of the finan?
cial system as a whole. Sometimes, efforts to
save individual financial institutions ended
up undermining the stability of the financial
system.
In the U.S. case, for example, we have
observed what resemble bank runs in the
repo market, where financial institutions
borrow and lend money using repurchase
agreements. As the problem of subprime
loans and securities backed by those loans
emerged in the summer of 2007, financial
institutions became reluctant to lend the
full amount of the value of collateral to each
other. They started to demand "haircuts"
and the amount of these haircuts increased
over time.2 As Gorton (2010) points out, this
process is very similar to a classical bank run.
The lenders worry about the financial health
of the borrowers so they start to lend less,
which prompts some borrowers to liquidate
a portion of their assets at low prices and suf?
fer financial losses. Here both lenders and
borrowers are acting rationally to reduce
the risk of their own failures, but the result?
ing increase in haircuts and shrinkage of the
repo market endangers all financial institu?
tions that participate in that market.
A related problem was the fire sales risk.
When a financial institution is forced to liq?
uidate a portion of its assets, it usually has to
offer price concessions. But the sale of assets
can be a prudent behavior if, for example,
the financial institution faces larger hair?
cuts in the repo market. If a large number
of financial firms sell their assets at the same
time, however, the amount of any required
price concession increases. Moreover, if the
financial institutions are required to mark
their assets to market, fire sales affect the
value of all the financial institutions that hold
the same class of assets.
Finally, the portion of the U.S. financial
system that had direct exposure to subprime
loans was a small part of the whole. Closing
down many subprime mortgage lenders
such as New Century Financial Corporation
(failed in April 2007) would not have dam?
aged the whole financial system if this part of
the financial system had been totally discon?
nected from the rest of the financial system.
But there were important interconnections.
Subprime loans were pooled together with
other mortgages to be structured into mort?
gage backed securities, which were used as
collateral in the repo market. Thus, the prob?
lem of subprime loans started to lower the
2 In financial markets, a haircut is a percentage that is
subtracted from the market value of assets that are being
used as collateral.

value of all mortgage backed securities that
might include subprime loans and created
runs in the repo market.
In the Japanese case, the difference
between the health of individual banks and
the stability of the banking system as a whole
surfaced in a different way. The Japanese
regulator was often concerned with pro?
tecting all the individual banks. There were
no bank failures in the post-World War II
period until 1995. As discussed above, when
a bank was on the brink of failure, the regula?
tor asked a healthy bank to absorb the failing
bank. So when the problem of nonperform
ing loans started to emerge in the early
1990s, the initial response of the government
was to try dealing with the problem quietly
without letting the public know which indi?
vidual banks were in trouble. Before 1993, a
regulatory definition of nonperforming loans
did not exist. Even after 1993, disclosure
requirements for nonperforming loans were
introduced gradually over the next five years.
Allowing weak banks to hide their problems
may have helped them survive but created
a systemic problem. When the "Japan pre?
mium," the higher interest rate that Japanese
banks were required to pay in the Eurodollar
market, started to emerge in the summer of
1995 following failures of large credit unions
and a bank (for the first time in postwar
Japan), all Japanese banks had to pay a similar
premium for interbank loans. The expectation
of convoy rescues that forced strong banks to
absorb failing banks may also have helped to
make nonperforming loan problems at indi?
vidual banks into a systemic problem.
For large banks that have high degrees of
interconnection to the rest of the financial
system, individual problems become sys?
temic problems in the absence of an orderly
resolution mechanism. In these cases, regu?
lators may have to rescue individual banks to
protect the financial system as a whole. In the
Japanese crisis, when regulators let Sanyo
Securities fail in November 1998, it resulted
in Japan s first interbank loan default. Two
weeks later, the Hokkaido Takusoku Bank
could not borrow in the interbank market
and was forced to declare bankruptcy. In
the U.S. crisis, the government's decision
to let Lehman Brothers fail in September
2008 led to the collapse of the entire finan?
cial system.
Thus, the second lesson from our experi?
ence with the two crises is the importance
of maintaining a systemic viewpoint on finan?
cial regulation. A regulator needs to monitor
the health of the financial system as a whole.
Protecting individual institutions sometimes
undermines the health of the system. But the
health of some large financial institutions has
serious systemic implications?so regulators
need to pay special attention to the individ?
ual health of systemically important financial
institutions.
3. The Squam Lake Report
The Squam Lake Report proposes many
recommendations for the reform of financial
regulation. The reforms aim to reduce the fre?
quency of future financial crises and to reduce
the cost when a crisis happens. How do the
recommendations address the two important
lessons from the Japanese and the U.S. crises?
The report starts by laying down two prin?
ciples on which the recommendations are
built (p. 2). First, policymakers must consider
how regulations will affect not only individual
financial firms but also the financial system
as a whole. Second, regulations should force
firms to bear the costs of failure they have
been imposing on society.
The first principle is essentially the second
lesson that we observed from the two crises:
the importance of a systemic viewpoint.
Based on this principle, the report recom?
mends the creation of a systemic regulator
and argues that an ideal systemic regulator
is the central bank, which is called on to
deal with systemic problems once a crisis

happens. The report also recommends the
collection of a new set of financial informa?
tion relevant to measuring systemic risk.
The systemic concern also shapes the rec?
ommendations on capital ratio regulation.
The report argues that the required capital
ratio must be higher for large banks, which
are systemically more important. It also
adds two more recommendations to impose
higher capital requirements for those banks
that are more likely to create systemic prob?
lems. Since banks with a large position in
illiquid assets are more likely to trigger fire
sales of those assets, they are required to have
higher capital ratios. Higher capital require?
ments are also applied for banks with higher
proportions of short-term debt because they
could encounter acute refinancing problems
that can be systemic.
The report also points out the importance
of monitoring credit default swaps (CDS)
and primary dealers of over-the-counter
derivatives from a systemic point of view.
These are the areas where systemic risk
was magnified during the most recent cri?
sis. The proposal recommends encouraging
the use of well functioning clearing houses
for CDS and liquidity requirements for
broker-dealers.
The second principle of the Squam Lake
Report is closely related to the first lesson
that was pointed out above: the need for
an orderly resolution mechanism for large
financial institutions. Indeed this is a recom?
mendation that the report derives from this
principle. Chapter 8 of the report correctly
points out that the "World Financial Crisis
revealed critical holes in the existing regula?
tory framework for handling large complex
financial institutions that become impaired"
(p. 95) and goes on to make several recom?
mendations. First, the report proposes the
creation of a better resolution mechanism
for systemically important financial institu?
tions. Second, the report points out the need
for cross-country negotiations and coordina
tion in creating such a mechanism. Chapter
8 of the report also recommends requiring
systemically important financial institutions
to prepare "living wills" every quarter, so that
should they fail, their resolution would pro?
ceed smoothly.
Thus, the recommendations in the Squam
Lake Report reflect the two lessons very well.
It is a promising start and a reference point
for the financial regulatory reform that has
been progressing in many countries.
4. The Dodd-Frank Act
One of the major regulatory reforms is in
progress in the United States. The process
formally started with the U.S. Treasury's
proposal to reform the financial regulatory
system on June 17, 2009. The House of
Representatives passed the reform bill on
December 11. The Senate version of the bill
did not get to a vote but, on May 20, 2010,
the Senate passed the House bill with some
amendments. After reconciliation between
the House and the Senate, a revised bill
passed the House (June 30) and the Senate
(July 15), and was signed into law as the
Dodd-Frank Act (July 21).
This section looks at the Dodd-Frank Act
briefly and examines how it corresponds to
the recommendations in the Squam Lake
Report and the two important lessons from
the recent crises that this paper identifies.
One of the major components of the
Dodd-Frank Act is the creation of a systemic
regulator. The Financial Stability Oversight
Council (FSOC) was established on October
1, 2010, and is made up of ten voting mem?
bers (nine federal financial regulators?
Treasury, Federal Reserve Board, Securities
and Exchange Commission, Commodity
Futures Trading Commission, Office of
the Comptroller of the Currency, Federal
Deposit Insurance Corporation, Federal
Housing Finance Agency, National Credit
Union Administration, Consumer Financial

Protection Bureau?and an independent
insurance expert) and five nonvoting mem?
bers (Office of Financial Research, Federal
Insurance Office, and state banking, insur?
ance, and securities regulators). The FSOC's
mandate is to monitor and, if necessary,
respond to systemic risks. The council has
the authority to designate nonfinancial com?
panies as systemically important and to put
them under regulation. It can also desig?
nate certain market activities as systemically
important and regulate them. The FSOC
also has the power to recommend stricter
standards for systemically important finan?
cial institutions and to break up large and
complex companies if they impose a "grave
threat" to the financial system. Finally, the
council works with the Office of Financial
Research, another newly created entity
within the Treasury, to collect data and infor?
mation relevant to systemic risks.
Thus, the Dodd-Frank Act follows the
recommendation of the Squam Lake Report
on the importance of systemic regulation
at least partially. Their recommendation of
making the central bank the systemic regula?
tor, however, is not followed. The chairman
of the Federal Reserve System is a member
of the FSOC, but he is one of the ten vot?
ing members. Having various regulators
that focus on different parts of the financial
system within the systemic regulatory body
raises a danger of creating a coordination
problem because protecting individual firms
or a part of the financial system is different
from maintaining the stability of the finan?
cial system as a whole, as we learned from
the recent crises. Whether the FSOC can
facilitate coordination among these various
regulators and become the effective monitor
of systemic risks remains to be seen.
The Dodd-Frank Act does not put for?
ward capital requirement regulation, another
Squam Lake Report recommendation.
But the new capital regulation frame?
work is under discussion at the Bank for
International Settlements and the so-called
"Basel III" is likely to include higher capital
requirements for those financial institutions
that are deemed systemically important. The
other recommendations on capital require?
ments (changing capital requirements
according to illiquidity of assets and liquidity
of liabilities) do not seem to be reflected in
the Basel III discussion. What Basel III may
include is a requirement about the "liquidity
ratio," which is defined to be the amount of
assets that are considered to be liquid over
the amount of liabilities that are considered
to be short term. But, at best, such regula?
tion contributes to reduction of maturity
mismatch, which is not the same as reduc?
tion of systemic risks.
The Dodd-Frank Act introduces new reg?
ulations to reform derivative markets. The
authority to regulate over-the-counter deriv?
atives has been provided to the Securities and
Exchange Commission and the Commodity
Futures Trading Commission, and they are
working on new rule making, which should
be complete by July 15, 2011. These rules
are likely to include the requirement for cer?
tain derivatives to be traded and cleared in
central exchanges. Moreover, some liquidity
requirements on primary dealers of deriva?
tives are also likely to be introduced.
Turning to the second set of major rec?
ommendations in the Squam Lake Report,
which try to force failed financial institutions
to bear the social cost of failures, the Dodd
Frank Act proposes several mechanisms to
reduce the "too-big-to-fail" problem. First, it
will create an orderly resolution mechanism
for the FDIC to unwind failing financial
companies that are systematically signifi?
cant. Second, systemically important finan?
cial institutions will be required to develop
"living wills" in coordination with the FDIC.
Financial institutions that fail to submit
acceptable plans would face higher capital
requirements, restrictions on their activities,
and potential divestment.

In addition to the creation of an orderly
resolution mechanism and the requirement
of living wills for systemically important
financial institutions, the Dodd-Frank Act
includes some mechanisms to reduce tax?
payers costs in dealing with failed financial
institutions. The law requires that funds not
repaid by the sale of the assets of the failed
financial institution would be repaid in two
ways: claw-back of any payments to creditors
that exceeded liquidation value and assess?
ments on large financial companies with the
riskiest paying more. The law also proposes
to make debt guarantees of insured banks
more difficult. It will take two-thirds major?
ity approval of the Federal Reserve Board
and FDIC Board for the FDIC to guarantee
the debts to prevent bank runs. The Federal
Reserves 13(3) emergency lending author?
ity is also limited and emergency lending
to individual entities or insolvent firms is
prohibited.
Although the details are still being devel?
oped, the Dodd-Frank Act follows the rec?
ommendation of the Squam Lake Report
to mitigate the "too-big-to-fail" problem. A
resolution mechanism for failing systemi?
cally important financial institutions will be
in place. Systemically important financial
institutions will be required to develop living
wills. The other important recommendation
of the report related to the resolution mech?
anism (coordination with international regu?
lators), however, has not been implemented.
On this, FDIC states:
If this is followed through, the Squam
Lake Reports recommendations on the reso?
lution mechanism will be mostly realized.
Overall, the Dodd-Frank Act is a good
starting point for what the Squam Lake
Report recommends. When the reform is
complete, the new financial regulatory struc?
ture will reflect the two lessons from the
United States as well as the Japanese crises.
There are, however, details of the new regu?
latory structure that still need to be worked
out. For the FSOC, how to achieve coordi?
nation among various regulators will be the
key concern. In developing the orderly reso?
lution mechanism for systemically impor?
tant financial institutions, international
coordination with regulators and resolution
mechanisms in different jurisdictions will be
critical, but the process of international coor?
dination has not yet started.
5. Conclusions
This paper has derived two important les?
sons for future financial regulatory reform
from the experiences of the Japanese crisis in
the 1990s and the one started in the United
States in 2007. The lack of a resolution mech?
anism for large financial institutions created
a serious problem in both crises. The impor?
tance of a systemic view in financial regulation
was also revealed in both crises. The Squam
Lake Report learns both lessons well and
makes recommendations based on them. The
Dodd-Frank Act in the United States takes
up many important recommendations of the
Squam Lake Report and provides a promis?
ing start for financial regulatory reform in the
United States. Many details of the regulatory
structure, however, are still unclear as of this
writing and need to be developed. Important
challenges going forward are how to establish
close coordination among regulators in the
FSOC and how to achieve international coor?
dination on resolution of systemically impor?
tant financial institutions.
... it is essential that legal and policy reforms
are adopted in key foreign jurisdictions so that
the cross-border operations of the covered
financial company can be liquidated consis?
tently, cooperatively, and in a manner that
maximizes their value and minimizes the costs
and negative effects on the financial system....
(The FDIC) is engaged with foreign regulators
in the work required to improve cooperation
and ensure a much better process is imple?
mented in any future liquidation involving a
cross-border company (FDIC 2010, p. 8)

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