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DYNAMIC REGULATION
Sarin, Natasha
Sarin, Natasha
Abstract
There is widespread consensus that the Great Recession did not have to be as "Great" as it was; had regulators acted earlier, its consequences would have been less severe. Two explanations are typically offered for early inaction. The first is that crises occur unexpectedly, so there is little time to respond aggressively. The second is that even regulators who suspected a downturn was imminent lacked the legal authority to intervene. This Article disputes these myths. First, empirical evidence demonstrates that more than a year elapsed between the first tremors in financial markets and the crash. Second, legal analysis illustrates that regulators had at their disposal significant authority to bolster banks. In fact, they used this authority with respect to small banks but not with large, systemically important firms. There is an alternative explanation for the tepid initial response to the crisis. Regulators' default rule is inaction until regulatory measures of bank health signal distress. These measures are slow to update--in many cases, the day before banks failed, their regulatory capital measures suggested no cause for concern. In the absence of significant change, regulators will inevitably be firefighting future financial crises ex post rather than successfully policing financial markets ex ante. The reticence to forestall capital disbursements as the COVID-19 crisis has raged is a testament to difficulties faced by regulators today, in which the default rule as a crisis begins is inaction rather than action. The next crisis can be prevented, but to do so will require changing the default rule. This Article proposes a way forward, advocating for automating aggressive action when financial markets indicate distress is likely. Such reform will finally make costly bank failures a relic of the past.