Bank Regulation

A common view is that banks were not sufficiently regulated. The fact that contradicts this is that most banks were more highly capitalised and more liquid than the regulations required.

Jeffery Friedman and Wladimir Kraus argue in their book called Engineering the Financial Crisis: Systemic Risk and the Failure of Regulation that regulations intended to minimise risk actually encouraged perverse behaviour. By holding assets that regulators deemed to be safe, they could free up capital to fund the expansion of their operations.

A bank that bought bonds issued by Fannie Mae or Freddie Mac could reduce its capital requirements by 60 percent, because these were deemed by regulators to be safe. The regulations created an incentive to securitise loans through these agencies, because it expanded its lending capacity. Time proved that regulators were wrong about the safety of these government-sponsored institutions.

This is an example of government regulation increasing instability by trying to make the situation better.