Countercyclical Regulation and Its Challenges

Patricia A. McCoy.

Historically, U.S. financial regulation has normally been procyclical, with federal regulators and Congress relaxing oversight during bull markets and cracking down once financial crises hit. After 2008, the wisdom of this approach came under attack. Critics argued that procyclical regulation left financial institutions undercapitalized and unable to withstand panics. Other critics asserted that economic downturns could be mitigated and even averted if regulators took steps to puncture asset bubbles.

The concept of countercyclical regulation responds to both of these critiques. This new approach posits that financial regulation would be more effective if financial regulation clamped down during financial expansions and lightened up during economic slumps, when banks and other financial services firms are struggling financially and typically are at their most risk- averse. One objective of countercyclical regulation is to require financial firms to build up reserves during flush times, so that they can draw on those resources when downturns strike. A second potential objective is to modulate the growth of easy credit and the asset bubbles that it fuels in order to avoid a string of bank failures following a surge in loan delinquencies.

Countercyclical regulation is the single most important breakthrough in years to ending cycles of boom and bust. As such, it deserves serious consideration. Implementing countercyclical regulation, however, is not as easy as it seems. So far, discussions of countercyclical reforms have been mostly limited to identifying tools to address procyclicality and evaluating the efficacy of those tools. Institutional and legal impediments to the successful implementation of a countercyclical approach, however, have not been given sufficient consideration.

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