Cleveland Fed: Regulatory gap contributed to erosion of lending standards, financial crisis

Flaws in regulatory design contributed to the erosion of lending standards and ultimately, the financial crisis, says Cleveland Fed researcher

Disparities in the regulatory treatment of banks and shadow banking organizations before the financial crisis encouraged heavily regulated bank holding companies to lend through their less-regulated subsidiaries. Lending through nonbank mortgage companies allowed BHCs to conserve their regulatory capital, avoid recognizing costly loan losses, and pursue riskier lending while still adhering to banking regulations, according to Yuliya Demyanyk, an economist with the Federal Reserve Bank of Cleveland, and Elena Loutskina, an associate professor at the University of Virginia.

Demyanyk and Loutskina say their research documents that mortgage companies – even when they were the subsidiaries of BHCs — originated riskier mortgages to borrowers with lower credit scores, lower incomes, higher loan-to-income ratios, and higher default rates.

The researchers say their results suggest that pre-crisis regulatory standards were not as inadequate as they are perceived to be. However, the inconsistent coverageand enforcement of these regulations eroded their effectiveness and contributed to the deterioration of lending standards, as did a misunderstanding of the risks inherent in the burgeoning securitization market.

Demyanyk and Loutskina note the importance that legislators and regulators are now placing on the bird’s-eye view of the financial landscape. “Because financial and regulatory systems are complex and markets are driven to maximize profits and innovate, new gaps could emerge. Regulators who are able to focus on the financial system as a whole are in a better position to recognize and address these,” say the researchers.

Read A Gap in Regulation and the Looser Lending Standards that Followed

Federal Reserve Bank of Cleveland

The Federal Reserve Bank of Cleveland is one of 12 regional Reserve Banks that along with the Board of Governors in Washington DC comprise the Federal Reserve System. Part of the US central bank, the Cleveland Fed participates in the formulation of our nation’s monetary policy, supervises banking organizations, provides payment and other services to financial institutions and to the US Treasury, and performs many activities that support Federal Reserve operations System-wide. In addition, the Bank supports the well-being of communities across the Fourth Federal Reserve District through a wide array of research, outreach, and educational activities.

The Cleveland Fed, with branches in Cincinnati and Pittsburgh, serves an area that comprises Ohio, western Pennsylvania, eastern Kentucky, and the northern panhandle of West Virginia.

Media contact

Doug Campbell, doug.campbell@clev.frb.org, 513.455.4479