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Investing.com -- Federal Reserve Governor Michael S. Barr warned that weakening financial regulations during economic booms often leads to devastating financial busts, citing historical patterns from major U.S. financial crises.
Speaking at The Brookings Institution on Tuesday, Barr highlighted how regulatory failures contributed to the Great Depression, the Savings and Loan Crisis, and the 2008 Global Financial Crisis.
"One factor that is common to many past cycles of boom and bust is weakening financial regulation," Barr said. "Weakening regulation often drives risk-taking and increases bank fragility during the boom, making the ensuing bust more painful."
Barr defined regulatory weakening as both direct deregulatory actions and the failure of regulatory frameworks to keep pace with changing financial conditions.
In discussing the Great Depression, Barr noted that the regulatory environment failed to adapt to financial innovations of the Roaring Twenties. Approximately 9,000 of the nation’s 23,000 banks failed during this period, resulting in major losses to depositors and a significant credit contraction.
Regarding the S&L crisis of the 1980s and early 1990s, Barr explained that "affirmative deregulation led to excessive risk-taking by S&Ls, as well as banks, during a boom period." Congress attempted to bolster the struggling sector by further loosening regulations, which "failed to resolve the underlying stress and instead further fueled the buildup in risk-taking."
The final cleanup of the S&L crisis cost $160 billion, roughly 5% of GDP at the time, with an additional $36 billion spent resolving failed insured banks.
For the 2008 Global Financial Crisis, Barr pointed to regulatory failures that allowed the emergence of "large, short-funded, and interconnected financial entities—both banks and nonbanks." He cited the Gramm-Leach-Bliley Act and the Commodity Futures Modernization Act as examples of legislation that expanded financial activities without establishing adequate regulatory frameworks.
Barr outlined three key lessons for policymakers: maintain a through-the-cycle perspective rather than believing "this time is different"; resist pressure to loosen regulations during boom times; and ensure regulation evolves with the financial sector.
"It is well within our ability, and is our duty as regulators, to learn from these episodes to avoid making the same mistakes," Barr concluded. "In doing so, we can help to ensure that the financial system is prepared to weather downturns and continue to serve households and businesses."
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