The Hoover Institution and European Central Bank Team Up to Pinpoint Threats to Global Financial Stability

In a landmark collaboration, the Hoover Institution's Financial Regulation Working Group joined forces with the European Central Bank (ECB) to tackle one of the most pressing questions facing the global economy: What could trigger the next financial crisis? The conference drew senior officials from the world's most influential financial institutions, including the ECB, the Federal Reserve, the Bank for International Settlements, and the European Banking Authority.

Several Stanford scholars, led by Hoover senior fellows and conference co-organizers Ross Levine and Amit Seru (also a professor at the Stanford Graduate School of Business), helped shape the conversation, ensuring that the latest research on financial regulation was debated directly with the policymakers and supervisors charged with safeguarding the global system.

Lagarde's Challenge: "This Time Is Never Different"

ECB President Christine Lagarde set the stage with a pointed warning: Financial markets may evolve, but the dangers that destabilize them remain constant. Excessive leverage, sudden runs, misallocated credit-these themes echo across centuries of crises. "This time is never different," she said. Her message was not one of despair but of vigilance: Policymakers must recognize recurring patterns, adapt quickly, and never grow complacent.

That challenge framed two days of rigorous debate on how regulation, supervision, monetary policy, and financial innovation can both strengthen and weaken stability.

Rajan's Keynote: Is It Necessary to Integrate Financial Stability into Monetary Policy?

Raghuram Rajan, Hoover senior fellow and former governor of the Reserve Bank of India, delivered the opening keynote, "Monetary Policy and Financial Stability." Building on Lagarde's theme, he showed how keeping interest rates low for extended periods-effectively flooding the banking system with liquidity-encourages excessive risk-taking by banks and other financial institutions. Analytical and measured in tone, his remarks nevertheless offered a stark warning: Financial systems are becoming increasingly fragile in the aftermath of the Great Financial Crisis because of prolonged liquidity abundance. Rajan's reputation as one of the few who foresaw the 2008 financial crisis in his research years earlier gave his warning particular force.

Where Do Banks End and Non-Banks Begin?

Where does the banking sector end, and where does the non-bank financial intermediary (NBFI) sector begin? Traditional views present competing ideas: Banks and non-banks perform different roles, or non-banks replace banks when regulations limit banks.

Nicola Cetorelli (Federal Reserve Bank of New York) and his coauthors proposed a third perspective, explaining that banks and non-banks are closely linked. Non-banks depend on banks for credit lines, warehousing, and liquidity, while banks rely on non-banks for securitization and investment flows.

The message: Crises cannot be contained within neat boundaries. Risk spreads through the interconnected web of banks and non-banks.

Do Non-Banks Need Access to the Lender of Last Resort?

Unlike banks, funds lack direct access to central bank liquidity. Marie Hoerova (ECB) examined how mutual funds performed during the March 2020 "dash for cash." Hoerova questioned whether ECB actions indirectly stabilized funds by expanding asset purchases and providing liquidity to banks, which in turn lent to the funds.

The evidence was clear: Yes, ECB actions helped stabilize mutual funds. While banks with access to ECB liquidity offered some support to funds, ECB asset purchases were the most significant factor for fund stability.

Bank Runs and Interest Rates

Not all runs involve depositors. Corporate revolving credit lines-essentially giant credit cards for companies-can also be subject to sudden mass drawdowns.

Victoria Ivashina (Harvard University) explains that these "revolver runs" are highly sensitive to interest rates. When rates are high, drawing down is expensive, making runs less likely. But when central banks cut rates, precautionary drawdowns become cheaper-ironically creating stress for banks. This dynamic was evident in early 2020, when firms heavily tapped lines just as the Fed cut rates to zero.

Interest Rate Risk

Juliane Begenau (Stanford Graduate School of Business) showcased the vulnerabilities of banks to interest rate risk, which were exposed by Silicon Valley Bank's collapse, demonstrating that large banks with many uninsured deposits are especially at risk. In contrast, smaller banks are less vulnerable to interest rate risk because they rely more on insured deposits.

Discussions emphasized the policy implications: One-size-fits-all capital rules are blunt tools. Tailored, size-dependent regulations may better reduce run risk without overburdening community banks.

Discretion in Regulation

In the United States, examiners assign ratings that influence a bank's future. Kelly Shue (Yale University) and coauthors showed that examiner identity matters: Supervisors with similar qualifications often reach different conclusions, and banks adapt their behavior accordingly. Since lead examiners are randomly assigned to most banks in their study, this introduces a substantial amount of inefficiency in the supervisory system, driven purely by examiner discretion-or "noise."

The main message from the paper and discussion: The US supervisory system generates significant noise that materially influences bank behavior. At the same time, supervisors provide valuable soft information. The challenge is to design supervisory strategies and organizational structures that preserve the benefits of soft information while minimizing the costs of noise.

Policy Panel on "The Next Financial Crisis?"

A policy panel led by Isabel Schnabel, a member of the Executive Board of the European Central Bank, discussed the threats facing the global financial system. Panelists also included Pierre-Olivier Gourinchas, chief economist of the International Monetary Fund, and Klaas Knot, former president of the De Nederlandsche Bank and the Financial Stability Board.

The group emphasized that large and rapidly growing fiscal debts pose risks to financial stability and restrict the ability of fiscal authorities to respond to new challenges. They highlighted that while NBFIs, stablecoins, cryptocurrencies, and AI offer significant opportunities, they also introduce new risks for regulators and supervisors to address. Schnabel suggested that, given the globalization of financial markets and the current period of rapid innovation, international communication and cooperation are particularly important.

Conclusion

In his closing remarks, Amit Seru underscored three major challenges raised at the conference: the rise of NBFIs, the limits of existing stability tools in a new rate environment, and the unintended effects of supervisory design:

1. Perimeter problem: NBFIs, their deep connections with banks, and the potential growth of stablecoins and cryptocurrencies are reshaping credit allocation and risk-taking, with implications for how crises unfold. This raises the regulatory question: Where do banks end and markets begin?
2. Interest rate environment: The shift to a new interest rate regime changes the effectiveness of traditional financial stability tools, which were largely designed for liquidity-driven runs. This suggests that frameworks need to be rethought and redesigned-not just patched together.
3. Supervisory design: The structure and operation of financial supervision have first-order-and often unintended-effects on financial-sector efficiency and stability. This underscores the need for better ways to measure, evaluate, and design supervisory systems.

One facet of the Hoover Institution's mission is to promote prosperity by addressing complex policy questions. What should be regulated, and how? When do interventions stabilize, and when do they sow new risks and inefficiencies? This joint Hoover-ECB conference brought together leading scholars and top policymakers from around the world to explore these challenging questions with rigor and honesty.

The conference was jointly organized with the ECB's Luc Laeven, director-general of research, and Marie Hoerova, senior advisor in the Directorate General Research.

View recordings of the sessions here.

About Hoover's Financial Regulation Working Group

Which financial regulatory reforms promote economic prosperity? And why do societies find it so difficult to create financial systems that are both efficient and stable? The Financial Regulation Working Group convenes an interdisciplinary network of scholars from economics, finance, law, political science, and history. Its goal is to spur research addressing these pivotal questions and disseminate the findings to the research community, policymakers, and the wider public.

The Financial Regulation Working Group is an initiative of the Hoover Program on the Foundations of Economic Prosperity, which conducts evidence-based research on the institutions and policies that foster economic prosperity amid today's public policy challenges.