By Ross Levine

Kevin Warsh hasn't even been confirmed by the Senate to become the next Federal Reserve chair, but economists and commentators are already speculating about what his tenure will look like and what stamp he will leave on the institution.

Warsh's legacy won't be determined by whether he perfectly times the next rate change or how many times he cuts. Rather, it will be shaped by how he handles weakening financial market discipline and regulation.

Congress and the president set the statutory framework for financial regulation, not the Fed. But within that framework, the Fed wields enormous discretion over how capital rules are calibrated, how stress tests are designed and enforced, how supervisory standards are interpreted, and how emergency lending powers are deployed in moments of stress. Warsh's approach to these matters will either strengthen market discipline or weaken it further, potentially leading to dire consequences for the global economy.

One path Warsh could take is the "true-market" approach. In such a system, investors and executives at financial institutions have meaningful skin in the game. They benefit when their firms perform well and suffer real losses when risks go wrong. Because downside risk is real, these actors have strong incentives to restrain excessive risk-taking.

In this framework, regulation can be relatively light-touch. Its role isn't to micromanage decisions but to ensure transparency and to guarantee investors that financial institutions can fail without bringing down the broader economy. A large body of economic research shows that when incentives are aligned this way, capital is allocated more efficiently, innovation flourishes, and long-run growth is stronger.

Another path is the "regulatory" approach, which relies less on markets and more on official oversight. Policymakers provide broad loss protection -- either explicitly or implicitly -- thereby weakening private incentives for prudence. To compensate for these weakened incentives, regulators build an extensive supervisory apparatus to restrain risk-taking.

This all comes with a cost. Beyond imposing compliance burdens, heavy regulation invites regulatory arbitrage, impedes efficient credit allocation, and slows economic growth. It also places enormous weight on regulators' ability to identify and contain risks before markets do -- something history suggests is extraordinarily difficult for them to do.

The third approach, however, is even more dangerous -- and it is the one the U.S. is currently pursuing. Call it the "fake-market" approach. Policymakers claim to rely on market discipline while undermining the incentives that make markets work.

As with the regulatory approach, investors and executives are insulated from catastrophic losses through explicit or implicit government protection. But, instead of offsetting those distorted incentives with tight, enforceable constraints, regulators scale back limits on risk-taking. The result is neither a true market nor a robust regulatory regime, but a hybrid that preserves the language of markets while disabling their disciplinary force.

A case study in the fake-market approach is the 2023 collapse of the Silicon Valley Bank. Uninsured depositors were made whole -- no haircuts and no meaningful loss-sharing. This told investors in large or interconnected institutions that they can expect a rescue, even on deposits that are technically uninsured.

Policymakers have repeatedly demonstrated a willingness to protect creditors well beyond traditional deposit insurance over the past 15 years. In 2008-09, the Fed extended extraordinary support beyond insured banks to investment banks, the commercial paper market, and insurance companies, such as AIG. In 2020, they backstopped money market mutual funds. Each episode widening the implicit safety net. Some Republicans in Congress are now trying to expand the official deposit insurance limit to $10 million in order to give banks even more cover.

The financial safety net for those at the perimeter of the banking system is expanding, too. Broker-dealers, money-market funds, and other systemically important financial intermediaries increasingly operate under the expectation that the Fed will step in during periods of stress. Investors build that expectation into their decisions.

Despite tougher-sounding rules after the 2008-09 global financial crisis, limits on risk-taking remain surprisingly weak. Capital requirements rely heavily on risk weights and internal models that understate true exposure. Supervisory stress tests rely heavily on discretion and are largely negotiated behind closed doors. Meanwhile, large segments of the financial system that benefit from implicit public support -- particularly in the shadow-banking sector -- remain subject to far lighter oversight than traditional banks.

That is how you wind up with our current financial system that marries broad protection from losses and weak official restraints. Both undermine market discipline and stability.

If Warsh maintains the fake-market approach, it is likely to produce a crisis even larger than that of 2008. Thanks primarily to policy choices made in response to that crisis, specifically the Dodd-Frank Act, the Fed is now authorized to support a much broader set of systemically important nonbank financial institutions. Markets understand that in a systemic event, authorities now possess -- and have shown the willingness to use -- an array of tools to support failing institutions and markets. That expectation lowers perceived downside risk, encourages leverage, and spurs risk-taking across the much larger array of institutions. When losses eventually materialize, as they always do, the scale of intervention required will be larger.

The fake-market approach isn't simply imposed on the Fed by statute; it has been actively constructed through the exercise of Fed discretion. Which brings us back to the incoming Fed chair.

Warsh's legacy hinges on whether he confronts the dangerous approach that took hold in the Fed in 2008 and accelerated over the past year. If he keeps on the current path, he may find the next financial crisis much worse than the last. And this time, it will be on his books.

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February 18, 2026 04:00 ET (09:00 GMT)

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