Is deregulation to blame for the financial crisis?

From: Thompson Reuters/News & Insights

By David Barker, Ph.D

(David Barker received his Ph.D. from the University of Chicago, where he previously taught real estate, urban economics, industrial organization and corporate finance.  He has worked as an economist for the Federal Reserve Bank of New York and taught at the University of Iowa.)

Financial regulation, or lack of it, has created political conflict in the United States since the nation’s founding.  Central banks were established, dismantled and established again, and in the states and territories, banking was at times outlawed and at other times only lightly regulated.

Financial regulation reached a high point following the Great Depression of the 1930s, but it was far less popular around the most recent turn of the century.  Despite a disastrous experience with deregulation of savings and loan institutions during the 1980s, there was great enthusiasm for financial deregulation during the administrations of Bill Clinton and George W. Bush.  The financial crisis that began in 2007 led to another reversal in the popularity of deregulation.

But is it true that deregulation helped cause the financial crisis?  The story sounds plausible at first, but it breaks down when specific policies are analyzed.  For example, some financial regulations enacted during the 1930s were repealed, but it is difficult to see how any of them would have prevented the crisis.  Claims that financial firms’ capital requirements were relaxed shortly before the crisis are greatly exaggerated, and derivative mortgage securities multiplied not because of deregulation, but because their use was actively encouraged by government policy.

An argument can be made that a completely different regulatory structure, such as the Canadian system, might have prevented the crisis.   The institutions of the United States before deregulation, however, probably could not have done so.  Whether a comprehensive regulatory system covering all kinds of previously unregulated entities is desirable or possible is, however, a different question than whether deregulation caused the financial crisis.

The argument that regulators were asleep at the switch is also different than blaming deregulation for the crisis.  Regulators can be caught up in the same fads and memes as the finance industry, and they have always had considerable discretion as to how they interpret and enforce regulations.  Regulators with perfect foresight could have used existing laws to prevent the crisis, but regulators will never be omniscient.

REPEAL OF 1930S-ERA REGULATIONS

Following the Banking Act of 1933, also known as the Glass-Steagall Act, and through at least the 1990s, U.S. banks were arguably the most heavily regulated in the developed world.1  The act created the Federal Deposit Insurance Corp. to insure deposits and also to supervise and examine many of the banks that were insured.  The Federal Reserve was given additional authority to prevent banks from making loans that were deemed too speculative or that were made to insiders.  New criminal penalties were established for misconduct by bank officers.  All of these parts of the 1933 act are still in effect.  The parts of the 1933 act that have been repealed are the prohibition of interest being paid on ordinary bank accounts and the separation of commercial and investment banking activities into different institutions.  In addition, state regulations that prohibited interstate banking and branching have been repealed.

The prohibition of interest on demand deposits started to break down during the 1950s and 1960s as banks competed for deposits by offering services other than higher interest rates.

The prohibition further deteriorated with the introduction of NOW (negotiable order of withdrawal) accounts during the 1970s, which for technical reasons did not fit the legal definition of demand deposits, but for practical purposes were just like them.  Savings accounts, money market accounts and other devices went further in allowing banks to compete for deposits on the basis of interest rates, and the regulation was completely repealed in 2011 by the Dodd-Frank Wall Street Reform and Consumer Protection Act.  It is difficult to imagine this bit of deregulation as a culprit in the financial crisis of 2008.  Weak institutions have at times irresponsibly raised deposit rates to attract deposits, such as during the savings and loan crisis of the 1980s.  This behavior, however, was not an important factor in failures of financial institutions in recent years.

The end of the Glass-Steagall Act’s separation of commercial and investment banking is also unlikely to have been an important cause of the financial crisis.  Financial firms that failed, such as Bear Stearns and Lehman Bros., had not combined with commercial banks.  In fact, as some observers have pointed out, if they had, they would have been more likely to survive.2  President Clinton pointed out that Bank of America’s purchase of Merrill Lynch may have prevented that firm’s failure, which would have significantly exacerbated the crisis.  Even before the repeal of Glass-Steagall in 1999, investment banks were allowed to do the things that many people believe led to the crisis, such as investing in mortgage securities, credit default swaps and other derivative financial instruments.

Prohibitions on interstate banking are believed by many financial economists to have led to more banking panics in the past, since banks confined to single states are more susceptible to local economic busts and do not have the financial strength of nationwide institutions to handle market fluctuations.  The fact that more banks are regional or national in scope than before deregulation almost certainly reduced the number of bank failures that occurred as a result of the crisis.

The financial regulation that remained after deregulation was onerous enough to push many transactions into the unregulated shadow banking system.  New regulations, such as the Dodd-Frank Act, may have the perverse effect of reducing oversight by sending more business into the unregulated sector.

CAPITAL REQUIREMENTS

None of the erosions of 1930s-era regulations seem likely to have caused the financial panic of 2008.  But what about bank capital requirements?  Minimum capital requirements are now perhaps the most important of banking regulations.  Regulators have long required weak banks to raise additional capital, but bank capital as a percentage of overall assets was not explicitly regulated until 1981.3  Capital ratios, now adjusted for asset risk, are still strictly regulated, although non-bank financial firms face looser requirements.

Financial institution capital is simply the difference between assets and liabilities.  By selling shares, retaining earnings or selling assets and retiring liabilities, an institution can increase its ratio of capital to assets.  More capital relative to assets reduces the chance of failure.

Although the capital requirements of commercial banks have not weakened over the past few decades, many observers believe that capital requirements for investment banks were significantly weakened by the Securities and Exchange Commission in 2004.  In 2008, a former SEC official wrote an article in a banking industry publication claiming that a rule change in 2004 allowed some financial firms to hold less capital and dramatically increase their leverage.  The claim was that leverage was allowed to increase from 12-to-1 ($1 of capital for every $12 of assets) to 33-to-1.  This claim was widely reported in major news outlets and was repeated by prominent economists.

However, a convincing case has been made by Massachusetts Institute of Technology economist Andrew Lo4 that nothing of the kind actually happened.  SEC Rule 15c3-1 was amended in 2004 in an attempt to help the five largest investment banks in the United States meet European regulatory requirements.  Some investment banks, referred to as holding companies, owned several “broker-dealers,” meaning firms that traded securities.  Individual broker-dealers were regulated by the SEC, but there was no regulation of the holding companies themselves.  European authorities required this level of regulation, and so the SEC rule change provided it.  No requirements for holding companies were eliminated or relaxed, because none had previously existed, and the rules for individual broker-dealers remained the same.  The additional layer of regulation was misinterpreted by many observers as deregulation.

It turns out that the original 12-to-1 capital requirement was not a binding constraint for broker-dealers, because there were numerous ways to get around the rule.  Leverage at large investment banks did increase from 2004 to 2007, but it had been just as high or higher in the late 1990s as it was in 2007.  Of the largest investment banks, only Merrill Lynch had significantly higher leverage in 2007 than it had in the late 1990s, and it was not one of the firms that failed during the crisis.  In other words, regulatory capital requirements had little to do with leverage levels that were chosen by investment banks.  In particular, there was no deregulation that led to higher leverage.

CREDIT DEFAULT SWAPS

Another alleged culprit of deregulation is the Commodity Futures Modernization Act of 2000.  That act established that complicated financial instruments traded between “sophisticated parties” would not be regulated as futures, securities or insurance.  In particular, credit default swaps, which are contracts that require one party to pay the other in the event that a third party defaults on some obligation, could no longer be regulated by states as insurance or gambling.

CDSs grew rapidly during the years before the crisis.  By 2007, the total amount of coverage from these instruments exceeded $60 trillion, and in 2008 the insurance giant American International Group required a federal bailout because of losses from writing CDSs.

Traditional insurance regulation requires that a buyer of insurance have an “insurable interest.”  In other words, a person is allowed to purchase insurance against her own house, but not a neighbor’s house.  The CDS market attracted speculators who believed that they had better information than other market participants about whether companies would be able to pay their debts.

It also attracted bondholders and others owed money by companies who wanted to hedge against the risk of a default.  Without speculators willing to bet that the odds of default were low, investors wanting to hedge would not have been able to find counterparties and would not be able to protect themselves.  Observing CDS pricing also gave many interested parties useful information about the probability of a company’s likelihood of default.

The claim is often made that the CDS market caused the demise of firms such as Lehman Brothers, leading to the financial crisis.  When CDS prices indicate that a firm is weakening, creditors demand payment, worsening the firm’s condition.  But supporters of CDS markets respond that this argument is like attacking a messenger — hiding information from investors hardly seems to be a good solution to the problems of firms.

The continuing importance of the CDS market suggests that maintaining the existing regulatory structure would not have prevented its growth.  Stanford economist Darrell Duffie has said, “If you outlaw them, then the financial engineers will just come up with something else that gets around the regulation.”5

THE MORTGAGE MARKET

The market for mortgages backed by houses clearly played an important role in the financial crisis.6  Was deregulation involved?

The federal government has played a major role in housing finance since the Hoover administration.  The government’s goal, however, has been very different than it is in other areas of financial regulation.  In banking and finance generally, the goal is stability.  Regulators want to avoid company failures and financial panics.  In housing finance, the goal has been to expand mortgage credit so more people can afford to buy houses.  True deregulation would have involved less support for house buyers, which would have lessened the financial panic.

Demand for mortgage-backed securities came from what has been called the “giant pool of money.”7  Capital available for investment in the world increased very rapidly during the 1990s and 2000s, aided by economic development in countries such as India and China.  Owners of that capital bid up asset prices and drove down yields.  Investors accustomed to higher yields wanted new investments that would pay more than Treasury securities or certificates of deposit.  Securities backed by loans, in turn backed by houses, seemed like perfect investments.  House prices were rising and seemed unlikely to fall.  As more capital fueled house purchases, prices rose and made mortgage-backed securities even more attractive.  Accelerating this cycle were government programs that assisted homebuyers with down payments, subsidized their interest payments and punished lenders who did not aggressively extend credit to racial minorities and poor neighborhoods.

Mortgage-backed securities were a creation of government agencies such as Ginnie Mae (Government National Mortgage Association), established in 1968, and government-chartered companies such as Fannie Mae (Federal National Mortgage Association) and Freddie Mac (Federal Home Loan Mortgage Corporation).  Private issuers followed.  The federal government had pushed for expansion of mortgage lending for decades, but the push became much stronger during the George W. Bush administration.  Tying homeownership to the fight against terrorism, he said that he wanted to “make sure America is secure from a group of killers, people who hate — you know what they hate? They hate the idea that somebody can go buy a home.”8

In the same speech, he advocated smaller down payments, tax credits for house buyers and simpler mortgage documents.  “The rules are too complex,” Bush said. “People get discouraged by the fine print on the contracts. They take a look and say, well, I’m not so sure I want to sign this. There’s too many words.”9  The American Dream Downpayment Act of 2003 implemented many of Bush’s recommendations, and subprime lending, financed by mortgage securities, accelerated.

Deregulation means reducing the government’s role in some part of the economy so that market forces determine outcomes.  The federal government is deeply involved in housing finance, pulling some levers and pushing others.  Some rules were relaxed before the financial crisis, but the goal was not to allow housing markets to operate freely, it was to push these markets to move in a certain direction.  The unfortunate outcome should not be considered to be the result of deregulation.

THE CANADIAN ALTERNATIVE

To the north of the United States, temperatures, temperaments and financial markets tend to be cooler.  In Canada, there were no bank failures or bailouts during the financial crisis, and the recession has been less serious there than in the United States.  In fact, there were no Canadian bank failures during the Great Depression or the panics of 1893 and 1907.  Does the Canadian experience suggest that deregulation was a mistake?  Oddly enough, deregulation in the United States moved the country’s system closer to the Canadian model.  Canada has never had restrictions on branching and had already allowed commercial and investment banks to merge in 1987.10  Canadian banks were also more heavily leveraged than large U.S. banks such as JPMorgan Chase and Wells Fargo at the time of the crisis.

Financial regulations in the United States have always been fragmented, complex and contentious, unlike the Canadian system.  Americans would never have consented to the Canadian compromise of a highly profitable banking oligopoly along with strict supervision.  The United States did not have a golden age of financial regulation that resembled the Canadian system and which was destroyed by deregulation. Also, the Canadian system, with its implicit government guarantees and lack of competition, might not avoid crises forever.11

Conclusion

Deregulation did not cause the financial crisis, because financial regulation in the United States has always been flawed.  In many ways, regulation worsened the crisis, and keeping old regulations might have made it even worse.

Instead of blaming deregulation, it would be more appropriate to ask how regulators could help banks lure business away from the shadow banking system and how the federal government can be prevented from undertaking massive and disruptive social engineering schemes such as the promotion of home ownership.

Notes

1          Neely, Michelle, Going Interstate: A New Dawn for U.S. Banking,  Federal Reserve Bank of St. Louis (July 1994), available at http://www.stlouisfed.org/publications/re/articles/?id=1885.

2          Mark A. Calabria, Did Deregulation Cause the Financial Crisis? Cato Policy Report (July/August 2009), available at http://www.cato.org/pubs/policy_report/v31n4/cpr31n4-1.html.

3          James Barth, Dan Brumbaugh & Glenn Yago, Restructuring Regulation and Financial Institutions 46 (Milken Institute Press 2000).

4          Andrew Lo, Reading About the Financial Crisis: A Twenty-One-Book Review, 50 J. Econ. Literature 151 (March 2012).

5          Matthew Phillips, The Monster That Ate Wall Street, Newsweek, Sept. 27, 2008, available at http://www.newsweek.com/id/161199.

6          Gerald Dwyer & Paula Tkac, The Financial Crisis of 2008 and Subprime Securities, in Financial Contagion: The Viral Threat to the Wealth of Nations (Wiley 2011).

7          Alex Blumberg & Adam Davidson, The Giant Pool of Money, “This American Life from WBEZ,” Chicago Public Media (May 9, 2008).  See also Ben S. Bernanke, Chairman, Board of Governors of the Federal Reserve System, Address at Morehouse College (Apr. 14, 2009), available at http://www.federalreserve.gov/newsevents/speech/bernanke20090414a.htm.

8          President George W. Bush Speaks to HUD Employees on National Homeownership Month (June 18, 2002), available at http://archives.hud.gov/remarks/martinez/speeches/presremarks.cfm.

9          Id.

10        Michael D. Bordo, Angela Redish & Hugh Rockoff, Why Didn’t Canada Have a Banking Crisis in 2008 (or in 1930, or 1907, or …)?, National Bureau of Economic Research Working Paper 17312 (August 2011), available at http://www.nber.org/papers/w17312.

11        Peter Boone & Simon Johnson, Canadian Banking Is Not the Answer, N.Y. Times, Mar. 25, 2010, available at http://economix.blogs.nytimes.com/2010/03/25/canadian-banking-is-not-the-answer/.

(This article was originally published in Westlaw Journal Bank & Lender Liability, Vol. 18, Iss.3, June 18, 2012)

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