The Key to Regulatory Reform: Flexibility

By Kindred Winecoff

We hear a good bit about how deregulation contributed to the financial crisis. Much less often do we specifically hear which pieces of deregulation are to blame. As expected, Krugman puts it all on Reagan's shoulders, but this is a very selective view of history. McMegan:

For starters, of course, deregulation kicked off under Jimmy Carter, with the Depository Institutions and Monetary Control Act of 1980. More importantly, deregulation wasn't simply the brain child of some Chicago-crazed lunatics at Treasury. It was the brainchild of Fernand St. Germain, the Democratic representative from Rhode Island, which is not surprising, because of course, Democrats had control of the House of Representatives. And he wasn't being driven just by ideology, or even bank lobbying; he was being driven by the fact that the previous regulation regime had driven the Savings and Loans into a ditch. They were stuck with a bunch of fixed rate mortgages paying low interest rates at a time when Paul Volcker was driving short term interest rates up to 20%. Mortgage deregulation was supposed to be a solution to the problem of banks that borrowed short and lent long bleeding to death.

And why were they borrowing short and lending long so disastrously? Because Congress had prohibited banks from making anything other than long-term fixed rate loans, and until the deregulation of 1982, sellers could pass their low-interest loans on with the house when they sold it. ...

More broadly, it doesn't make a whole lot of sense to deride those who have linked the crisis to the Community Reinvestment Act because 1977 was such a very long time ago . . . and then claim that it can all be linked back to one law passed a few years later.

Ah, but what about the repeal of Glass-Steagall? Surely such blind faith in the market is what sunk the financial system? Not according to the leading Democratic economists:

Many critics have argued that Clinton’s 1999 repeal of the 1933 Glass-Steagall Act, which had separated commercial and investment banks, contributed to the meltdown last year. “It was a clear signal to the big banks to get much bigger and to become kind of financial supermarkets,” Robert Reich, Clinton’s first Labor Secretary, said. “It’s not the biggest factor, but it’s certainly a step along the way.” In an article on the causes of the current crisis, Joseph Stiglitz wrote, “When repeal of Glass-Steagall brought investment and commercial banks together, the investment-bank culture came out on top.”

But others note that the pure investment banks, like Lehman Brothers, have been the greatest source of instability, while the banks with combined commercial and investment arms have fared the best. “Banks did terrible things, investment banks did terrible things, a big insurance company named A.I.G. (AIG) did terrible things, but basically none of that was enabled by the repeal of Glass-Steagall,” said Alan Blinder, an economist at Princeton, who had his share of confrontations with Summers when he was a member of the C.E.A., in the first two years of the Clinton Administration. Brad DeLong added, “To say that the breaking down of the Glass-Steagall wall between investment banks and commercial banks was the source of the current crisis is just wrong.”

Volcker, Summers, Blinder, DeLong... these are not slaves to a rigid laissez-faire ideology. And the two greatest periods of financial deregulation of the past 25 years were begun by Democratic presidents. Meanwhile, Reagan/H.W. Bush raised capital adequacy standards (Basel Accord) and W. Bush strengthened accounting standardsin the wake of the Enron scandal (a move applauded by Greenspan). Many think that strict mark-to-market accounting rulesand high capital requirements made the financial crisis in the Fall of 2008 much worse than it needed to be, by placing more stress on already-strained banks.

The point of this is not to play a partisan blame game. I couldn't care less about that, and there have been enough tweaks to regulatory policy by both Republican and Democratic administrations that that conversation could go back and forth forever. The point is that constructing good regulatory policy is very difficult, and what works at one point in time may not be effective at another. When Republican or Democratic administrations strengthen or loosen regulations they do so for specific, contextual reasons: The status quo is untenable, so reform is needed. Policy-makers aren't necessarily looking 30 years down the road, nor should they be.

But this should give us pause when thinking about policy. It's not necessarily about making regulations tougher or looser across the board. Instead, some financial practices may need tougher regulations while others need looser regulations. Adding a layer of flexibility giving regulators the power to adapt their requirements to changing circumstances and making regulations countercyclical might not hurt either. What does seem clear is that regulatory policy cannot remain fixed for very long: the status quo is constantly shifting, and if regulations are constantly addressing the last war then we'll always be susceptible to financial panics.

Comments

[Nick36:]

I don't think any kind of regulations or flexibility in regulations can work well when executives and managers know that the Fed and the US Treasury will probably do their best to bail them out in case of any big trouble.

You can have the best regulations in the world. But if the financial industry lobbies politicians and gets them to appoint regulators who won't enforce the rules. Then this isn't be much better than having no regulations at all.

The Fed had plenty of powers to stop the housing bubble from getting out of hand. But both Alan Greenspan and Ben Bernanke denied that there was any housing bubble until it was too late. They refused to use their flexibility and discretion to protect the financial system.

To make regulations credible, the US government needs to eliminate the moral hazard where some companies are too big to fail. Everybody needs to play by the same rules and suffer the same consequences if they make wrong business decisions.

No regulations can prevent people from taking excessive risks, when these people know that if they win then they keep their profits. But if they loose, then US taxpayers are responsible for the losses.

Oct 06 08:23 AM

[Tom Armistead:]

The "moral hazard" is ceated by the fact that any government that is confronted by speculative attacks on key financial institutions has no realistic alternative but to defend the institutions by issuing guarnatees or other capital support.

Speculative attacks normally occur when a country has excessive debt, whether located in the financial sector, the private sector, or the government.

The implication is that regulation will not be successful until debt in the overall system is brought down to manageble levels and contained there by fiscal discipline on the part of government and prudential regulation of those who grant credit, to prevent excessive lending.

Capital requirements for banks need to be flexible and contra-cyclical: they need to be strict when times are good and lenient when times are bad. Counter-intuitive but Bernanke has stated over and over again that the current regulatory regime is pro-cyclical and accordingly unstable.

What that means is that just as soon as the economy gets rolling sustainably capital requirements for banks need to be ratcheted up and kept up as long as conditions are prosperous. Then, when things get tough, there will be room to cut them some slack.

Oct 06 09:17 AM

[BullnBear:]

The bailouts have changed everything, going forward things will never be the same, without consequences of failure I can only imagine that restraint has been removed from all manner of fiscal policy thought process.

Oct 06 01:27 PM