The New Deal era financial regulations created several separate financial industries, each governed by its own set of regulators and insulated by regulatory barriers to entry. Although this system functioned remarkably well for several decades, the pressures imposed by high inflation and new technologies forced a process of deregulation, which gained steam over the past several decades. In 1999, Congress passed the Gramm-Leach-Bliley Financial Services Modernization Act. It permitted the consolidation of commercial banks, investment banks, securities firms and insurance companies in financial holding companies, thereby eliminating the last vestiges of Glass Steagall. “Functional regulation” continued to exist, even if the functions were consolidated in financial holding companies. Moreover, while the 1999 Act essentially revoked Glass-Steagall, many of the changes had already occurred incrementally. For example, often through mergers and acquisitions, commercial banks had already made forays into investment banking and brokerage activities, creating more diversified financial service companies.
In an ideal world, a new regulatory architecture would acknowledge these changes rather than layering another set of processes and institutions over an already fragmented system.
As we discovered in the last few years, regulators will come to the rescue of large financial firms regardless of which industry or industries they are in. Under the assumptions:
(1) We cannot return to the tidy world of Glass-Steagall where there are clear regulatory firewalls between financial industries, and
(2) There are few things more dangerous than implicit guarantees
One would have hoped that regulations would have subjected all financial firms, regardless of industry, to a form of insurance comparable to that in place with the Federal Deposit Insurance Corporation. The funds, could be used to rescue failing firms. More importantly, the system could be used to subject insured firms to higher levels of oversight and there could be a uniform set of procedures in place for liquidating (or “winding down”) failing firms.
The Senate legislation makes motions in this direction (i.e., it expands the reach of the FDIC) but it retains the high fragmented regulatory structure and simply creates new means of coordination (i.e., through the creation of a new Financial Stability Oversight Council).
There are a number of potentially positive features of the legislation.
It makes sense to bring much derivative trading off of “dark markets.” The requirement that banks spin-off their derivative activities is unlikely to survive conference (and may well die at the Obama administration’s request).
Some of the duties assigned to the new Consumer Financial Protection Bureau are necessary. Markets cannot function effectively when there are great information asymmetries and this has been a serious problem in consumer financial markets (as Elizabeth Warren has documented). However, one can question whether the Senate’s desire to place this new agency within the Fed will survive conference. Moreover, regulators often over-reach. Can we be confident that the new bureau will restrict itself to the functions promoted by Warren?
It is also quite positive that the legislation addresses the conflicts of interest among credit rating agencies (they are compensated by the financial firms whose securities they rate).
But there is also much room for mischief. Banks with more than $250 billion in assets will be subject to higher capital standards. One can imagine that the process of setting these standards will lead to efforts of social engineering (e.g., setting standards to create an “ideal” industrial structure).
Most important: I remain highly skeptical that this legislation is based on a coherent understanding of the causes of the financial collapse. If, as Gary Gorton has argued in his new book, Slapped by the Invisible Hand, the crisis was a panic in the repo market, it is unclear how this legislation will prevent a similar set of events from occurring in the future—or, more to the point, that such events can be prevented.
Of course, financial regulation is only part of the problem. The existing regulatory framework was inadequate. But absent the housing bubble, the collapse would not have occurred. The bubble, in turn, cannot be understood without reference to elected officials leveraging financial markets and using government sponsored enterprises (Fannie and Freddie) to engineer a desired level of home ownership, and the Fed’s promotion of low interest rates rather than acting under the discipline of the Taylor Rule.
Needless to say, neither of these issues has been addressed by the legislation.