Neil H. Buchanan

What Are We Doing Today to Hasten the Next Financial Crisis? The Ticking Time Bomb of Partial and Ill-Conceived Financial Market Reform

Thursday, October 7, 2010

It took American politicians almost seven decades to forget the lessons of the Crash of '29 and the Great Depression that followed. The concentration of wealth in the 1920's, which coincided with (and arguably was caused by) the loosening of standards governing financial markets, led to the complete meltdown of the U.S. financial system, with the rest of the world soon to follow.

In the aftermath of that crisis, Congress took a hard look at the failings in the financial markets; and it concluded that the system was prone to excesses that could only be addressed by careful regulations, administered by newly-created agencies such as the Securities and Exchange Commission. It also enacted broader-based reforms that changed the landscape of American banking and finance in fundamental ways. The result was seventy-five years of economic prosperity, interrupted by occasional small financial crises, as well as a series of recessions, none of which ever approached the scale of the Great Depression.

Until now. The crisis that President Obama inherited in January 2009 nearly brought the world economy back to the levels of desperation last seen in the Thirties. Accordingly, the U.S. government is once again, as it did in the Thirties, enacting changes designed to prevent a repetition of the very problems that brought the original disaster upon us. Unfortunately, it now seems clear that the actions being taken are too tentative, easily evaded, and fundamentally inappropriate to the underlying problem. Worse still, it now appears that the possibilities for improvement of our regulatory approach are all but gone.

While no one can predict when the next financial crisis will come, it seems reasonable to conclude that we have not done nearly enough to prevent it. Indeed, we might even have made it more likely.

Behavior versus Structure in Regulatory Policy

The most important lesson that the Congress of the early 1930's learned from its economic crisis is that the financial markets need to be restrained in two ways: by changing the rules of operation for banks and other financial players (and enforcing those rules strictly), and by erecting rules that altered the structure of the banking system.

The most notable of those structural rules was a key provision in the Glass-Steagall Act. That provision separated commercial banking (done by traditional banks that take deposits and make loans to businesses) from investment banking (done by experts who put together financing deals for issuing stock, and engage in similar activities).

These structural rules were important, because they acted as easy-to-police barriers that would prevent certain kinds of excesses, and their consequences, from building up in the financial system. The experience of the bank runs in the early Thirties had shown that the commercial banks needed to be backed up by government deposit insurance, which meant that the government ultimately would be responsible for systemic failures in the commercial banks. If an investment bank were to fail, however, there was no reason to worry that this would cause a bank run, because at an investment bank, there are no depositors who would line up at the door, demanding their money, if there were a hint of bad news about the firm's finances. This allowed the investment banks to act roughly like the textbook version of market capitalists, taking risks and reaping the rewards, while also absorbing the losses.

Mixing together the two types of banking would, of course, allow a single financial firm to subsidize its losses on the investment-banking side with money from the commercial-banking side. This would ultimately mean that the entire firm's risks were in effect guaranteed by the federal government, because it would be too risky for the government to allow a major combined bank to fail -- even if its losses were entirely due to the investment-banking side of its business, where formally, no insurance existed.

As sensible as that separation might sound, it does come with a cost. Any bright-line rule will necessarily rule out some financially-advantageous strategies by banks that could -- at least in theory -- be controlled by a set of more nuanced regulations on banks' behavior. Just as there are times when it might make sense to allow people to drive on the opposite side of the street (when, for example, there is little oncoming traffic, and there is a sudden surge of traffic in one direction only, such as after a baseball game ends in a large stadium), it is easy to imagine situations in which adept financial managers could combine the advantages of commercial banking with those of investment banking, with adept regulators there to guarantee that the risks being taken are not a threat to the overall economy.

As the memories of the Thirties faded, and as it became easier and easier to believe that the financial markets simply could not melt down in the way that they did in the 1929-33 period, U.S. policymakers, under President Clinton, concluded that the costs of the Glass-Steagall rules could no longer be justified. Thus, in 2000, those rules were repealed. But in 2008, after a near-decade of 1920's-style financial hyperactivity, the next collapse came.

The Regulatory Response to the Crisis that Began in 2008

When Congress and the White House assessed the damage from the recent financial crisis, they had to make a fundamental choice: to change only the rules of behavior, or to change some structural rules as well. Overwhelmingly, they chose only to change the rules of conduct. (They also changed the regulators' roles in enforcing that conduct.) This meant that they not only rejected structural rules such as a reprise of Glass-Steagall's wall between investment and commercial banking, but they also rejected "too big to fail" rules and other simple, easy-to-enforce remedies.

The resulting legislation, the Dodd-Frank Act, was enacted into law this past July. It represents a bet on the ability of federal regulatory agencies to rein in the behavior of financial firms that are just as large (if not larger) and just as integrated as before the current crisis. This bet might have been a reasonable one (although I doubt it), if the rule-making process had been carried out openly and had been carefully specified in the legislation. Unfortunately, neither of those conditions has been met.

Congress, it turns out, did not merely refuse to draw bright lines with respect to broad matters like the size and the basic activities of financial firms. It also acceded to financial firms' fierce lobbying efforts by writing in "to be determined" in a surprisingly large number of places in the legislation.

For example, as The New York Times's business commentator Gretchen Morgenson described in a column several weeks ago, the Dodd-Frank legislation originally included strict ownership limits in obscure (but extremely valuable and systemically important) financial operations called "swaps clearinghouses," restricting any financial institution to a maximum of a 20% ownership share in the operation. By the time the legislation had been passed, however, that limit was gone. In its place was a vague provision permitting -- but not requiring -- the relevant regulatory agency to consider imposing a structural limit on ownership.

Therefore, having rejected the imposition of big structural rules, Congress went further -- moving nearly all of the actual rulemaking into the agencies' internal processes. This decision has the effects both of moving the rulemaking out of the public eye, and of giving the regulated parties -- who have well-established contacts with the relevant agencies -- the chance to try to change the rules in their favor even long after the law's passage. Morgenson even quotes a former regulator as saying that the intent of Dodd-Frank can be reversed -- not merely muted, but actually negated -- during the rule-making process.

This Is The Worst Time to Trust the Regulators, As We Have In Dodd-Frank

One of the most painful lessons that we have learned in this country over the last several years is that many of our regulatory agencies have been corrupted to a degree that few would have thought possible. "Agency capture" has always been a concern of administrative law scholars and agency watchdogs. After all, even the best-written laws must ultimately be interpreted and enforced by the administrative agencies that make up a modern government. But the level of incompetence and outright corruption has recently become much worse than the simple revolving-door problems and other standard concerns about agency culture that have traditionally been voiced.

Perhaps the most dramatic recent example of this degradation of our administrative agencies was the Minerals Management Service's grotesque mishandling of BP's serial misbehavior before the recent catastrophe in the Gulf of Mexico, as well as its mishandling of other regulated companies. The agency's employees were sometimes literally in bed with the people they were entrusted to regulate. And even when their malfeasance fell short of such salacious scandals, the results of the agency's failures include not just the still-unknown environmental damage from the millions of gallons of oil spilled into the Gulf, but also the tragic deaths of the people unfortunate enough to have been working on the Deepwater Horizon drilling rig on April 20. Similar malfeasance has been found in the agency that is supposed to protect coal miners, again with deadly results.

In sum, the problems with regulation go very deep, especially today, and may well affect our optimal policy choices. For example, during the debate over the healthcare reform bill in 2009, I had initially endorsed the idea of having the government strictly enforce rules against health insurers, because it seemed at least possible to design a set of rules that would have disciplined private insurers better than the "public option" would have. Ultimately, however, I concluded that the regulatory process was too open to abuse by the regulated parties to believe that a solution that was based only on changes in regulations could solve the health care market's deeply-ingrained problems. (Sadly, neither strong regulations nor a public option were ultimately adopted, even though the final legislation did include some other important features.)

We need not, however, look to other areas of the economy to see the increasing failure of regulation in the financial markets. The Securities and Exchange Commission -- the financial regulatory agency directly born of the Great Depression -- had become so chummy with the financial markets in the early 2000's that this closeness had become a joke among financial market insiders. The Federal Reserve's performance, similarly, was less than stellar in the lead-up to the recent crisis, to say the least.

This is not, of course, to say that it is possible to write a law that is self-enforcing. Cleaning up the corruption (as well as the milder forms of capture) in our regulatory agencies is an ongoing necessity, precisely because the agencies will always have an essential role in making sure that the rules of the road are interpreted and enforced in the public's interest.

Even so, Congress must make the rules as clear as possible in the actual legislation that it passes, leaving the agencies only to do what they should reasonably be expected to do: interpret the inevitable gaps in the legislation, and enforce the rules against those who defy the law.

The most distressing fact of all, however, is that Dodd-Frank -- with all of its serious problems, discussed above -- appears to have been the high-water mark of financial market reform. That law was widely opposed by Republicans; and if the mid-term elections, as expected, put more Republicans in Congress, then the likelihood of meaningfully strengthening the law will be significantly reduced. Even Democrats, moreover, seem unlikely to want to try again to do this right.

There will, of course, be another political moment when we could get it right. After the next big financial crisis -- which will almost surely take much less than seven decades to arrive -- we will have to try again. It would be nice, however, if we did not have to wait until that unhappy day to do what needs to be done.

Neil H. Buchanan, J.D. Ph. D. (economics), is a Visiting Scholar at Cornell Law School, an Associate Professor at The George Washington University Law School, and a former economics professor.

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