Arnold Kling  

What Financial Re-Regulation?

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In two weeks, I am supposed to speak on a panel entitled "Financial Re-regulation." My question is, what re-regulation? To me, re-regulation means you would reverse some step that you took toward deregulation. But the new financial reform bill does not reverse any of those steps, as far as I know.

For example, the new bill does not repeal Gramm-Leach-Bliley, a 1989 law that ratified the de facto breakdown of the separation between commercial banking and investment banking, which is often blamed for the crisis. You would think that for symbolic reasons, if nothing else, you would repeal that law and go back to Glass-Steagall. Of course, I do not think there is much connection between GLB and the crisis, so I am not advocating repeal. I am just pointing out an inconsistency between one narrative of the financial crisis (it was caused by GLB) and the actual response.

In fact, if you wanted to restore the distinction between commercial banking and investment banking, you would need an entirely new law. That is because Glass-Steagall did not contemplate money market funds (are they commercial banking or investment banking?) or mortgage-backed securities (same question) or credit default swaps (ditto). There is no clear-cut inherent distinction between commercial banking and investment banking. It is true that some folks have a reasonable intuition that combining certain functions may be anti-competitive or unsafe and unsound, but that intuition needs to be articulated in a way that speaks to the modern financial world.

Back to the main point--if we are re-regulating, then what was deregulated? For example, where did subprime mortgages come from? Can anyone point to a particular legal or regulatory barrier that was removed in the last two decades? If so, has the new legislation restored this barrier?

When banks created structured investment vehicles (SIVs), collateralized debt obligations (CDO's), and other innovations, did this require a specific deregulation? Were the actions of the credit rating agencies a result of their becoming deregulated in some way? In my own analysis of the crisis, I point to capital regulations that rewarded CDO's, SIVs, and the manufacturing of AAA-rated securities. But that was not deregulation. And it was not reversed by the legislation.

Perhaps the centerpiece of the new legislation is a consumer protection agency for financial products. But if the core problem was a lack of consumer protection, what we should have seen was banks extracting profits from loans and foreclosures. Instead, banks got wiped out by losses. As Tyler Cowen points out, given where the losses took place we should be talking about predatory borrowing.

As I have said before, there is no coherent narrative that connects an analysis of the causes of the crisis to the financial reform legislation as written. Rather, the bill serves to deflect blame from government's role in pursuing housing policy through dubious mortgage market intervention and from the mutual overconfidence of large financial institutions and their regulators.

The new law is not re-regulation. The regulations it contains are largely irrelevant to financial stability. And potential regulations that would improve financial stability (such as increasing the use of subordinated debt to discipline banks or requiring sizable down payments on mortgages) are not in the bill.


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COMMENTS (9 to date)
John V writes:

If you approach this panel with this kind of theme, you're going to get a lot of frustrating glazed stares.

Good Luck.

And if you speak in front of Congress? hehehe

Franklin Harris writes:

Well, to paraphrase Robin Hanson, financial regulation has nothing to do with finance.

Joe in Morgantown writes:

The most salient aspect of the current situation--- which 'reform' did nothing to change--- is too big to fail. This is an invitation to looting and guarantees further trouble.

Glass Steagall, like other arbitrary splits of the industry, might be helpful to the extent it shrank the number of TBTF institutions.

Ted writes:

A few points,

(i) You are 100% correct about Gramm-Leach-Bliley, it had nothing to do with the crisis. In fact, I would argue it helped stabilize the situation since it made it easy for JP Morgan to acquire Bear Sterns and BoA to acquire Merrill. The best you could argue is that the repeal made it possible for Citigroup to fail, but they were already ignoring Glass-Steagal through exemptions and legal maneuvers before Gramm-Leach-Bliley anyway.

(ii) I see no clear reason why to prohibit combining investment and commercial banking. Until someone gives a good reason beyond some ridiculous hypothetical, especially since I could come up with ridiculous hypotheticals where the separation would be destabilizing also, then I see no reason to take action.

(iii) Yes, I can actually point to a particular legal or regulatory barriers that were removed that allowed subprime lending to come into existence, although I have to go back three decades, not two. Prior to the Deregulation and Monetary Control Act of 1980 it was not possible to charge high rates and fees to borrowers. Then the Alternative Mortgage Transaction Parity Act of 1982 permitted variable interest rates and balloon payments. Also important in the crisis was the Tax Reform Act of 1986. The Tax Reform Act eliminated the tax deduction of interest on consumer loans, but then allowed interest deductions for mortgages. Thus, even very expensive mortgage debt was now actually cheaper than consumer debt for a great deal of households. This helped create large amounts of cash-out financing and encouraged the market to grow. These "deregulations" coupled with the specific evolution of the macroeconomy and finance allow subprime to come about. Now, I don't personally believe we should go back to the restrictive mortgage controls by the government, but suffice to say I can trace the subprime lending habit to specific deregulations. This is always the price you pay in a deregulated environment. Yes, more often than not it's a positive thing, but at the same time you risk greater danger. Theoretically, all banking crisis are preventable, but the regulatory burden would be so great it would stifle growth. Also, I really don't have a problem with subprime lending, so long as it doesn't bring down the banks. I think it's possible to have both with appropriate reforms myself.

(iv) I think subprime borrowers did get hurt though. I don't think it's particularly fun to lose your home, which you were basically using as a source of income, and likely go into bankruptcy. My guess is that these borrowers would have been less likely to initiate these loans if they understood how they worked precisely and the risk posed by them (I don't think any of them understood house prices had to keep rising for them to keep refinancing and they would then go bust when they didn't). Banks went along with this game due to a combination of moral hazard and stupidity. I think this is a situation where both sides of this game lost in the end. Now, whether a consumer financial protection is the right way to go is a different question. If we are going to do a consumer financial protection agency though, I would really like to do something similar to what the Canadian government's consumer protection does. They have a large research arm and they provide information on various financial products. I think something like that would be great in the United States (I'd prefer a private sector group did it, but I'm willing to submit that is probably unlikely to happen). Rather than direct regulation, an information repository where consumer (particularly those with less education) can get a breakdown of various products and concepts in simple english would be a plus for consumers, I believe. Plus, it would create market discipline since a lot of the information asymmetry between less-informed consumers and bankers would be reduced.

(v) I think the primary thing with regulation is to set up an appropriate resolution authority along with some sensibly sized debt-cushion, with layered debt obviously. Derivatives being forced to go through clearinghouses would be appropriate also. But the bill leaves a lot to be desired on these fronts.

Josh writes:

I think you mean 1999 law, not 1989, for Gramm-Leach-Bliley.

Pietro Poggi-Corradini writes:

I have the sense that "manufacturing AAA-rated securities", which was only possible because of massive govt distortions and regulatory free passes, was a way to "inflate" without formally using the monetary levers. If so, it puts all the discussions about fine-tuning interest-rates a bit in perspective. Is the quantity of AAA paper just as important as the quantity of money in the economy?

To my mind a crisis of confidence of the proportions we just witnessed, could only have come about because of a "hyperinflation" in the notion of "safest" or "guaranteed", not "subprime". As the term indicates, everyone knew that subprime was "subprime", i.e. "junk". That can't be the generalized problem. With this in mind, what is being done to prevent another hyperinflation of "safe" investment vehicles?

Yancey Ward writes:

I wonder, still, where most of the overconfidence actually was. Some institutions were folded into others, but most were making their previous bets counting on government backstops and most have survived- so they turned out to be right.

KDeRosa writes:

One way to regulate is by changing regulations.

Another way to regulate is to change the way existing regulations are enforced. It's called prosecutorial or executive discretion.

The subprime mess was at least partial caused by the latter. See the Boston Fed's Policy Directive:

{Closing the Gap:} A Guide to Equal Opportunity Lending.

Banks, this is your regulator. Here's what we'd like you to do. If you don't do it, you're a racist and will be prosecuted accordingly.

Noah Yetter writes:
There is no clear-cut inherent distinction between commercial banking and investment banking.

Sure there is. A commercial bank is a bank and an investment bank is not. Somewhere along the way we used the word "banking" to describe an activity that is not, in any way, shape, or form, and that has confused our thinking ever since.

Now, that may not be a valid reason to prohibit a single firm from undertaking banking and non-banking financial intermediation, but let's stop lying to ourselves that the two categories of activity are species of a common genus.

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