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Regulation and the Financial Markets

Deregulation and the Financial Crisis

Some believe that the deregulation of the financial markets, particularly the repeal of the Glass-Steagall Act (that kept commercial banks from competing in investment banking and investment banks from competing as commercial banks), played a role in the recent financial crisis. Despite the fact that many of the players in that crisis were commercial and investment banks, it’s not clear that repeal of Glass-Steagall had a major impact on the crisis. 

What is clear is that there is enormous bi-partisan blame to be spread around over the roots of the financial crisis of 2008.  At its core, the crisis was caused by the housing bubble. The housing bubble was caused or exacerbated by: low interest rates maintained by the Federal Reserve Bank (supported by both parties); inadequate regulation of the banks and other financial institutions by the Fed (supported by both parties); lax lending policies promoted by Fannie Mae and Freddie Mac (supported by both parties); conflicts of interest and bad analysis at the rating agencies; compensation policies at banks and other financial players that failed to provide appropriate long-term incentives to manage risk responsibly; and bad behavior on the part of lending institutions and borrowers.

There may be a role for regulation to play in preventing such a crisis in the future but it is not clear we are getting the appropriate kind of regulatory remedies out of the current partisan bickering. While some kind of regulatory reform may be essential in financial markets, and in other areas, it needs to be remembered that the three most troubled markets in America are housing, education, and medical care. These markets are all as troubled as they are, in large part, because of the degree of government involvement in these markets. This is not an argument for a libertarian state free of government regulation, but a reminder that government intervention does not always result in superior outcomes.

Too Big to Fail

One key issue to be resolved is the doctrine of “too big to fail” that led to the massive intervention in capital markets known as TARP, the Troubled Asset Relief Program, (or the “bailout”). We don’t know if the intervention was a good idea or not. Unless we repeat the same events, and do not intervene in the markets, we are unlikely to ever know.

It is interesting that, although the authorized amount for TARP was $700 billion, the ultimate cost to taxpayers for this program appears to be around $19 billion. While that is by no means trivial, it is only slightly more than the cost of the taxpayers of bailing out GM and Chrysler. It is difficult to say what the consequences of not doing TARP would have been, but the stakes were very high for the U.S. and world financial markets. In the case of the GM and Chrysler the stakes were quite a bit more predictable. If these firms had simply gone through Chapter 7 bankruptcy, their assets would have been purchased by Ford, Toyota, Nissan, Honda and other solvent automakers. The shareholders of GM and Chrysler would have been wiped out, but they were anyway. The big losers would have been the bond holders for these companies and the auto unions. The auto industry would still exist in the U.S., the physical assets would still be used, and U.S. workers would still operate them. But the union contracts would have been voided and along with them significant union medical care and pension benefits. While the case for intervention in the financial markets is debatable, the case for intervention in the auto industry was not. The later was a largely politically motivated transfer of wealth from the taxpayer to unionized labor in the auto industry and the bondholders. GM and Chrysler were not "too big to fail," the auto unions were too powerful to be ignored.

What is clear with regard to the bailout of the financial sector is that, if the government has a role as the backstop for major financial institutions, then it has a legitimate claim to regulate their behavior. The issue is: what is the least burdensome way for the government to accomplish that objective? We believe the best approach requires the application of four principles: disclosure, appropriate incentives, avoidance of conflicts of interest, and limiting “too big to fail”. 


One of the key problems during the crisis was that when the financial markets began to panic, it was not clear what the level of exposure was for each financial institution, so all were suspect. There ought to be a way of requiring sufficient disclosure of the holdings of all major financial institutions so that this kind of blanket lack of confidence in the system can be avoided in the future. 


Unfortunately, many of the players in the system were rewarded handsomely for their prior bad behavior and lack of foresight. Large financial institutions that could be eligible for protection under “too big to fail” should be required to make sure that their executives are compensated through mechanisms that allow claw backs, if their earlier decisions prove unwise. This should not be used as a surreptitious way of controlling the total level of compensation for executives, but rather insuring that these executives have a long-term time horizon. This is also in the interest of the shareholders of these firms.

Conflicts of Interest

Many of the players in the crisis were relying on credit ratings provided by the rating agencies. These ratings should have been suspect given that these agencies had a self interest in supplying acceptable ratings so that they, the rating agencies, would get paid. This is an inherent conflict of interest. 

The government plays a role in the current arrangement by requiring credit ratings from these rating institutions for a number of purposes. If the credit rating agencies cannot find a way of isolating themselves from these blatant conflicts of interest, perhaps an appropriate governmental response would be to cease providing implicit governmental support to the rating agencies with these kinds of requirements. The demise of the rating agencies would force the buyers of bonds to develop the capability to assess the risk of new financial instruments on their own without the conflict of interest.

Another approach that might have some merit is to require the rating agencies to take an economic interest in financial instruments that they grant high ratings to. This approach has also been suggested for banks selling bundled securities, since a bank required to keep a quarter or a third of all such bundled securities might exercise better due diligence in the loan approval process. Alternatively, the rating agencies could be held legally liable for the failure of a highly rated financial instrument to perform well over time.

Limiting “Too big to fail”

The federal government has the ability to limit the growth of financial and other institutions through mergers, if that growth is anti-competitive.  We would support extending that authority to preventing mergers, if the merged entity would be viewed as “too big to fail.”

We would also support taxing existing institutions that are deemed "too big to fail" using a tax that increases with the firms scale and is inversely related to their financial reserves. Large institutions could avoid these taxes completely by maintaining sufficient financial reserves or by breaking themselves up into smaller firms.

Glass-Steagall and Competition in Commercial and Investment Banking


The concept behind repeal of Glass-Steagall, greater competition, was a good one. Both sectors, especially investment banking, are dominated by a small number of players which inevitably leads to non-competitive behavior at the expense of the general public. In this case the victims are the shareholders in public traded companies that end up paying above competitive rates for investment banking services, such and stock and bond underwriting and support for mergers and acquisitions. We support efforts to increase competition and restrict anti-competitive behavior in both investment and commercial banking.



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