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Increasing Financial Sector Rules Won't Necessarily Stop the Next Crisis

Anthony Randazzo
June 3, 2009, 12:37pm

As the battle for regulation of the financial sector regulation looms a question arises: was the reason for the current recession and financial crisis because of deregulation? If so, it would change the definition of overreacting with new regulations. It would shape how lawmakers approach the question of regulation. The reality is that, despite claims to support this theory from President Obama down to a number of economists, the data points to over-regulation and bad regulation as complicit in the creation of the crisis.

First, it is questionable that more regulations would have prevented the current crisis. Financial sector regulation during the 1970s was much heavier than today, and that did not prevent Stagflation, with unemployment reaching 9 percent in May 1975 and inflation nearly topping 14 percent. And yet, most of the regulatory structure then remains the same today. Similarly, Europe today boast some of the tightest financial sector regulations, and its banks have suffered just as much, if not more than American banks in this recession. Their banks made the same bad bets, the same poor investments, and the same over leveraged mistakes.

Second, deregulation has been small and began a while ago. The first move was the Depository Institutions Deregulation and Monetary Control Act of 1980 that dropped Regulation Q ceilings on deposit interest rates and expanded access to the Fed discount window. In 1982, the Garn-St. Germain Depository Institutions Act authorized banks to compete with money market mutual funds. And then in 1999, Congress repealed the famed Glass-Steagall Act that kept deposit-bearing institutions and investment banks separate from competing. All of this hardly constitutes being able to blame “deregulation” broadly.

More accurately, bad regulation is to blame for many of the financial crisis woes. The impact of Garn-St. Germain has been blamed for causing the Savings and Loan Crisis by allowing those thrifts to gamble with taxpayer insured investments. Garn-St. Germain has also been linked to today’s crisis because it loosened restrictions on issuing mortgages, allowing for the development of subprime loans. However, it wasn’t Garn-St. Germain—it was the surrounding, poorly designed regulations that created perverse incentives.

Garn-St. Germain could have allowed banks more freedom to compete while also clarifying the role of the FDIC. The implicit to big to fail doctrine, which private firms were more than willing to take advantage of, was the real culprit in this case. The relaxation of mortgage-lending standards is not inherently a bad thing (neither are the concept of subprime loans). Tighter standards might have reduced the number of subprime mortgages weighing down bank balance sheets, but it would have also reduced the flexibility of banks to lend to good credit risks that were outside previously established standards. Mortgage issuers and investors should bear personal responsibility for relaxed credit standards. Omitting within regulations the consequences of excessive investment failing is poor regulation.

Repealing Glass-Steagall was one of the key deregulatory moves that allowed for all the wealth that was created during the bubble to be created in the first place. It was the fringe regulations related to the interconnectedness of financial institutions that bear the weight of blame for poor regulation. Had mark-to-market regulations been more flexible banks would have had more time to raise capital and sell assets. Had Wall Street not seen Washington as a lender of last resort that would bailout investments gone awry, they would have managed their risk better (discussed in section 5). Had capital reserve ratios been higher banks and investment institutions would have had more liquidity when prices dropped (though there is a trade off with higher ratios in limiting wealth production). Or, if qualified special purpose entities had required more transparency, banks would have had to keep more risky mortgages on their books, subject to reserve requirements.

Richard Fisher, President of the Federal Reserve Bank of Dallas, told the Wall Street Journal that regulators had enough authority to prevent a crisis. They simply failed. "The regulators didn’t do their job," he said, "including the Federal Reserve." The Fed and SEC were not able to keep up with rapidly innovative investment vehicles (SEC Chairman Mary Schapiro has admitted as such). Many charged with oversight couldn’t understand the complex guarantees and obligations being traded. (And to be fair, many top level Wall Street executives didn’t understand them either.) But giving the SEC more rules to enforce wouldn’t have stopped a recession or prevented fraud like that of Bernie Madoff.


Anthony Randazzo is Director of Economic Research


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