Maybe. Then again, probably not, and definitely not all on its own.
We are now ten years removed from the beginning of the financial crisis that would become the Great Recession, and after all that time the mainstream explanation for the crisis can be summed up in one word: deregulation.
But, what deregulation? That is where the stories get more complicated. One theory that has risen to prominence is that the repeal of the Glass-Steagall Act of 1933, by way of the Gramm-Beach-Bliley Act, is to blame. Another theory argues that regulation of the banking system had ostensibly been unraveling since the Reagan Administration, and that it was only a matter of time before fraud and abuse of the system reached critical mass and the house of cards collapsed. However, there are serious problems with both these theories and many others that are so haphazardly thrown out as a panacea-like explanation for something as complicated as the housing boom and bust, and subsequent Great Recession.
On this ten-year anniversary, these topics temporarily become salient in the public discourse once again. Therefore, why not take the opportunity to flip (at least part) of the accepted narrative on its head?
What follows is a short summary of only a few of the problems with the deregulation as boogeyman hypothesis; this is not a research article, but a polemical and by no means comprehensive response to a narrative that will not die no matter how many times you shoot it, and always catches up no matter how fast you run away.
Glass-Steagall repeal is the ultimate strawman. The Gramm-Beach-Bliley Act that supposedly repealed Glass-Steagall prohibitions against financial and commercial bank collusion, in fact, did nothing of the sort. Glass-Steagall did four things: 1) prohibited banks from underwriting or dealing in securities; 2) prohibited dealers in securities from taking commercial deposits; and, in two final provisions, essentially prohibited commercial banks from being affiliated with or existing under the same holding company as firms that dealt in securities.
The so-called repeal only removed the final prohibitions. Commercial banks are still prohibited from dealing in securities. However, even if repeal had been total, the legislation would have had nothing to do with the crisis. The housing bust and the financial crisis occurred because commercial banks failed in the performance of traditional banking activities; they made poor loans and invested in overvalued mortgage-backed securities (MBS). The US economy did not crater because commercial banks started dealing in complex financial instruments, both because that is not the purpose for which they were chartered and because to do so would be in violation of federal law.
But were commercial banks existing under the same corporate umbrella as financial institutions pressured into taking on toxic MBSs and other assets that their securities firm brethren were desperate to unload? Hardly. Commercial banks invested in MBSs because they were rated AAA by a government-licensed cartel of ratings agencies. For a long time, MBSs provided a substantial ROI, and commercial banks were desperate to hold them because of the minimal reserve capital requirements necessary to do so. Banks could lend out significantly more of their reserves because they were holding AAA-rated paper. Commercial banks did not need an edict from their corporate overlords. The prospect of solid, consistent returns and minimal capital requirements was incentive enough to hold these assets.
Maybe. Then again, probably not, and definitely not all on its own.
We are now ten years removed from the beginning of the financial crisis that would become the Great Recession, and after all that time the mainstream explanation for the crisis can be summed up in one word: deregulation.
But, what deregulation? That is where the stories get more complicated. One theory that has risen to prominence is that the repeal of the Glass-Steagall Act of 1933, by way of the Gramm-Beach-Bliley Act, is to blame. Another theory argues that regulation of the banking system had ostensibly been unraveling since the Reagan Administration, and that it was only a matter of time before fraud and abuse of the system reached critical mass and the house of cards collapsed. However, there are serious problems with both these theories and many others that are so haphazardly thrown out as a panacea-like explanation for something as complicated as the housing boom and bust, and subsequent Great Recession.
On this ten-year anniversary, these topics temporarily become salient in the public discourse once again. Therefore, why not take the opportunity to flip (at least part) of the accepted narrative on its head?
What follows is a short summary of only a few of the problems with the deregulation as boogeyman hypothesis; this is not a research article, but a polemical and by no means comprehensive response to a narrative that will not die no matter how many times you shoot it, and always catches up no matter how fast you run away.
Glass-Steagall repeal is the ultimate strawman. The Gramm-Beach-Bliley Act that supposedly repealed Glass-Steagall prohibitions against financial and commercial bank collusion, in fact, did nothing of the sort. Glass-Steagall did four things: 1) prohibited banks from underwriting or dealing in securities; 2) prohibited dealers in securities from taking commercial deposits; and, in two final provisions, essentially prohibited commercial banks from being affiliated with or existing under the same holding company as firms that dealt in securities.
The so-called repeal only removed the final prohibitions. Commercial banks are still prohibited from dealing in securities. However, even if repeal had been total, the legislation would have had nothing to do with the crisis. The housing bust and the financial crisis occurred because commercial banks failed in the performance of traditional banking activities; they made poor loans and invested in overvalued mortgage-backed securities (MBS). The US economy did not crater because commercial banks started dealing in complex financial instruments, both because that is not the purpose for which they were chartered and because to do so would be in violation of federal law.
But were commercial banks existing under the same corporate umbrella as financial institutions pressured into taking on toxic MBSs and other assets that their securities firm brethren were desperate to unload? Hardly. Commercial banks invested in MBSs because they were rated AAA by a government-licensed cartel of ratings agencies. For a long time, MBSs provided a substantial ROI, and commercial banks were desperate to hold them because of the minimal reserve capital requirements necessary to do so. Banks could lend out significantly more of their reserves because they were holding AAA-rated paper. Commercial banks did not need an edict from their corporate overlords. The prospect of solid, consistent returns and minimal capital requirements was incentive enough to hold these assets.
Republicans actually expanded financial regulators’ control over the economy, in both their power and purse. George W. Bush increased funding to the SEC at an average of 11% per year for the eight years of his administration. Bill Clinton increased the Commission’s funding at 1% per year. Jimmy Carter shrunk the agency by 1.2%. Small government Republicans indeed.
However, the fact that Republicans spent more money on financial regulation is not necessarily a compliment to their stewardship of the economy. Obviously, more money did not lead to better regulation, and why would it?
Boston University economist Lawrence Kotlikoff bothered to count the number of financial regulatory agencies operated by the federal government. He found 115. Adjusted for inflation, spending on these and their precursor agencies has tripled since the supposed era of deregulation of the Reagan Administration in 1980. One wonders what proponents of increased regulation think could power a 116th agency with quadruple the funding over the finish line?
Furthermore, as alluded to above, it was federal regulations that incentivized commercial banks to hold MBSs in the first place. Traditionally, a commercial bank must hold 10% of its assets in reserve to hedge against unexpected risk. This is called the reserve ratio and is regulated by the Federal Reserve. However, for each MBS a commercial bank took on, it only needed to keep 5% on reserve. The federal government was telling commercial banks they could lend double the money if they held an MBS rather than a standard loan on their books, because the MBS was rated AAA by ratings agencies the feds had licensed. Is it really any wonder they chose the former?
Final thoughts. There is so much more that could be said to make this treatment comprehensive — whole books have been written on the subject — but the purpose of this piece is far narrower and far shorter than such a magnum opus. Its purpose is to plant the seed in readers’ minds that perhaps it is, in fact, not so clear that giving more control to financial regulators could have staved off a crisis built, literally, on tranches of overvalued assets, made so by a decade of bad government policy and blind lending standards. Are not absurdly low interest rates held down by Federal Reserve policy also to blame? What of government mandates in such legislation as the Community Reinvestment Act, that all but mandated lending to many previously subprime borrowers? Ratings agencies are to blame, but who oversees them? Who chartered them? Who gave the financial markets the implicit guarantee that these agencies knew what they were doing?
At some point in the future, another recession is coming. Banks will appear insolvent, firms will request bailouts, and politicians will tell you that if we do not act it will be the end of the world. Hopefully, when that day comes, the response will be more nuanced than the last time, and understanding of the idiosyncratic second-order effects of financial regulation and intervention will be more widespread.
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