Chapter 11: The Economics of Financial Regulation
"The economy" is merely the behavior of buyers and sellers in the market - it is not a thing unto itself that can be wrangled or controlled. All the same, whenever anything bad happens in the world, many people immediately clamor for their government to do something about it and politicians feel the need to appease the demands of their citizens - in spite of the fact that there is nothing meaningful they can do. Government can no more control the economy than it can control the weather, but this does not stop them from meddling in it, generally to negative effect.
One way in which government attempts to control the economy is through prohibition - making it illegal for sellers to distribute merchandise to buyers who want it. Naturally, this is ineffective: so long as buyers wish to have something and are willing to offer sufficient financial incentive to someone to provide it, sellers will find a way to get it to them. Banning any product simply moves the economy underground and makes it more difficult for people to get the things they want - but not impossible.
There are a myriad of ways in which government can attempt to interfere, short of prohibition, but these have similar effect. It may attempt to levy a tax on a good to make it undesirable, but a black market forms to supply the item at a lower price. It may attempt to provide a subsidy to promote the production and consumption of a good, but the people will consume no more than they wish to have and suppliers will have to deal with excess inventory - plus the fact that subsidies are paid for by buyers through taxes anyway, making them less able to afford other goods. There is very little good that government can do for the economy except by leaving it alone.
A second and more insidious problem in giving government the power to interfere in the economy is that politicians are not the angels people seem to assume them to be. They do not always act in the interest of their people and often serve their own interests. When the people empower a government to interfere in a market, certain suppliers will attempt to use government to change the game in their favor and offer incentives (generally in the form of "campaign contributions") to politicians who will help them gain advantages in trade. In some instances, they may attempt to help their "friends" in the commercial sector, but ultimately these parties are regarded as friends because they have done favors for the politician or promise him favors in the future that serve his personal interests.
The basis of economic activity is trade - and to intervene to benefit one party always harms another. There is no single instance of any economic legislation that was universally beneficial, and most of them have been harmful, and many regulations are propped up until they have resulted in an undeniable catastrophic failure.
The Great Depression as Regulatory Failure
The author looks to the Great Depression of the 1930s as an example of regulatory failure. As with many economic catastrophes, it has been blamed on the market, or on the behavior of a few wealthy individuals - but this behavior is facilitated and often encouraged by legislation. It is said that the depression of the 1920s "started" with the stock market crash of 1929 and the subsequent bank panic - but there were a series of very bad legislative maneuvers that preceded the crash.
The first mistake was a program of economic stimulus. The interest rate was artificially lowered by increasing the money supply and lowering the reserve rate. The immediate effect of this was on the banking industry, which found itself flush with cash to lend, and was encouraged to lend it out to fund business ventures regardless of their chances of success.
The next link is the funding of those business ventures created a lot of stock, and further borrowing provided speculators with the ability to obtain cheap funds to invest in the stock of these ill-conceived businesses. The result was a feeding frenzy that pumped op stock prices - the Dow Jones Industrial Average to nearly sextuple itself, from 60 to 350 by August 1929. All of this activity represented people investing with cheaply borrowed money in business ventures that had no hope of ever becoming profitable.
A third factor, created by legislation that had been passed decades earlier, were prohibitions and discouragements against banking diversity, such that most banks were small and had few major accounts - such that if even one of their major creditors defaulted, the bank would become insolvent. There were meanwhile no federal guarantees in place to protect bank deposits - so that when the factory defaulted, the bank ran out of cash, and people who had deposits with those banks were unable to withdraw them.
A fourth factor was trade protectionism, which prevented foreign capital from entering the US and US capital from being invested in foreign markets. This was not just in the US, but common to most countries as a retaliatory measure, and the net result is that national economies were separate and isolated from one another. This worked well when the economy was strong, as all the benefits of US growth were enjoyed by the participants in the domestic market - but when the economy fell, it also ensured that all of the damage fell on the domestic market.
Government is very reluctant to admit its mistakes, and very often the way to cure the problems caused by bad legislation is to simply add more legislation to cure the problems caused by the original legislation (rather than to do the sensible thing, which would be to repeal a bad law). So in the wake of the depression, a wave of new legislation occurred ...
Primarily, federal insurance was instituted to protect the funds deposited in banks, such that even if a bank became insolvent, its depositors could collect their funds (currently limited to $250,000, which is quite enough). While this sounds like a good idea, nothing is ever free: like any insurance program, the deposit insurance is funded by banks who pay an insurance premium that is calculated to cover the amount of benefits it will receive, plus an additional measure for risk, plus an additional measure to cover the operating costs. While this is not charged directly to depositors, it is paid by them because it is an operating expense of the bank, reducing the amount of capital it can disperse as interest to its depositors.
The Glass-Stegal act was also implemented to prevent banks from investing their capital in risky ventures, which stagnated growth in the banking industry as well as in all other industries that rely on banks to finance their operations. Arguably, the great depression may have been less severe and less lengthy if these restrictions had not been put into place, and the economic growth that occurred in the 1990s when banking was deregulated represents growth that was unable to occur under the same legislative restrictions.
Finally, there was the establishment of the Security and Exchange Commission (SEC), meant to be a watchdog over American financial markets, but the organization "simply does not do its job very well." It simply makes it difficult for entrepreneurs to raise funds on some capital market, so they in turn seek to raise their funding on other markets (such as the OTC market), or to restrict their initial offerings to private placement to wealthy investors (so the average investor misses out on the ability to profit), and so on. Refusing to be listed with the SEC does not prevent a firm from doing business any way it pleases, it merely means it is not available in the major markets until it decides to comply with SEC regulations. Moreover, the costs of compliance (estimated at about $100,000) means that many small businesses simply can't afford to list their securities on the major exchanges.
The Savings and Loan Regulatory Debacle
Next, the author turns his attention to the savings and loan catastrophe of the 1980s, which itself is a result of some of the legislation that was imposed after the depression. Essentially, the government regulated the interest rate to assure banks that they would remain profitable and to make it difficult for anyone to start a new bank so that the market would be stable.
Savings and Loan associations were hit particularly hard by these legislations because the primary source of income was interest on long-term loans (such as mortgages) and their primary source of capital was from short-term holdings (savings accounts and CDs), making them highly vulnerable to interest rate risk: their income would be locked in by the length of contracts (many mortgages last 20 to 30 years) while the interest rate on acquired capital could fluctuate daily.
As a result, many such banks (about 750 by the author's estimate) were in a very precarious situation. Their appeals to legislation only made matters worse. While reforms allowed banks to engage in other forms of lending activities (such as commercial loans), many of them had never engaged in anything other than traditional banking, which led them to make many blunders.
And worse, regulators enabled failing banks to stay afloat by allowing them to add "goodwill" as an asset to their balance sheets. The category of "goodwill" is largely fictional numbers, such as how much the bank's brand is worth if it were franchised to another firm - which is a complete fabrication and not at all fungible: a bank cannot withdraw funds from its goodwill. But since it was listed as an asset, the bank appeared more solid and creditworthy, enabling it to borrow more money based on intangible (which is to say nonexistent) assets, digging themselves deeper into the hole. Those who recognized this problem referred to such institutions as "zombie banks," still moving around in the markets even though they were functionally dead.
To make matters worse, a company that is in financial peril tends to panic and act in a desperate manner to regain its footing - which is to say that it will "roll the dice" by engaging in highly risky investments to make a lot of money quickly and restore their solvency. But much like a gambling addiction, desperation does not increase competence and instead results on betting on long-shots, hoping to get even quickly while sliding deeper into debt. And because the banks were already bankrupt and borrowing on imaginary "goodwill", this put them in the position of moral hazard: they had nothing to lose except other peoples' money.
Eventually, the piper has to be paid, and many S&L banks failed during this period. The good news for the depositors is that their funds were insured through the FDIC so they were able to get their money back; the bad news for the taxpayer because when government bailed out the banking system, it was done with tax dollars.
Better but Still Not Good: U.S. Regulatory Reforms
Following the S&L debacle, there have been a number of regulatory reforms to the banking industry.
In 1989, the Financial Institutions Reform, Recovery, and Enforcement Act essentially ended the old S&L regulations and created new agencies that imposed different regulations such as increasing their capital requirements and imposing risk0based capital standards to which commercial banks were already subjects. The results were mixed: some S&Ls converted themselves into commercial banks, but other corporations formed new S&L operations.
In 1991, there was additional legislation to improve the FDIC, which raised insurance premiums for banks and compelled the FDIC to be more stringent in auditing and closing down the "zombie" banks that remained, giving them greater latitude in the way that they dismembered and salvaged failed bank operations. While the idea was to place a greater burden on banks who exercise risky behavior, the result was increased premiums for 90% of all banks, with most of them paying the same premium regardless of the soundness of their operations - in essence, taxing safe banks to reward risky ones. This is because the regulation did not provide a method of oversight, so the government was (and remains) largely unaware of what's going on in most banks. That is, it gives orders, but doesn't pay attention to whether those orders are actually obeyed.
Another problem of this act is it set a precedent for the "too big to fail" policy, justifying the unlimited support that would be given to prop up failing financial institutions because their collapse would be detrimental to the entire market. Naturally, this creates a situation of moral hazard - if any organization felt it would be considered too big to fail, then it no longer feared bankruptcy because it was confident the taxpayers would bail it out. This problem received little attention until the financial crisis of the early 21st century, where a few organizations took advantage of being TBTF.
He briefly mentions the 1994 Interstate Banking and Branching Efficiency Act (which repealed restrictions on interstate banking and led to considerable consolidation) and the 1999 Financial Services Moderation Act (which repealed Glass-Steagall and enabled banks to diversify their investment activities and engage in multiple lines of business). Together, these acts enabled banks to increase their geographic scope and breadth of services, making more and more organizations fall into the TBTF classification.
Basel II's Third Pillar
While there is no international authority over the banking industry, regulators often turn to the Bank for International Settlements in Basel, Switzerland, which has released two sets of recommendations (called Basel 1 and Basel 2) that are not binding on sovereign nations, but often serve as a model for regulation that is adopted by various governments. Their regulations have three basic "pillars" - capital reserves, supervisory review process, and market discipline. The system is not without its flaws, but provides a good basic model for bank governance.
However, the problem with regulation remains: when government dictates the way that businesses may run their operations, then their operations become commoditized, there is no basis for competition other than cost, and there is no room for innovation. Worse, where banking operations are mandated, the banks are all hung on the same nail - if there is a bad regulation, all banks are subject to follow it, and all will succeed or fail to the same degree. This becomes a serious issue when failure occurs, because it is industry-wide rather than limited to a few banks.