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Financial Deregulation: Is it really the problem?

Image source: Seeking Alpha

Many have argued that financial deregulation was the cause of the 2008-09 financial crisis. In theory, regulations protect from speculative profit-seeking committed by banks, a conflict of interest between banks’ profit motivations and depositors’ interests. Indeed, after the repeal of Sections 20 and 32 of the Glass-Steagall act, sub-prime loans rose from 10% of all mortgage lending to more than 20% in 6 years. Let us investigate the argument behind financial (de)regulation by looking at the theoretical and evidence bases.

The historical motivation behind the passing of the Glass-Steagall act was the separation of commercial from investment banking in order to reduce the risk of unified banking and to fight the aforementioned conflict of interest, with the ultimate goal of stabilizing the economy.

Looking at the reduction of risk argument, one can say that many securities, such as stocks and bonds, are less risky than loans and more liquid. Liquidity allows from the quick rebalancing of banks’ portfolios. Even if we assume that all securities are riskier than loans, forbidding holding such securities increases the risk of the portfolio due to lack of diversification. Out of the 9000 banks that failed during the Great Depression, non security-affiliated banks were four times as likely to fail compared to the ones having security affiliates. Canada had no regulation separating commercial from investment banking, and had zero bank failures during the Great Depression.

Looking at the conflict of interest argument, we must not forget that securities are publicly observable. Public observability allows investors to have a more accurate picture of the banks’ portfolios and allows them to make more well-informed decisions. Given that, poor investment advice on behalf of the affiliates is more likely to lead rational investors to withdraw their investments from the parent bank. Evidence for that is the fact that bond issues by banks with security affiliates rose from 36.8% of all bond issues in 1927 to 61.2% in 1930. Unified banks also issued higher quality securities.

Lastly, if controls are the answer to economic instability, why did the U.S. experience growth swings and recessions during the validity of the Glass-Steagall act, particularly in the 70s?

Looking at the failures in the 2008-09 financial crisis, the biggest losers were financial institutions that did not combine commercial with investment banking. Bear Sterns, Lehman Brothers, Merrill-Lynch and Goldman Sachs were all pure investment banks. AIG was a pure insurance company, while New Century Financial was a real estate investment trust. Wachovia and Washington Mutual were commercial banks that made risky loans to homeowners. Bank of America, a mainly commercial bank, got in trouble because it bought Countrywide Financial, a mortgage lender, once again not an investment bank. J.P. Morgan and Wells Fargo – two banks with big investment banking arms – resisted taking government capital and it has been argued that they could have survived without it.

Yet we can agree that complex financial derivatives were indeed a factor of the crisis. Not because of their complexity, or even their interconnectedness, but because of their nature as financial instruments and the way incentives in the modern financial system work.

Take this analogy as an example: Aaron produces 10kg of corn and sells it for $10. We can say that the $10 he acquired are backed by 10kg of corn. He deposits that $10 in Bank Alpha. We must not forget that Aaron can at any time request to have his money back. Ben asks for a $5 loan from Bank Alpha, and Bank Alpha takes $5 from Aaron’s account and gives them to Ben. Ben then buys bread from Charlie with a $5 check written against Bank Alpha. In this, he has exchanged nothing for something (well, actually the loan is backed by the promise to repay in the future, but let us ignore this for now since we don’t know if Ben will repay or not). Charlie banks with BetaBank, and submits the check to credit his account. If BetaBank presents Bank Alpha with the check to get the $5 and Aaron goes at the same time to withdraw his deposit, before Ben has repaid, Bank Alpha is in trouble.

The more competing banks you have and the less clients per bank, the more probable it is that the Bank will get caught overextending and will be incentivized to be prudent. The less banks you have and the more clients per bank, the easier it will be for the banks to hide their overextension. Yet today we have several banks competing with each other in given places at given times. The issue is caused by central banks.

Central banks distort the pricing system. They insure people’s deposits against the possibility that the bank fails. How do they do it? By printing money out of thin air and handing it to banks in case things go awry. This reduces people’s incentives to be careful about where they put their money in. And it increases banks incentives to take on more risk.

Up to the 80s, regulation made sure that money would be funneled where the central bank intended it to go. Bank profits were predetermined by controlling interest rates. With deregulation banks started fiercely competing against each other. Profit margins went down, and so banks had to increase the amount of credit extended in order to maintain profits. This money pumping led to a massive credit creation out of thin air and to the eating up of real savings, such as Aaron’s corn.

And the sad byproduct of all this is, people like Aaron actually lose. Banks extend massive credit and get rid of the risk, making quick profit, by transferring it into a complex shadow banking system of financial derivatives. David, the CEO of Bank Alpha, then uses up his nice million-dollar bonus on bread, leading to an increase of the price of bread (Micro 101: Increased demand ceteris paribus leads to increase in equilibrium price). As a result, Aaron’s $10, who was thrifty and decided to save that money (which he expended labor to acquire) for bread tomorrow, are worth less than an equivalent $10 spent today by David.

Do regulations increase the stability of the system? It is debatable. They do make sure that monetary policy is more accurately prescribed. Is monetary policy a stabilizing force? I doubt it.




#Finance #Deregulation #CentralBanks #ShadowBanking

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