Financial Regulation Efforts Following The Recent Financial Crisis
Below is an essay that I completed for a course in monetary policy. The goal was to critically appraise financial regulation efforts in light of the recent financial crisis.
Essay Prompt: Drawing on the experience of the Great Financial Crisis, critically appraise how changes in the system of financial regulation might assist avoidance of future such financial crises.
In order to critically appraise current financial regulation efforts it is important to first review what history has taught us. Prior to the Glass-Steagall Act, financial panics were a common occurrence as consumers had no assurance that their deposits were in fact soluble. The Glass-Steagall Act effectively created the Federal Deposit Insurance Corporation (FDIC) with the mission of “maintaining stability and public confidence in the nation’s financial system by: insuring deposits, examining and supervising financial institutions for safety and soundness and consumer protection, and managing receiverships.” Banks could no longer recklessly speculate on risky assets as they were now under the oversight of the FDIC.
However, all of that changed in the 1980s as traditional banking institutions began to encounter new competition from what we now call “shadow banks.” These new institutions were not subjected to the provisions of the Glass-Steagall Act as they did not accept traditional bank deposits. Due to this rather minute oversight, shadow banks were able to recklessly speculate on short-term liabilities while their primary assets remained illiquid in the long-term. As the size and market scope of these highly-leveraged firms grew, the picture was all but drawn out for a massive financial panic. Eventually, so-called shadow banking made up roughly half of the American financial system, thus recreating the same preconditions for a panic that existed prior to the 1930s. These highly-leveraged shadow banks were vulnerable to liquidity risk, but unlike traditional banks the FDIC did not back them in a “lender of last resort” fashion.
Innovation, namely financial innovation, is the sole reason why this financial crisis was able to occur. As Goodhart’s Law explains, any attempt at regulation — in this case the Glass-Steagall Act — will simply be circumvented by an individual’s ability to innovate around it. In spite of this, current regulation efforts must allow for a certain degree of discrepancy when enforcing the rules. Regulators must be able to interpret the law in real time on account of the financial industry’s ability to adapt around it in pursuit of greater profits.
In a perfect world the above solution would prove flawless. However, we live in a world that is far from perfect. We must count on the fact that regulators will eventually slip up, whether provoked or not. Therefore, we cannot rely on them to proactively spot and disarm every potential risk that may come about. Another financial panic is all but guaranteed, and it is only a matter of time until we face another crisis. Once again, we must turn to history to teach us a very important lesson on insolvency, one of the primary causes of the recent financial crisis. What we have learned from the past is that excess capital — namely bank reserves — has the ability to soften the impact of a potential panic. With enough cash on hand, well capitalized banks would be less likely to face a run as they would be considered liquid and therefore be able to gain enough equity to write off any bad investments and repay all deposits.
A final point to address is the overall size and interconnectedness of the major financial institutions. The recent crisis rippled through the global chain of financial systems due to the obvious behavior of banks and other financial institutions, which chose to mimic each other’s junk assets thus causing a universal aggregate liquidity risk. Consequently, this universal risk greatly enhanced the speed and severity of the crisis as the major financial institutions found themselves directly linked to one another. A potential tax levied on those firms who choose to merge with each other in order to increase their market dominance, effectively becoming ‘too big to fail’ in the process could solve such a problem. Regardless of the efficacy of a new tax, regulation efforts must focus on making financial institutions reluctant to consolidate. In its current form, the Volcker Rule seeks to “ensure that no bank or financial institution that contains a bank will own, invest in or sponsor a hedge fund or a private equity fund, or proprietary trading operations unrelated to serving customers for its own profit.” Essentially, depository institutions would be prohibited from engaging in risky investments that do not align with the interests of their customers. This regulation would make firms more careful in their conduct of issuing assets, and, given the limit on their size, be able to better manage their liquidity thus preventing — at least on a partial basis — another crisis.
History and experience of past crises has shown that there can be no fail-safe regulatory system as innovation will always seek out and exploit any loopholes in the system. Nevertheless, areas of reform are undoubtedly needed to attempt to avoid such crises. The measures that have been proposed above would first allow for regulation to adapt to current market conditions, and, in the case that they do not adapt quick enough, institute a fallback plan that would utilize excess reserves to pay off all creditors thus avoiding a liquidity trap. In addition, the Volcker Rule would ensure that banks “give priority to their essential lending and depository responsibilities.” All of this in conjunction with individual financial prudence should be enough to properly offset the next financial crisis.
REFERENCE
- Caruana, J. 2010, ‘Financial Stability: 10 questions and about seven answers’, Reserve Bank of Australia 50th Anniversary Symposium 9 February. <www.rba.gov.au/publications/confs/2010/caruana.pdf>
- FDIC Mission, Vision, and Values 2009, Federal Deposit Insurance Corporation. <http://www.fdic.gov/about/mission/index.html>
- Goodhart, C.A.E. 1975, “Monetary Relationships: A View from Threadneedle Street”. Papers in Monetary Economics.
- Office of the Press Secretary 2010, President Obama Calls for New Restrictions on Size and Scope of Financial Institutions to Rein in Excesses and Protect Taxpayers. <http://www.whitehouse.gov/the-press-office/president- obama-calls-new-restrictions-size-and-scope-financial-institutions-rein-e>
- Rothbard, Murray Newton, 2005, ‘The Colonial Era to World War II’, A History of Money and Banking in the United States.
- Shadow Banking System 2010, Investopedia. <http://www.investopedia.com/terms/s/shadow-banking-system.asp>
- W. Blumenthal, N. Brady,’2010, Congress Should Implement the Volcker Rule for Banks’, The Wall Street Journal. <http://online.wsj.com/article/SB10001424052748703983004575074123680183534.html>
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