Monday, September 26, 2011

Financial Crisis and Deregulation

The most recent financial crisis, which was instigated by the housing bubble, was one of the worst economic meltdowns witnessed since the great depression. The ripple effects of this crisis were felt all around the world, causing some countries to be on the verge of economic collapse. Virtually no country was left without having its economic foundation shaken to some extent. Some blame the many companies who went bankrupt or nearly bankrupt of thirsting on greed and not being held accountable for their actions. Yet other people blamed the government and its lack of regulation for being the very inception of the financial crisis.

The purpose of the government and government agencies regulating financial institutions is so that investors and the public have access to information about the companies in which they are investing. As such, the SEC has independent auditors conduct audits of publicly traded companies, in order to ensure that accurate information is being disclosed.[1]  This helps to reduce the moral hazard that is inherent in our financial system and the fact that there is information asymmetry.
Credit worthiness is determined by credit rating agencies, who determine the creditworthiness of different securities. Ironically, however, the issuers of the securities are the ones who pay the credit rating agencies to rate their securities. This poses a conflict of interest, which surfaced during the most recent financial crisis.  
Due to scandals such as WorldCom and Enron, the Sarbanes-Oxley Act of 2002 was implemented in order to supervise auditors and insure their independence. Even so, this did not stop financial institutions from finding creative ways to skew information in their favor. Upon a bubble, however, the economy stagnates, and turning itself around is not an easy task.
Creditors are currently deleveraging, as they cut back on their lending because they have less capital. This results even further in a dormant economy. The asset-price bubble that resulted in the mortgage market, could have possibly been “pricked” by a contractionary monetary policy, in which the Federal Reserve could have markedly raised interest rates in hopes of discouraging borrowing. They are the only institution which has the power to set and regulate mortgage lending interest rates. The Federal Reserve, however, chose to do very little. They kept interest rates very low for quite a long time; this in turn helped to add more fuel to the housing bubble, enabling easy access to cheap money for masque, risky investments.
It seemed like nobody wanted to burst the bubble and experience the recession and asset-price decline which was sure to follow. After all, huge sums of money were being made. People who couldn’t afford homes felt that they were living the “American Dream.” The financial crisis kept being prolonged and masked; perhaps that is why it is felt so deeply today—it was allowed to continue for much too long.
Despite top economists saying that the financial crisis could not have been avoided or predicted, there were numerous warning signs of abnormal, too-good-to-be-true economic activities. “There was an explosion in risky sub-prime lending and securitization, an unstable rise in housing prices, widespread reports of egregious and predatory lending practices, dramatic increases in household, mortgage debt, and exponential growth in financial firms trading activities”.[2]
The shadow banking system is comprised of “hedge funds, investment banks, and other nondepository financial firms”.[3] Shadow banks are not regulated like depository banks and thrifts; therefore, they can employ far greater leverage than commercial banks, by offering higher rates of return, seeing as how they invest in riskier securities. Typically, the money in the shadow banking system comes directly from risk-seeking investors and not from the typical commercial bank customers, who seek FDIC, Federal Deposit Insurance Corporation, backed deposits.  Around the early nineteen-eighties, depository banks were no longer able to compete with investment banks, which provided their investors with higher rates of return, while depository banks held safe but less attractive investment options, with lower rates or return.
Commercial banks, as a result, started lobbying for deregulation in the financial system in order to allow them to compete against investments banks. Deregulation was called for! Self-regulation was considered a safe bet! “Fed Chairman Greenspan and many other regulators and legislators supported and encouraged this shift toward deregulated financial markets. They argued that financial institutions had strong incentives to protect their shareholders and would therefore regulate themselves through improved risk management.”[4] As a result, in the eighties and nineties, commercial banks expanded their operations into higher-risk loans, which offered higher rates of return for their customers and allowing them to more readily compete in the growing market. The remaining restrictions of the Glass-Steagall Act of 1932 were completely shattered after President Clinton signed the Gramm-Leach-Bliley Act in 1999. Investment banking and commercial banking were no longer separate entities. Many blame this very piece of legislation to have severely influenced the speculation that took place in the most recent financial crisis. Investment banks began gambling with the deposits of their commercial bank clients as investment banks and commercial banks merged.  This deregulation allowed banks to get bigger and bigger; it also allowed for more complex transactions and securitizations, such as CDOs, collateralized debt obligations. As these banks became bigger, they continued to exert more pressure on Congress to deregulate the system even more. “From 1998, to 2007, the combined assets of the five largest U.S banks more than tripled, from $2.2 trillion to $6.8 trillion. And investment banks were growing bigger, too.”[5] All of a sudden, when the mortgage bubble burst and the economy was vigorously shaken, these institutions were now “too big to fail” or the entire financial system would collapse. The government was left with no choice but to bail out the predatory lenders themselves.
In July of 2010, the Dodd-Frank bill was passed. This bill increased consumer protection and permanently increased the federal deposit insurance to $250,000. Also, firms who are deemed systematic and could cause widespread damage can be taken over by the government and broken up. A Financial Stability Oversight Council, headed by the Treasury secretary, will monitor markets for asset price bubbles and systematic risk. Banks who receive federal deposit insurance will be limited on their proprietary trading and owning of hedge funds. Also, there is regulation of financial derivatives.[6]
Although this is a step toward the realization that the deregulation that existed was insufficient to oversee the greed that causes financial crises, this legislature is just the beginning. Financial innovation cannot be completely stifled, however, as this may stifle future economic growth. It will take much time and much debate to decide where the line should meet between deregulation and overregulation.  Perhaps a return to Glass-Steagall is necessary. One thing is certain—the SEC should require more capital from investment banks as collateral in order to curb risky investments.

--Michael&Regina Helou--

[1]  Mishkin, Frederic S., and Stanley G. Eakins. Financial Markets and Institutions. Seventh ed. Essex: Pearson Education Limited, 2012. 182.
[2] The Financial Crisis Inquiry Report. Xvii.
[3] Mishkin, Frederic S., and Stanley G. Eakins. Financial Markets and Institutions. Seventh ed. Essex: Pearson Education Limited, 2012. 214.
[4] The Financial Crisis Inquiry Report. 455.
[5] The Financial Crisis Inquiry Report. 53.
[6] Mishkin, Frederic S., and Stanley G. Eakins. Financial Markets and Institutions. Seventh ed. Essex: Pearson Education Limited, 2012. 488 – 490.

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