For some time, many regulators have viewed the Volcker Rule (part of the Dodd-Frank law which was put in place after the 2008 financial crisis) as too complicated to enforce.
Former Chairman of the Fed, Janet L. Yellen, and present Chairman, Jerome H. Powell, concur. The rule put in place to prevent banks from making unsafe bets with insured depositor’s money was widely criticized by Wall Street. In fact, it also hurt some smaller to mid-size banks which were hit with the heavy costs of compliance that had to be followed.
So slowly but surely the present administration has been chipping away at regulations. Regulators have said that the “intent of the Volcker rule would remain intact” to prevent banks from returning “to the wild days of proprietary trading when traders made big bets with the bank’s money and sometimes lost huge sums.”
According to Fed Chairman Powell, “The proposal will address some of the uncertainty and complexity that now make it difficult for firms to know how best to comply, and for supervisors to know that they are in compliance… Our goal is to replace overly complex and inefficient requirements with a more streamlined set of requirements.”
Many changes have already been put in place that loosen regulations. The Fed and the Comptroller of the Currency have recently proposed easing limits on how much large banks can borrow. There have also been changes to the annual stress tests that large banks undergo to determine if they can withstand an economic downturn and the Securities and Exchange Commission eliminated a rule that requires mutual funds to inform shareholders about large holdings of hard-to-sell assets.
The list keeps getting longer.
He claims that Fed Chair Powell and Vice Chair Randy Quarles are trying to substantially water down the Volcker Rule, and while he believes that one move is not a huge deal, several other regulatory provisions that are in place to safeguard against another financial debacle and TBTF taking over once again are also going by the wayside.
Mr. Yglesias is most concerned that “the dispensability of each of these individual provisions in isolation is the problem… They’re tearing down the safeguards and putting nothing in their place while assuming, rightly, that nobody is paying attention. One day there will be a price… And the nature of bank regulation is that even when it’s done really, really poorly, the odds are overwhelming that on any given day, nothing bad is going to happen. As long as the economy is growing and asset prices are generally rising, a poorly supervised banking sector is just as good as a well-supervised one.”
However he says, “when the music stops, and it always does, a poorly supervised banking sector can turn into a huge disaster. It’s only a question of when.”
The issue is much broader, by far, than the watering down of regulations one at a time. David Dayen, the author of Chain of Title: How Three Ordinary Americans Uncovered Wall Street’s Great Foreclosure Fraud, also warns us that the present administration’s zeal for financial deregulation could lead to an economic crisis.
Dayen ticks off a list of softening enforcement measures going beyond the weakening of the Volcker Rule, to include the Consumer Financial Protection Bureau’s new strategic plan which says it will “fulfill the Bureau’s statutory responsibilities, but go no further.”
He notes the Securities and Exchange Commission now doesn’t even publicize its weak attempts at punishment, burying announcements of fines in legal documents, and the Federal Reserve wants to weaken rules on leverage. Dayen says: “While our present administration insists this financial deregulation will relieve costs from businesses and jumpstart the economy… it’s clear where this laissez-faire approach leads: Without a cop looking over their shoulder, banks take more risks, increasing the danger of another crash.”
Mr. Dayen believes the deregulation concerns are supported by the findings of a new working paper, published in January by the International Monetary Fund, which provides empirical support for the idea that large-scale deregulation generates a financial crisis.
The paper, a brilliant synopsis and examination of boom-to-bust cycles by economist Jihad Dagher looks at ten financial crises going back 300 years, from a 1720 stock market crash in England to the Great Recession. It encompasses a span of crises from across the developed world: Japan, South Korea, England, Ireland, Spain, Sweden, and the U.S. The concept that deregulation increases risks to the financial system sounds like common sense. However, Mr. Dagher explains, “What makes this paper particularly timely is the high likelihood that the U.S. is on the verge of entering a period of deregulation.”
Rather than just focusing on the economics of the various collapses he cites, Mr. Dagher investigates the political economy and asks, “What was happening within governments that created the conditions for catastrophe?”
He questions the premise that financial crises are traditionally analyzed as purely economic phenomena. His paper examines the political economy of financial policy during ten of the most infamous financial booms and busts since the 18th century, and presents consistent evidence of the pattern of regulatory policies by governments.
He calls this consistent pattern “pro-cyclical” regulatory policies. A kind of pendulum: deregulation coincides with a financial boom that inevitably busts, and then a new government comes in and re-regulates the financial system. He found that this pattern holds true for all ten of the crises he cited, with deregulation accelerating in the five years preceding the crisis in nine of the ten examples. The pendulum speeds up right before the calamity, and only then begins to swing in the other direction.
He goes on to say that the various governments in all the countries he cited amplified the boom by weakening existing regulations and refusing to enforce violations of the rules. His many examples, from the dot-com boom of the late 1990s which occurred during a series of deregulations in the securities industry, to the situations in Japan, South Korea, and Sweden where they had “lifted banking regulations that were present for decades” in the prelude to the crash.
Mr. Dagher points out that as bubbles inflated, governments worked with bankers and large companies to provide air for that bubble, by subsidizing the expansion of credit and boosting asset prices. Government policies fed booms and, through close relationships between politicians and financiers, lead to episodes of corruption.
He goes back as far as 1720, when the South Sea Company bribed politicians to take over the handling of government debt, creating a speculative bubble in its stock that popped. As most politicians were invested in the company in some form there was really no incentive to put reins on the rampant speculation. “Over time, the interest in financial regulation wanes, allowing the latter to decay and for regulators to be captured by concentrated private interests,” he writes.
We often state that history repeats itself. However, saying it and learning from the lessons it might teach are two very different things. The writing is on the wall but we rarely heed it. Mr. Dagher says, we “too often look at financial institutions as the cause of crashes, and of course, they play a role. But the relationship between politics and financial system performance needs much more scrutiny… Preventing the next crisis involves more than just an understanding of how the existing regulations failed, but also why they failed.”
Three hundred years of financial regulation offer a cautionary tale to today’s push against yesterday’s regulations. The pendulum has been speeding up and so it will just be a matter of time before it swings back and we are doing everything we can to ensure it goes from boom to bust. So if history does repeat itself can we do anything to prevent the same old story from occurring again?
In the IMF working paper, Mr. Dagher has made some very relevant observations and suggestions as to how the story might be changed, which I will be sharing in a future post.