Making Financial Regulation Work

This is something I did for the The Hearing blog at the Washington Post:

Making Financial Regulation Work: 50 More Years, by Mark Thoma: Banking regulation imposed in response to the Great Depression and the recurrent panics of the 1800s and early 1900s gave us 50 years of stability in the financial system without impeding economic growth. That’s quite a record to overcome for those who say regulation does not work.
 
But the stability began to break down with the savings and loan problems in the 1980s, and the growing instability since that time is evident in the severe meltdown we are experiencing today.
 
What happened? Deregulation beginning with the Reagan administration combined with financial innovation and digital technology led to the emergence of what is known as the shadow banking system. These are financial institutions that, for all intents and purposes, function just like banks but are not subject to the same rules and regulations and, in some cases, are hardly regulated at all.
 
The development of the shadow banking system is important because the troubles we are seeing today are not the result of problems in the traditional, regulated sector of the financial industry. The problems began in the unregulated shadow banking system.
 
We need to bring the shadow banking system – essentially any institution that takes deposits and makes loans either directly or indirectly – under the same regulatory umbrella as the traditional banking system.
 
What type of regulation should we impose to give us the best chance of achieving another 50 years or more of relative calm?

Initially my concerns were with the economic issues, and the focus was on designing a regulatory system that would overcome the market failures that led to excess risk-taking and to institutions that were too big and too interconnected to fail.

But large financial firms exert more than their share of political power, and this adds another dimension to the problem. Banks that are too big and too interconnected to fail pose an economic risk to the overall economy. However, firms can also be "too big for politicians to ignore." When this happens, they can exert undue influence on legislation or capture the regulatory process in ways that allow them to escape enforcement of rules already in place. So regulation is needed to limit political power as well as economic power.

But that is not enough. The environment the regulatory process operates in must also be changed if we are going to bring about a more stable, more reliable financial system.

Today’s problems could have been eased or perhaps even avoided entirely if regulators would have simply enforced regulations already in place, or called for new ones when existing tools were inadequate. But instead, regulations were not enforced to the extent they could have been, and there was little internal opposition when they were lifted.

The attitudes within regulatory agencies were driven by the widely held belief that the discipline of the marketplace would not allow the accumulation of excessive risk. Regulators did not believe that the type of meltdown we have just experienced could occur. Problems could develop in individual markets, and those could be troublesome, but the system-wide, falling-domino-type collapse we’ve just observed just couldn’t happen — not in modern financial markets with all their digital technology, fancy mathematics, and complicated risk-dispersing products. Or so it was believed.

If you don’t believe something can occur, you won’t be sensitive to signs that it might be about to happen. Regulators missed the signs of the crash because they didn’t think a crash of this breadth and magnitude was possible. Besides, more benign explanations could be made to fit the facts.

We now know that a system-wide financial breakdown was in the realm of possibility, and that should change how regulators view market developments in the future. They won’t soon forget that markets can and do collapse when left unattended, and they will interpret developments in financial markets with that in mind.

So what should we do? In very broad terms, we need:

• Regulations that limit both economic and political power and discourage the buildup of excessive risk.
• Regulators willing to assertively enforce existing regulation, think outside the ideological box and take an active role in identifying areas where regulation is inadequate.
• Regulators with the means and power to stand up to the biggest and most powerful financial institutions. Making financial institutions less powerful by breaking them up into smaller entities is one means to this end.
• A culture within regulatory agencies and their supporting institutions that reinforces and encourages the regulatory process.

It won’t be easy to bring about the needed regulatory change, not with still-too-powerful financial companies lobbying against it, but it’s essential that we do.

[You can leave comments here as usual, and, if you want to extend the reach of what you have to say, you can comment here too.]