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Financial Crisis Prevention Through Regulation

Introduction: Precursors of Financial Crises

A financial system consists of legal rules, firms, and markets, with the financial firms including commercial banks, investment funds, financial market participants, and government entities that purchase, guarantee, and provide security for mortgages (Anabtawi and Schwarcz 2013, 86). Financial firms and financial markets operate in the context of various regulatory bodies that, to a lesser or greater degree, “govern the provision, allocation, and deployment of financial capital” (p. 86).1 At the same time, relevant legislation provides for penalties to (a) prevent breaches of the regulatory framework, (b) mitigate the adverse consequences of breaches of the regulatory framework, and (c) reduce the likelihood of further losses (Anabtawi and Schwarcz 2013, 84).

Designed to ensure the stability and safety of depository financial institutions and to protect consumers, government financial regulations in the United States can be traced to the 1933 Banking Act,2 which was introduced to address problems that had contributed to the Great Depression. It tried to do that by inter alia creating the Federal Deposit Insurance Corporation (FDIC) to insure deposits in banks, compelling national banks to comply with federal regulations, and imposing restrictions on how much commercial banks could loan. Similarly, legislation was introduced to regulate other depository institutions, namely, the 1933 Securities Act (for the securities markets), the Federal Home Loan Bank Board in 1933 (for the savings and loan associations), and the Bureau of Federal Credit Unions in 1934 (for credit unions). However, for several reasons, which regulators and consumers were hard-pressed to understand, let alone control (e.g., computer technology, high interest rates, entrepreneurial innovations,3 political ideologies, and power), the regulatory system was introduced after the Great Depression and was not reformed until the 1970s (Liou 2013, 212). More specifically, usury laws were changed in 1978, interest rate ceilings were removed in 1980, banks were allowed to offer adjustable-rate mortgage loans in 1982, and the Financial Modernization Act4 of 1999 repealed restrictions provided in the Glass—Steagall Act of 1933, including the vital separation between commercial and investment banks. The abolition of the separation of banks made it possible for financial institutions to become mega banks by combining banking, securities, and insurance operations.

In the United States the regulatory legislation and institutions developed since the Great Depression and the deregulation policies since the late 1970s have created a “fragmented and complex regulatory system” (Liou 2013, 211). This regulatory system was characterized by a risk-averse attitude, moral hazard (Peretz and Schroedel 2009), conflicting goals, unregulated entities, and political incentives. The challenge for public administration researchers and governments alike in the wake of a devastating financial crisis, like the one in 2008, which “[appeared] to have been eminently preventable” (Kemper and Martin 2010, 229), is to address and balance “not only short-term, specific business or political interests but also long-term, social-justice and public interests in the development and implementation of consistent financial and regulatory policies” (p. 216).

The work of Chelikani and D’Souza (2014, 58) reminds us that markets exist in order to exchange assets and the formulation of explicit rules that govern or control this process is vitally important for efficiently pricing traded assets. In the wake of market crashes and the ensuing financial crises, legislators rush through ineffective legislation in an effort to ensure that such disasters do not recur; however, such legislation may well cause harm. The same authors also warned their readers that, if regulators are left unchecked, their laws may facilitate the very crisis they are intended to prevent. Further, Chelikani and D’Souza noted that mechanisms for testing recently implemented regulations are essential and should be developed. The fact remains, of course, that a government’s response to a financial crisis inevitably entails both challenges and concerns. Furthermore, in a democratic country and a free market system, “it is not easy to address these challenges and concerns because of the differing political philosophies, economic theories, and interest groups involved in our democratic state and market system” (Liou 2013, 219). As Liou reminds us, perspectives on government regulation can be understood in different ways depending on one’s definition of regulation (p. 216). Discussion of different definitions of regulation raises the issue of what role the government should have in the market system.5

In order for regulation to be put into effect, political will and political influence are needed. Lobbying has become the means by which the stakeholders, often without transparent methods, encourage legislation to be enacted or not. The financial services industry tends to “dominate public policy during times of relative financial stability” (Anabtawi and Schwarcz 2013, 97) because it is in their interest to take excessive risks, oppose regulatory efforts, and externalize significant costs. The public are “widely dispersed, weakly organized, enjoy diffuse political power and are susceptible to ‘availability bias’ which reflects the tendency to be most aware of recent or vivid events” (Slovic, Fischhoff, and Lichtenstein 1982),6 and thus they underestimate the potentiality of catastrophic risks because of what Dallas (2012) referred to as “disaster myopia.” Therefore, during financial stability or when the markets are calm, people do not fear a financial crisis, and the special interests of the financial services industry dominate public policy (Coffee 2012, 1021-1022).

Further to the brief examination of the etiology of the 2008 crisis (in the previous chapter), various authors have suggested a broad range offactors that combined to bring about the crisis. The discussion that follows focuses at a general level on those factors that are pertinent to the focus of the present book and does not, for example, consider relevant literature by economists and others.7 As Gambacorta and von Rixtel (2013) reminded their readers, the financial crisis highlighted the need (a) for reassessment of the benefits and the economic costs of “universal banks involvement in proprietary trading and other securities markets activities” and (b) “to strengthen market- based pricing of risk and market discipline” (p. 1). Also, because the taxpayer in the United States8 and elsewhere had to bear the heavy burden of bank losses, structural measures were introduced to segregate and regulate bank activities by separating “commercial” and “investment” banks. More specifically, the United States enacted legislation (s.619, the Dodd- Frank Wall Street Reform and Consumer Protection Act [the Volcher Rule]), while the United Kingdom and Europe had Commissioned Reports (i.e., the Independent Commission on Banking; see Vickers [2011] and the High-Level Expert Group Report to the European Commission [2012] on reforming the structure of the EU-banking sector, known as the Liikanen Report, respectively). Similar initiatives have been taken in France and Germany (Gambacorta and van Rixtel 2013). Examination of the literature shows that the roots of the 2008 crisis were many and varied, including loose credit conditions; risky overtrading in parts of the financial sector; overly optimistic risk management; lax accounting standards; and greedy and short-term compensation regimes. These elements, each toxic enough on its own, combined to create an environment characterized by excessive optimism and overconfidence.

According to Gambacorta and van Rixtel (2013, 1), a major cause of the financial crisis was that “many universal large banks shifted too many resources to trading books, supported by cheap funding.” As a result, market discipline was weakened by the complexity of many banks, and their interdependency increased systemic risk, worsening the contagion effect within and between banking institutions (p. 1). The sensible solution was to separate bank activities to reduce risk. Other important causes of the financial crisis of 2008 were the lack of government oversight of the highly risky mortgage-based security market (Fligstein and Goldstein 2010) and the lax regulation and lack of discipline, both arising from bankers’ active pursuit of narrow, short-term interests (Yue, Luo, and Ingram 2013, 60). On this point, the financial crisis of 2008 was strikingly similar to the October 1907 financial crisis in the United States, also known as the 1907 Bankers’ Panic or Knickerbocker9 Crisis, when the New York Stock Exchange fell almost 50 percent from the previous year’s peak. The 1907 Panic spread throughout the United States when many state and local banks and businesses declared bankruptcy.

Liou (2013, 211) stated that contributory factors to the 2008 financial crisis were the deregulation policies concerning the financial institutions and the failure of various government policies to intervene in the housing markets, monetary policy issues, and financial regulation; thus, the regulatory system failed to prevent the problems that brought about the financial crisis. Liou proposed that the contributory factors leading to the 2008 financial crisis were (pp. 208-210)

  • moral hazard such as paying excessive bonuses to managers out of funds they manage or inducing customers to obtain a loan, knowing that they cannot repay it;
  • corporate governance, that is, weaknesses of financial corporations, such as problems associated with financial management techniques, corporate accountability, and governance; inadequate assumptions of risk analysis models or tests; and weaknesses in procedural arrangements in transmitting risk information and exposure to the board and senior levels of management;
  • systemic risk, that is, the consequences of financial contagion exemplified by the liquidity crunch that first surfaced in firms and securities related to subprime mortgages in mid-1997 and expanded to nonbank financial institutions; and
  • government policy failure in the fields of housing market,10 monetary policy, and financial market regulations.

Avgouleas (2009) explained the causes of the crisis in two ways. First, commercial and investment banks exploited the prevailing conditions ofexcessive liquidity and financial innovation to obtain substantial exposures in the global credit markets that were largely impossible to value. Secondly, by using elaborate alternative investment schemes and complex credit derivatives, the banks moved a gigantic amount of assets and liabilities off balance sheet, creating a kind of shadow banking.

Avgouleas (2009, 455) offered another explanation for the 2008 global credit crisis, namely that a “recurring theme in every regulatory report on the causes of the global credit crisis is the role of lax risk management controls within financial institutions.” Avgouleas believed the failure of internal risk management controls was based on the following: (a) failing credit control and borrower vetting standards, (b) inability to properly value positions in structured credit securities, (c) excessive reliance on credit ratings in spite of their widely known shortcomings, (d) inadequate use of information when it was provided, and (e) ignorance of senior bank management of the true function of Special Investment Vehicles.

Regarding the failure in the United States, two under-recognized causes were identified by Coffee (2009) as the main reasons. First, the excessive reliance on credit rating agencies that gradually became subject to client pressure as competition increased in this market. Second, a shift had occurred toward more self-regulatory rules, which permitted investment banks to increase leverage and reduce diversification under competition pressure. The crisis caused a significant collapse of confidence around the world and led to extraordinary reductions in national output and industrial production. It also resulted in very serious recession for many countries worldwide. Significantly, it caused a considerable breakdown of trust in and within the financial system, in politicians, in bankers and directors, and even in the whole process of globalization (Green 2009). The crisis revealed that in the absence of a supporting infrastructure of governance, laws, and culture, markets cannot and will not function well. What we learned was that good corporate governance is a crucial ingredient of a country’s infrastructure and cannot be ignored. The system of checks and balances that supports corporate governance needs to work successfully. Let us next consider the notion and the need for regulation.

 
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