Published daily by the Lowy Institute

The tide is turning against US financial regulation

The lessons of the 2008 banking failures look like they have already been forgotten – or erased.

Photo: Johan Sjolander/Getty Images
Photo: Johan Sjolander/Getty Images

This article was orginally published on 7 February and has been reposted following legislative change this week in the US. 

For most of the decade since the global financial crisis, financial regulation has been strengthened. Now the tide is turning in America. Reform has come up against the combined forces of Wall Street lobbying and Donald Trump’s deregulation agenda.

It is beyond dispute that the financial crisis revealed not only serious deficiencies in prudential regulations, but also systematic gaming of the regulations by European and US banks. Alan Greenspan’s view that the self-interest of financial sector management would discipline their actions proved hopelessly out of touch with reality.

The reform efforts have been coordinated at the international level by the Bank for International Settlements, rewriting the Basel rules that focus mainly on ensuring the banks have enough capital to absorb losses. Within this global framework, national regulators have flexibility to modify and add to these rules in order to suit local conditions. Randal Quarles, Trump’s appointee in charge of supervision on the Federal Reserve Board, has foreshadowed changes to the US regulatory framework – all favouring Wall Street.

The first proposed change will weaken what has proven to be one of the most effective post-2008 measures: the requirement that banks undergo a stress test to simulate the impact of an adverse shock, such as a big fall in GDP, on the balance sheets of individual banks. Stress tests in 2009 were, in fact, the key to restoring public confidence in the US banking system after the crisis.

Since then, however, the banks have complained that they don’t know what the simulation shocks will be in advance, so can’t prepare themselves properly. This might sound a bit like students asking to be told what their exam questions will be ahead of time. Banks can tweak their balance sheets so that they look good in the context of these specific shocks. Nevertheless, Vice Chairman Quarles seems ready to make the stress tests more “transparent”.

The loudest of the bank complaints relates to the “Volcker Rule”, even the watered-down version of which was finally agreed upon in 2013. Until 1999 the Glass-Steagall Act separated banking from other financial activities, such as insurance and investment banking. The logic is simple: in a crisis, the banking sector is protected not only by depositor insurance, but also by the understanding that if a substantial bank gets into trouble, it will inevitably be bailed out by the taxpayers to ensure there is no general loss of confidence in the financial system.

The implicit downside of this guarantee is that it may make bankers less diligent and more risk-prone (moral hazard), and it certainly means that taxpayers subsidise the full range of risky activities. Thus, even though an implicit guarantee is necessary, it should be confined to the part of the financial sector that is really vital – simple deposit-taking and lending, and the payments system. The taxpayer should not be guaranteeing banks’ own-account trading in financial and commodity markets or risk-prone activities, such as derivatives and securitisation.

Of course, this comprehensive coverage suits banks. For a start, the government guarantee means that they can borrow more cheaply. All sorts of arguments, of varying merit, have been put forward in opposition to the Volcker Rule. But the need for this kind of separation has been recognised universally, with the UK and Europe moving to ring-fence traditional banking services.

The most powerful argument in favour of such a separation relates to the diverse nature of finance. A good financial sector should:

  • provide funding even for risky ventures
  • provide risk-management (such as underwriting IPOs, derivatives and forward cover)
  • participate in the full range of financial markets
  • be innovative.

All this is desirable and necessary. But providing a government guarantee for banks carrying-out this full range of services not only puts the taxpayer at risk, but also alters the structure of the financial sector. Core banking should be a dull part of finance, run by conservative, risk-averse managers. Without an enforced separation, banks expand their activities into these more exciting activities and are then managed by hard-driving, risk-loving Masters of the Universe. Didn’t we learn this lesson in 2008?

This prospective weakening of the Volcker Rule will not cause an immediate collapse of the financial sector. Memories of 2008 are still fresh enough to constrain management and stiffen regulators’ spines. But the lessons of the 1930s bank failures lasted for more than half a century. The lessons of 2008 look like they have already been forgotten, or erased.


2018-02-07 16:30:00 +1100

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