The Role of Deregulation and Financial Innovation in the Credit Crisis

Greg Billington

Lauren Davis

Joseph Hall

The Role of Deregulation and Financial Innovation in the Credit Crisis

The Subprime Mortgage Crisis of 2007 was born from the union of negligent deregulation and avaricious risk taking. With $20 trillion lost and incessant double digit unemployment, it stands as the greatest instance of financial turmoil since the Great Depression. Although proof of causation is often hazy at best, many of its origins and the avenues through which it was amplified have been identified. The systematic deregulation of the banking industry during the decades leading up to the crisis paved the way for over-sized and unmonitored loans; these in turn fueled the lending and mortgage boom that triggered the initial collapse (Brunnermeier, 2009). Once the housing bubble burst, the financial innovations which had grown out of and alongside deregulation inflated the worldwide loss of wealth (Krishnamurthy, 2009). A complete analysis of the crisis necessitates an understanding of how the financial sector was able to create so much systemic risk and why a relatively small number mortgage defaults burgeoned into a pandemic economic crisis.

Alan Greenspan served as Chairman of the Federal Reserve of the United States from 1987-2006. As chairman, Greenspan’s involvement with the deregulation of the financial markets was so deep that his stint has virtually become synonymous with the risky practice altogether. The era primarily centers around four laws: the Glass-Steagall Act (1933), the Depository Institutions Deregulation and Monetary Control Act (1980), the Garn-St. Germain Depository Institutions Act (1982), and the Gramm-Leach-Bliley Act (1999). This mindset of deregulation completely opposed that which dominated immediately following the Great Depression. Prior to WWII, all regulatory structures and legislation set in place were in response to several financial crises that occurred from the late 19th century into the 1930s. In 1927, the McFadden Act was passed, which banned interstate banking in order to evade much of the interstate competition that would eventually lead to risky lending. National banks were only permitted to operate within the state in which they were situated. Due to the Great Depression, the U.S. government was primarily focused on setting better sustainable regulatory structures in place. 1929 marked the year of the stock market crash that led to the Great Depression. As a response to the crisis, the Glass-Steagall Act was passed in 1933. Banks, whose profit stemmed from the gap in interest paid from depositors and to lenders, faced intense competition for interest rates on the payments, which encouraged them to make riskier loans. The act provided a formal separation between commercial and investment activities. Regulation Q, one of the act’s provisions, authorized the Federal Reserve to “regulate interest payments on deposits” (Hammond and Knott 14).

Three federal agencies were authorized as part of the regulatory structure supervising banks: the Office of the Comptroller of the Currency, the Federal Reserve Board, and the Federal Deposit Insurance Corporation (FDIC, 1984). In the possession of the Office of the Comptroller of Currency (OCC) lay an arsenal of methods that not only act to effectively regulate national banks, but ultimately to foster the health of the financial industry (Stiller, 1994). The OCC fulfills duties including: ensuring that all Americans gain fair and equal access to financial services, enforcing anti-money laundering and anti-money terrorism attacks, as well as investigating and prosecuting all those not willing to abide by sanctions set forth by the U.S. government (Stiller, 1994). To further strengthen its executive authorities, the OCC is allowed to intertwine its efforts with other leading policing and investigative units of the United States government, including the Federal Bureau of Investigations and Federal Deposit Insurance Corporation (FDIC). The FDIC offers insurance of up to $250,000 on the deposits of member banks as well as safety monitoring methods that overlap the actions of the OCC also working in conjunction with the Federal Reserve (FDIC, 1984). With these three main agencies in place, theoretically speaking, a catastrophe the size of the most recent crisis should never have been allowed to take shape. In looking back, one can deduce that the deregulation that took hold of the American economy began at a reasonable pace, “with the Carter administration’s abolition of restrictions on airline routes” followed by deregulation of the telecommunications, media, and financial services industries (Cassidy 7).

The financial deregulation and unchecked financial innovation picked up in the 1980s and continued into the twenty first century. Whereas at one time banks were not allowed to merge, their mergers have become “Capitol Hill’s longest and most expensive show,” and, similar to a bad horror film, “the issue appears as a rerun in Congress after Congress” (Lewis, “Financial Deregulation Fiasco”). To begin, the Securities and Exchange Commission eradicated fixed brokerage fees in 1975 (Hammond and Knott 5). Three years later, Congress passed the Airline Deregulation Act, and in 1980, “statutes deregulating aspects of the trucking, rail, financial and television industries were all approved” (Hammond and Knott 5). According to Hammond and Knott, “economic, technical, and legal changes in and around the financial industry” created “altered positions toward the regulatory status quo within the financial industry,” thus generating “competitors to the status quo outside the industry” (7). The two authors also coin the phrase “deregulatory snowball” to exemplify that once laws initiated a partial deregulation, this only promoted further deregulation.

The benefits and stability created by the regulatory structure were not recognized until the ‘deregulatory snowball’ had already begun, forever altering the financial sector. The 1960s and 70s saw changes in the financial environment which ultimately led to the passage of several of these deregulatory laws. The two decades were characterized by “growth in the Eurodollar market, interbank borrowing of funds, electronic transfers of funds, and the invention of other financial instruments outside the regulatory scope of Regulation Q” (Hammond and Knott 15).Under regulation, banks and savings and loans were able to reap extremely high profits compared to other industries (Hammond and Knott 14). Additionally, the probability of the two sorts failing was incredibly low. Between 1944 and 1974, less than ten banks failed on an annual basis (Cargill and Garcia 10). However, after the passage of the Depository Institutions Deregulation and Monetary Control Act in 1980, the probability of failure dramatically increased. In 1980, 10 banks failed, and by 1985, nearly a thousand banks and five hundred S&Ls were considered to be troubled institutions requiring government intervention (Hammond and Knott 14). In other words, the FDIC handled close to $10 billion in bank failures through 1980, followed by a processing of $30 billion between 1981 and 1984 (Hammond and Knott 14).

In 1980, Congress passed the Depository Institutions Deregulation and Monetary Control Act. This new legislation allowed banks to expand their practices and lending capabilities along with raising the deposits insurance limit from $40,000 to $100,000. Immediately following its passage, the economy spiraled downward into a recession that spread over two years: 1981-1982. This was bad news for many of the banks that had become involved in speculative lending and real estate. A couple of years later, in 1982, Congress passed the Garn-St. Germain Depository Institutions Act, giving S&Ls the ability to make a variety of short term loans, and “fully deregulated price competition between brokerage money market funds and banks” (Hammond and Knott 20). To do this, banks were now allowed to offer “Super NOW accounts and money market demand accounts which paid market rates of interest and bad checking privileges” (Hammond and Knott 20). Even after the enactment, several banks failed in the ensuing years. Without Regulation Q, the cost of attracting funds was much higher for banks, and “without corresponding increases in the return on bank loans, the spread between costs and revenues declined,” which motivated riskier lending with higher interest rates (Hammond and Knott 20). Here, the ‘deregulatory snowball’ picks up pace: “with bank deregulation by price in place, the banks want deregulation by geography and by product” because they believe that “price deregulation has increased their risks, which other kinds of deregulation would spread and reduce” (Hammond and Knott 21).

Further deregulation quickly picked up into the 1990s. In 1990, for example, JP Morgan became “the first commercial bank to underwrite securities,” and in 1996, Fed began allowing banks “to acquire investment banking affiliates, with some restrictions” (Cassidy 229). Greenspan did not make these decisions without objections, however. Many argued that the level of shock deregulation had caused in the financial system would lead to serious problems. He responded: “risks in financial markets . . . are being regulated by private parties” and “purchasers of financial products, even the most complicated ones, would regulate Wall Street” (Cassidy 230). Greenspan so strongly believed in the self-regulating, efficient free market, that he ignored many public concerns. Others attempted to reinstall regulation or to merely slow the deregulation to combat the risk taken on by the financial industry, but Greenspan fervently opposed these efforts.

In 1999, Congress enacted the Gramm-Leach Bliley Act, also known as the Financial Services Modernization Act. Senator Phil Gramm declared, “the hallmark of the bill is that it will make an array of financial services available to every American consumer that will provide lower prices and one-stop shopping at financial supermarkets in every city and town in the country” (Weissman 6). Many of the provisions of the new bill included: to “pave the way for a new round of record-shattering financial industry mergers as banks, insurance companies, and securities firms line up to take their marriage vows” and to “leave financial regulatory authority spread among a half dozen federal and 50 state agencies, all uncoordinated” (Weissman 6). Citibank and Travelers had merged prior to the enactment. However, this merger was prohibited under the Glass-Steagall Act, which had forbidden mergers between banks, insurance companies, and securities. This merger and several others were authorized post-enactment.

Many blame deregulation as one of the causes of the current economic crisis. Others argue that the Fed held interest rates down for too long, over-stimulating the economy. Phil Gramm, one of the sponsors of the Financial Modernization Act, still defends the deregulatory act and the deregulation that has taken place in financial markets. He mentions that the 1992 Housing Bill “set quotas or ‘targets’ that Fannie and Freddie were to achieve in meeting the housing needs of low and moderate-income Americans” (Gramm, “Deregulation and the Financial Panic”). Gramm also defends the bill, saying that no one has ever fully explained how deregulation has caused the financial crisis though people tend to point fingers at the GLB act and the Commodity Futures Modernization Act of 2000. The politician also claims that if the GLB act were the problem, the financial crisis “would have been expected to have originated in Europe where they never had Glass-Steagall regulations,” adding that “the financial firms that failed in this crisis, like Lehman, were the least diversified and the ones that survived [J.P. Morgan] were the most diversified” (Gramm, “Deregulation and the Financial Panic”). According to Gramm, regulators were extremely well equipped to handle their duties, and that one cannot say that the industry would have turned out differently if financial regulators had had more resources or authority at their disposal.

In July of this year, the Financial Oversight Bill was passed, which requires more federal oversight and creates more regulatory bodies, but leaves the actual regulating up to their discretion and utilizes most of the same individuals within those bodies that had responsibilities during the financial crisis. One element that contributed to the financial crisis was the lack of regulatory structure and oversight, and “as traders and lenders increasingly drove the nation’s economic growth, politicians of both parties” got out of the way, “passing a series of landmark bills that allowed financial companies to become larger, less transparent, and more profitable” (“Financial Oversight Bill Signals Shift on Deregulation”). The Bush administration pressured banks to lend to less credit worthy and less wealthy consumers so that every American could live the American dream and have a home. Officials, however, did not consider the extent to which deregulation of the financial sector would harm the economy in relation to how dependent the health of the financial market became on the housing market.

This history of deregulation set the stage for an environment on Wall Street that not only permitted, but necessitated excessively risky behavior in order to remain competitive (246, Cassidy). Leverage grew and finance teetered on an increasingly unstable platform. The derivatives market, which the Gramm-Leach-Bliley Act played a part in deregulating, (Cottrell, Lecture) had swollen to $900 trillion in value (Tolios). By the time delinquent subprime mortgages had triggered the 2007 Financial Crisis (Brunnermeier, 2009), institutions had become so leveraged that a small shock would have reverberated throughout the entire economy. So even though the initial effects of mortgage defaults were limited to the housing and financial sectors, and “the direct losses due to household default on subprime mortgages are estimated to be at most $500 billion... the effects of the subprime shock have been far reaching” (Krishnamurthy, 2009). In just the first year after the economy began its collapse, there was an estimated $8 trillion worth of wealth lost in the US (Brunnermeier, 2009). Since then, a further $12 trillion has disappeared from the collective pocketbook of America (DeLong). Clearly, the total depression of the US economy far outweighs the initial crisis. In order for the $500 billion loss of wealth to have increased 16 fold in merely one year (and 40 fold in three!), large multipliers must have played a role. By the time the crisis began, the financial derivatives market, which was based off little more than hedged monetary bets, had swelled to 16 times the size of the world’s economic output; to believe that such a bloated and risky system did not accelerate the economic meltdown would be blind, naive, and dangerous.

Not only did deregulation play a role in permitting unsafe practices on Wall Street, but financial firms also began creating new, riskier methods of funding which existed outside of regulations. So although increased delinquencies were the root cause of the mortgage crisis (Brunnermeier, 2009), the development and increased usage of financial innovations played a large role in amplifying the effects of defaulted mortgages (Krishmanurthy, 2009). Over the past two decades, the advancements in finance changed the fundamental way in which balance sheets, risks, mortgages, and credit were handled (Krishnamurthy, 2010). Structured investment vehicles were involved in a ‘shadow banking system’ that provided new sources of funding, but only by hiding systemic risk and increasing leverage (Rajan, 2006). Credit default swaps and securities were meant to move risk to those most able to bear its burden, but instead ended up increasing the number negligent loans and decreasing liquidity during the crisis (Gennaioli, 2010). The increased liquidity associated with Collateralized Debt Obligations and Credit Default Swaps, although at times socially desirable, also significantly increased risk by increasing the rate at which the prices of securities deteriorated (Rajan, 2006). Structured Investment Vehicles and the ‘shadow banking system,’ meanwhile, increased effective leverage by providing a source of funding and of debt that was not bound by regulation and capital reserve requirements (Brunnermeir, 2009). Thus, despite contrary intentions, banks ended up with increased leverage, increased systemic risk, increased debt, and a financial market that was on the brink of collapse.