There is much disappointment over the reach of financial reform in the wake of the financial crisis. Legislation passed in the United States since then, the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010, was weak soup by the standards of the 1930s. In 1933, in response to the banking crises of the Great Depression, the US went much further. It imposed a sharp separation between commercial and investment banking activities with the Glass-Steagall Act. That forced banks that took deposits from customers to divest their security-underwriting businesses which could threaten those savings. Federal deposit insurance, another sharp break with the status quo, was extended in 1933. The Securities and Exchange Commission (SEC) was created in 1934 to oversee financial markets, rejecting the fiction of self-regulation.
Reform in the United Kingdom and Europe was generally slower, the UK and other European countries not experiencing banking and financial crises quite as severe as those of the US. But in the UK and Europe, as in the US, the regulatory environment for banks and securities markets that emerged from the Second World War was strict and demanding.
In the absence of more far-reaching reform, pre-2008 risks and vulnerabilities are still out there.In contrast, no comparably tough financial reforms were undertaken after the recent crisis. Our banks remain undercapitalised and our financial markets vulnerable. The spectre of a Greek exit from the euro creates fears that other countries could follow, straining banks across the eurozone. Worries are mounting about whether companies in emerging markets can repay what they have borrowed, including from banks and securities markets in Europe and the US. Financial markets in the US and UK may be buoyant for the moment, but no one knows how they would react to a shock from Greece, from emerging markets or from elsewhere, given the untold trillions of dollars of exposures to derivative securities still circulating under the regulatory radar. In the absence of more far-reaching reform, pre-2008 risks and vulnerabilities are still out there.
What would more ambitious reform have entailed this time? Big banks would have been broken up, solving the problem of “too big to fail.” Deposit-taking banks would have again been told to divest themselves of their investment banking activities, eliminating the conflicts of interest that had jeopardised the savings of innocent households. The Basel Accord, the international agreement on bank capital that provided inadequate safeguards before the crisis, would have been torn out root and branch. In its place banks could have been required to hold much larger capital cushions, say 25 per cent of the market value of their investments, giving them a comfortable margin to absorb losses. They would have been less prone to fail or need a taxpayer bailout.
As part of this ambitious effort, complex financial securities would have been banned or at least standardised and forced to trade on an exchange. This would have been better than allowing them to be traded bilaterally (“over the counter”), where the failure of one party to deliver payment could damage the finances of its counterparty, in the worst case triggering a domino effect that could bring the financial superstructure tumbling down.
Lastly, the big three credit rating agencies—Moody’s, Standard & Poor’s and Fitch—could have been barred from advising security issuers on how to structure their offerings and then rating the resulting securities. Before the crisis, regulators relied on the commercial ratings supplied by these profit-oriented companies to gauge the riskiness of bank portfolios and confirm that the investment practices of pension funds and insurance pools conformed to their mandates. Given the demonstrable failure of such ratings to convey useful information about the performance of different securities during the crisis, law and procedure could have been changed to eliminate their role in regulation.
Alas, none of this was done. For banking, what we got instead was a modest revision of the Basel Accord that tweaked how capital was measured. Rather than a sharp Glass-Steagall-like separation of commercial and investment banking, we got the “Volcker Rule,” aimed to prevent US banks from engaging in risky securities trades, a measure so complex and opaque as to be unworkable. The UK has the more ambitious “Vickers Rule,” intended to ensure that banks engaged in risky investment and trading activities have the resources to repay their depositors in all circumstances. But the secondary legislation needed to implement the rule has yet to be adopted, and its effectiveness is unproven.
Rather than fundamentally reorganising regulation, governments settled for rearranging the deckchairs on the Titanic. The UK Financial Services Authority was abolished in 2013, and responsibility for financial supervision shifted to the Bank of England. Of the former, many will say good riddance. But it is not as if the Bank of England can be absolved of blame for the crisis. Recall how its then Governor, Mervyn King, insisted that Northern Rock and other institutions were fully capable of finding a “private sector solution” (meaning a deep-pocketed suitor) immediately before the Rock met its disorderly and, for the taxpayer, costly fate. An internal review commissioned by King’s successor, Mark Carney, criticises the central bank for “group think” and slow reactions. These observations should create some disquiet over the decision to reward it with more responsibility.
The EU, for its part, transferred the regulation of banks in the eurozone and other consenting European countries from national authorities to the European Central Bank. But rather than force-feeding capital to the banks and addressing the fundamental weaknesses of regulation, EU officials concentrated on publicity-friendly gambits like caps on bankers’ bonuses and pay, and “stress tests” that found all banks to be above average. The US settled for eliminating the Office of Thrift Supervision, the least competent of its seven regulators.
It looks like a crisis gone terribly to waste.Meanwhile, the complexity of pre-crisis markets remains. Rather than prohibiting complex derivative instruments, officials settled for requiring underwriters to provide more information on the loans backing their securities, and for adding a cooling-off period giving investors more time to consider their purchases. Rather than forcing trading on to an exchange, regulators designated eight private-sector entities as clearinghouses where bilateral trades can be pooled, while requiring those undertaking those transactions to set aside additional funds, or “margin,” to compensate the affected for the failure of one of their number. But these methods, which are suited to managing an isolated default, may not be enough in the event of a cluster of problems. Instead of reducing risk, this approach concentrates it in a new set of too-big-to-fail institutions, namely the clearinghouses, that will need taxpayer help when things go wrong.
Finally, rating-agency reform amounted to little more than obliging the agencies to publish their methodologies and report on the performance of their ratings. Rather than prohibiting the agencies from both advising issuers and rating their issues, their CEOs were merely required to attest to the fact that the two functions were properly separated. Reform meant asking us, in effect, to take their word.
Many will see all this as a missed opportunity. To paraphrase Rahm Emanuel, President Barack Obama’s former Chief of Staff, it looks like a crisis gone terribly to waste.
How do we explain this lack of ambition and contrast with more far-reaching reform in the 1930s? It may reflect scepticism about the ability of governments to solve problems at all, including those of a broken financial system. Such scepticism is ingrained in the American psyche—the Tea Party and Silicon Valley libertarianism are only the latest manifestations of this deep-seated instinct. It is reflected in interpretations of the crisis that blame US officials for encouraging the government-sponsored entities Fannie Mae and Freddie Mac to invest in the “subprime” mortgage market as a way of advancing politicians’ “affordable housing goals.” Equally, it is implicit in accounts of Britain’s crisis that point fingers at the Financial Services Authority and Bank of England for failing to anticipate and correct weaknesses in institutions such as Northern Rock. It is reflected in the British public’s doubts about whether Labour, traditionally the champion of government intervention, is competent to manage the economy and in the relative lack of resistance to the coalition’s efforts, behind the veil of fiscal consolidation, to reduce the role of the state in the economy.
But the long-standing nature of this scepticism is precisely why it cannot be used to explain why reform was less far-reaching than in the 1930s. Then, too, there was scepticism about a more expansive role for government. There was active opposition from business and finance to the creation of federal deposit insurance and resistance to the establishment of the SEC. Equally tellingly, today, in European countries where resistance to interventionist government is less firmly entrenched, post-crisis financial reform has been just as lacking in ambition.
Some will argue that our 21st-century financial system is simply too deeply embedded in the economy to permit amputation, or even radical surgery. Given the reach and sophistication of finance and its importance for the operation of the economy, putting the genie back in the bottle is no longer possible. Neither is it possible, so the argument goes, for any single country to go down the path of radical reform, since big banks span national borders and can easily relocate to avoid more stringent regulation.
There may be something to these points, but the correct response to more sophisticated markets should be more sophisticated oversight. To transnational financial institutions there is the response of transnational agreement and cooperation in regulating them. This is why the international community created the Basel Committee on Banking Supervision in 1974 and the Financial Stability Board in 2009, committees of national supervisors that meet to exchange information, consult and harmonise policies. And if financial institutions are too big and complex to be regulated, then they should be broken up. If they are too footloose to be corralled, they should be reorganised along national lines.
The fundamental explanation for more limited reform this time must lie elsewhere, therefore—in the fact that we averted the worst. Through a series of controversial actions, we avoided another Great Depression. Central banks injected liquidity into the banking and financial system. They cut interest rates to zero and, when that was not enough, followed with massive purchases of government bonds. The 2009 G20 summit, held in London under the chairmanship of Gordon Brown, agreed on a $1 trillion package of coordinated tax cuts and increases in public spending. Taxpayer money was mobilised to repair bank balance sheets. To be sure, there were missteps along the way, from the decisions that led to the runs on Northern Rock and Lehman Brothers to the premature turn to fiscal austerity in 2010-11 and the eurozone’s dreadful mismanagement of its own crisis. But there is no question that the situation would have been infinitely worse, 1930s-style, without this action.
As President Obama has said, no one wants to be defined by what he avoided. Still, preventing a repeat of the great economic catastrophe of the 1930s, the danger of which in 2008-09 was very real, was a monumental achievement. It is Barack Obama and Gordon Brown’s greatest legacy. But it is that very achievement that sapped the appetite for radical reform. In the 1930s, the depth of the depression and the collapse of banks and securities markets discredited the prevailing financial order. This time, depression and financial collapse were avoided, if barely. This allowed defenders of the system to declare that its flaws were less severe than others had asserted. It allowed the banks to regroup and mobilise in opposition to more ambitious regulatory action. It took the wind out of the reformers’ sails. Success thus became the mother of failure. This is the ultimate irony of the steps taken in 2008-09.
That failure has another consequence, too. By not doing more to fix the financial system and economy, we doomed ourselves to a painfully slow recovery. Growth since 2009 has run at barely half the rate typical of recoveries from recessions. Some have argued that slow recoveries from financial crises are inevitable, since the banking and financial system has been damaged and since firms and households, having learned painful lessons about the costs of too much debt, have chosen to work down their obligations rather than spending.
There are important counterexamples, however. One is the rapid US recovery that began in 1933, once a new President, Franklin Delano Roosevelt, took concerted steps to fix the banking system and the economy. How fast the economy recovers depends on how aggressively officials move to recapitalise and restructure the banking and financial system. It also depends on how quickly government steps up with more public spending to replace the private spending that was lost. The 2008-09 crisis did not doom us to a slow recovery. What doomed us was our own failure to do more.
But as that weak recovery persisted, the nature of the narrative began to shift. Problems in the banking and financial system could no longer be dismissed as having caused a crisis that was successfully contained, allowing business as usual to resume. Business, even now, is not as usual. The persistent weakness of the economy, a couple of quarters of strong growth notwithstanding, is a reminder that the problems of the financial system have not yet been dispatched. And that reminder has refocused attention on financial reform.
Fortunately, reform is not over. Dodd-Frank in the US and the Financial Services (Banking Reform) Act of 2013 in the UK are law, but they still need to be implemented through the promulgation of specific regulatory rules. In the US those are issued mainly by the Federal Reserve for banks and the SEC for securities markets. In the UK this rule-making requires parliament to pass secondary legislation. Those rules and that secondary legislation have been slow to arrive. Hearings must be held, and difficult technical issues must be addressed. Opinions must first be solicited from stakeholders. All this has made some delay unavoidable.
But those detailed rules and regulations are now coming and many of them are surprisingly strict. They are more demanding than the financial lobby expected, reflecting a new appreciation of the lasting impact of financial problems on the economy. The acute stage of the crisis may be over, but the chronic condition remains, prompting the rule makers to subject the financial sector to more serious lifestyle changes than it anticipated.
For example, the Fed and the Bank of England have now indicated that they will go beyond what is required by the revised Basel Accord in applying capital surcharges to big banks. The magnitude of these charges came as an unpleasant surprise to financial institutions. The additional capital that they are required to hold will give banks that are too big to fail an extra cushion against shocks. It will also give big banks that pose problems for the stability of the whole system an incentive to downsize.
Similarly, both the Fed and the Bank of England recently announced that they intended to subject banks to a simple leverage ratio, requiring them to hold capital equal to a fixed proportion of their unweighted assets. This will prevent banks from exploiting flaws in the risk-weighting process to get round the rules. Again these decisions came as something of a surprise to the financiers in question.
Another reform required large banks to submit “living wills” explaining how they would wind up their operations in the event of failure. The first round incorporated much wishful thinking—for example that the government would step in, and that there would be profitable competitors on hand willing to pay top dollar to take valuable divisions off a troubled institution’s hands. They ignored complications posed by the banks’ international operations, such as the danger that a foreign country might freeze assets. To the banks’ evident surprise, the Fed and the Federal Deposit Insurance Corporation sent them back to the drawing board to come up with more realistic plans, or to simplify their operations to make orderly resolution possible.
The SEC also announced new regulations in July making clear that in a crisis the shares of certain money-market mutual funds might go to a discount. That eliminated the pretence that such shares would always trade at par and that there would be government support if that were ever cast into doubt. Much of the mutual fund industry, as well as companies in whose commercial paper the funds invest, opposed the change, but no matter.
Critics were disappointed that neither Dodd-Frank nor the Financial Services Act required the banks to retain a portion of any security issue they underwrote in their own portfolios as an incentive to monitor quality more carefully and avoid endorsing questionable deals. The Bank of England has recently indicated that it is likely to impose such “risk-retention requirements.” This is more evidence that effective rule making takes time, but also that the lingering effects of the crisis will make for more demanding rules.
Finally, as more time passes and we learn more about the malfeasance of financial players themselves, we see more clearly the shortcomings and outright wrongdoing of the institutions for which they worked. Of course, some scandals came to light quickly in the wake of the crisis. The SEC charged Fabrice Tourre, a young trader at Goldman Sachs Group, with misleading investors by helping to sell a portfolio of mortgage-backed securities designed to fail so that the hedge fund Paulson & Company could bet against them. The US Justice Department pursued JP Morgan Chase for misrepresentation of the quality of securities sold to Fannie Mae and Freddie Mac, both by its own units and by the Bear Stearns units it acquired in 2008. Still, in the wake of the crisis such cases were few, and the facts surrounding them were unclear.
But more evidence surfaced after that, much of which was even more damning than previously imagined. There was the £290m fine meted out to Barclays for rigging interest rates on the inter-bank market. There were the revelations of former bank inspector Carmen Segerra, made known in September 2014, of the favourable treatment and confidential documents received by Goldman Sachs from its regulator, the Federal Reserve Bank of New York. There were the £2.6bn in fines for rigging the foreign exchange market levied on five banks in November by the US Commodity Futures Trading Commission and UK Financial Conduct Authority. A sixth, Bank of America, was fined for its actions in the subprime market. HSBC and Commerzbank agreed to pay fines to avoid being charged with money-laundering. BNP Paribas pleaded guilty to violating US sanctions against Cuba, Iran and Sudan. Most recently, 10 investment banks were fined $45m by the US Financial Industry Regulatory Authority for breaking rules designed to prevent conflicts of interest in initial public offerings.
These violations were unknown to politicians and the public in 2009 and 2010, investigations and court proceedings not yet having run their course. There was knowledge of individual acts of malfeasance, such as Bernie Madoff’s, and suspicion of others, but the scope of self-dealing and market manipulation, and the extent to which it infected large financial institutions and the entire system, were not fully appreciated. It was still possible to see scandals and failures as the product of a few bad apples rather than as symptoms of regulatory capture and of a pervasive “culture problem,” this last being the anodyne phrase of William Dudley, President of the Federal Reserve Bank of New York.
With the passage of time, the “bad apple” defence became untenable. Modest changes enhancing transparency and strengthening internal controls in individual financial institutions were no longer seen as enough to eliminate what is now widely acknowledged as a systemic pattern of bad behaviour. This recognition is now working to strengthen support for meaningful reform of the system itself.
Importantly, these new rules are designed and promulgated by independent central bankers and career civil servants appointed for their expertise. The banks are able to buy votes in the US Senate to overturn what they regard as particularly objectionable provisions of Dodd-Frank—as they did in December, when Congress agreed to revoke a provision that would have forced the banks to spin off certain of their derivatives-trading activities—because congressional elections turn on campaign contributions, which the industry is well placed to provide. But the banks find it more difficult to buy the rule makers at the Federal Reserve Board and the SEC.
A crisis may be a terrible thing to waste, but in focusing on the acute crisis of 2000-9 and the failure in the US and UK to respond with more far-reaching legislation, we have been looking in the wrong place. The process of financial reform is ongoing. Implementation requires rule making over a period of years and not just authorising legislation. Those responsible for the rules will exhibit the necessary staying power only if evidence of financial disfunction lingers. For better or worse, there is a growing body of evidence that it will.
