Major Financial Legislations In The U S

Published Date: 02 Nov 2017

YuanHong Wong

Macroeconomic Analysis

Prof Buckley

The financial Crisis of 2007 and the Trend in American Financial Regulation

Introduction

In the past two decades, recessions in the U.S. have become increasingly milder and shorter, leading to a general consensus amongst economists that financial crises of the magnitude experienced during the Great Depression were a thing of the past. However, the recent financial crisis of 2007 that reverberated throughout the world came as a wake-up call to the regulatory bodies of the financial sector and the general public. This paper aims to examine the processes that caused the crisis by exploring the impacts of policy changes that helped exacerbate the American economy and also propose possible solutions and provide different insights into the main problem.

I. Major Financial Legislations in the U.S

Glass-Steagall Act

In the aftermath of the Great Depression that ended in 1933, congress passed one of the major enactments of financial regulation that took place in the form of the Glass-Steagall act. It was a response to the massive bank failure that characterized the Great Depression and its provisions spurned the creation of the FDIC, separated the commercial banking from the securities industry, prohibited interest on checkable deposits while limiting such deposits to commercial banks and put interest rate- ceilings on other deposits. [1] The separating the commercial banking industry and the investment banking industry was seen as an important step towards restoring public confidence in the banking industry by managing the risk exposure of banks because the business of securities tends to be risky and can lead to excessive losses while depository institutions are supposed to limit their exposure to risk. [2] Glass-Steagall thus minimized conflict of interest problems that would easily arise if both of these businesses were under one entity because then the motivation for profit through speculating on securities would lead to reckless use of the line of credit offered by consumer deposits. Another important provision to note is interest rates ceilings on other deposits because they reduce the risk of deposit holders because by standardizing the rates, the party paying the interest won’t be tempted to make dangerous investments in order to pay their deposit holders.

Securities Act of 1933 and Securities Exchange Act of 1934

The Securities Act of 19 33was a response to the stock market crash of 1929 and the ensuing great depression and requires that investors are provided with sufficient information on securities offered for public sale and that these securities be registered with the Securities and Exchange Commission (SEC). The driving force behind this legislation is to disclose to investors any adverse or vested interests the issuer or underwriters have in the securities, the nature of the issuer’s business, and the state of their books, which are independently verified and audited by an outside party. [3] The significance of this act comes from its increase in transparency regarding the sale of securities and minimized the misrepresentations and fraud present in the sale of securities through the creation of a governing body that reserves the right to approve or reject the offering of securities based on legislative standards. [4] 

II. Major Financial Deregulations in the U.S.

Depository Institutions Deregulation and Monetary Control Act of 1980

While this law was signed with the goal of extending the Federal Reserve’s influence over non-member banks by making them abide by the rules of the Fed but also removed the Fed’s prerogative to impose interest rate ceilings on other deposits other than checkable deposits. Besides that, the act also allowed the provision of Negotiable Order of Withdrawal (NOW) accounts to be offered nationwide, which are essentially checkable deposits that pay interest. Furthermore, the deregulation of Savings and Loans associations also allowed them to engage in a wider range of financial activities, notably the offering of checkable deposits and also enabled financial institutions to charge any interest rates on loans as they choose. The lack of interest rate ceilings on Savings and Loans Associations combined with the prerogative to choose their own interest rates only made them excessively competitive against other financial institutions. [5] Since low interest rates attract more borrowers than lenders, excessive competition led to lower interest rates and hence more borrowing than lending, the liabilities of financial institutions increased while their profit margins decreased.

Depository Institutions Act of 1982

Essentially, this act deregulated Savings and Loans association’s even further and allowed banks to provide a wider range of services, notably adjustable-rate mortgages (ARMs) which are mortgages with fluctuating interest rates that vary according to the cost of borrowing in the credit market. Furthermore, it allowed depository institutions to provide Money Market Deposit Accounts (MMDAs), which pay a higher rate of interest based on current interest rates in the money market. Due to the nature of ARMs, they are sometimes sold to consumers who bankers know cannot repay the loan should the interest rate rise, leading to a rise in predatory lending and adverse selection. [6] Essentially, this now means that Savings and Loans associations can now make investments with their deposits.

Gramm-Leach-Bliley Act of 1999

Also known as the Citibank Relief Act, this act was signed into law with the purpose of modernizing financial services. It essentially repealed the Glass-Steagall act, thereby allowing banking, securities and insurance companies to consolidate into one entity. Consequently, investment banks then became public, giving them more capital, allowing them to make more investments, and essentially undertake more risk. [7] This led to many mergers and that allowed for the creation of huge financial conglomerates that were so intertwined in the financial system that any one failure could cause a disastrous shockwave that would reverberate throughout the entire economy. Implicitly, due to the size of these conglomerates and their importance to the economy, the government would not allow them to become insolvent and knowing this, they adopted a "too big to fail" mentality which increased their tendency to adopt a business model that fostered moral hazard, knowing the costs they incur will be minimal at most. [8] 

III. The Financial Crisis of 2007

To fully understand how the financial crisis occurred, a cross examination of various sectors of the economy must be undertaken in order assess the feedback effect. This part of the paper will discuss the main factors involved that led up to the systematic collapse of the economy.

Financial Innovation

With the advent of computers and refinement of statistical techniques, financial institutions can now obtain data about their customers relatively cheaply and easily. [9] This allowed them to ascertain the credit risk of their customers conveniently, thereby allowing banks to easily determine the interest rates and loans their customers could obtain, essentially lowering transaction costs. Financial engineering also allowed for the creation of new debt instruments like never before, e.g. mortgage-backed securities, collateralized debt obligations and complex financial instruments called derivatives.

Mortgaged-backed securities (MBSs) are essentially mortgage loans bundled to form a debt security. These are basically bonds that are backed by interest payments from the mortgages made payable to the bond holder. Financial institutions typically sold these securities to investment banks, transferring ownership of debt to the bond-holder, meaning that the financial institutions that made the loan in the first place are no longer at risk of the failure to repay. [10] 

Furthermore, investment banks would then repackage these MBSs according to their risk exposure into something called Collateralized Debt Obligations (CDOs), which is basically an obligation to pay investors who own CDOs through the cash flow that is generated by the bundle of assets in the CDO itself. Naturally, higher risk mortgages called subprime loans carry higher interest rates and the bundling of these loans into CDOs only served to increase the risk to the investors who purchased these debt instruments. [11] 

By selling the MBSs to investment banks, the money went to investors rather than the original lenders, with the bank making money from the sale of MBSs.

If we illustrate this process of securitization, we get a chain of events which show the transfer of debt from home buyers to financial intermediaries to investment banks and eventually investors.

Credit Rating Agencies and Adverse Selection

The role of credit rating agencies is to evaluate and ascertain the quality of debt securities in terms of their risk of default with AAA being the highest rated and least risky and anything below BB is considered junk and carries high risk. These agencies contributed to asymmetric information within the financial sector because they were paid to rate securities issued by investment banks and had a conflict of interest because at the same time they were also paid to consult on the structuring of said securities in order to achieve a higher rating. Consequently, as long the securities were structured as the rating agencies liked them to be, they had little incentive to determine the accuracy of their ratings, resulting in inflated ratings and asymmetric information to investors, prompting investors to buy securities that exposed them to more risk than they knew about. Since credit rating agencies weren’t held liable to the ratings they made and no regulatory constraints existed to enforce them, it gave lenders an excuse to increase the amount of loans they had.

Principal-Agency Problems

Due to the high interest rates of subprime loans and the profitability of selling them to investment banks without incurring much risk exposure, lenders became indifferent to the types of borrowers leading to what we call moral hazard. The problem of moral hazard led to an increase in predatory lending, where lenders would make subprime loans to borrowers who are more likely to default, capitalizing on the higher interest rates. Further along the securitization chain, investment banks who underwrote these CDOs were also indifferent because the more CDOs they sold, the money they would make while transferring the risk further down the chain to the investors who bought these CDOs. [12] This created a vicious cycle of predatory lending with lenders trying to pump out more and more loans, unnecessary or not in order to sell them to investment banks because they want to generate more profit and so on and so forth. This was all made possible by the ratings agencies that appraised and evaluated these CDOs.

Credit Default Swaps

Credit default swaps (CDS) were essentially an insurance policy that applies to bonds. Basically, they compensate the bond holder when a default occurs and is structured in such a way that bond holders pay the insurer an annual premium much like regular insurance in exchange for protection. However, CDSs differs from regular insurance because it allows multiple parties to insure the same asset even if they have no vested interest in it. [13] This made it popular with speculators who wanted to bet against debt instruments like CDOs which they didn’t own themselves and if the CDO ends up defaulting, the insurer ends up compensating all the parties owning CDSs and the number of losses in the system becomes proportionately larger. [14] Also, the lack of regulation on CDSs meant that insurers didn’t have to put aside any additional money to cover potential losses, exposing them to an even greater risk of bankruptcy in an event of a catastrophic default. Besides that, some investment banks were also structuring CDOs to fail while insuring themselves with CDS at the same time. [15] 

This was what caused the collapse of AIG because they found themselves having to pay enormous amounts of compensation while having to hold all these toxic CDOs. Consequently, due to the large volume of toxic CDOs in the system, the market for CDOs collapsed and the investment banks found themselves holding hundreds of billions of dollars of bad debt that they couldn’t sell. [16] 

The Housing Bubble

The low interest rates on residential mortgages and the ease of obtaining loans with low transaction costs gave rise to the subprime mortgage market. Rising property prices in the aftermath of the recession of 2000 enabled subprime borrowers to refinance their homes with even larger loans when the value of their property appreciated. [17] With the increasing value of property, the risk of default is also lowered because borrowers could simply sell off the house to repay the loan. The low cost associated with borrowing thus increased the demand for houses and created a housing bubble which burst when there was no good reason to justify the rise of property prices. Due to the tendency of homeowners taking out additional mortgages as the value of their property increased, when the value of property dropped far below the mortgage value, many homeowners found it easier to default, leading to an abundance in foreclosures, leaving a lot of debt behind. [18] 

The Breakdown of the Financial Crisis

As we’ve seen above, the mismanagement of financial innovation and the deregulatory changes that preceded it prompted financial institutions to engage in risky lending behavior, leading to a boom in credit availability. Due to the overwhelming volume of loans, it becomes increasingly difficult to evaluate the credit risk prevalent in the system until the losses on loans start piling up. This causes a decline in the value of the financial institution’s assets relative to its liabilities and financial institutions must compensate for this by decreasing its liabilities, causing their net worth to decrease. Due to the decrease in assets a financial institution holds, lenders become more uncertain and withdraw their funds, leading to a decline in loans that generate income, effectively severing the line of credit. With the shrinking availability of funds, economic activity begins to contract.

In response to the scarcity of funds and the burgeoning value of their liabilities, some financial institutions become insolvent, triggering a bank panic which is exacerbated by depositors who in their panic withdraw their money, causing banks to fail completely.

Due to decreased consumer optimism and contraction of economic activity, consumer demand decreases, shifting the demand curve to the left, causing a sharp decline in the price level which constricts economic growth even further, leading to a recession. Producers start going bankrupt because of the decrease in consumer spending, causing exports to slowly deteriorate while uncertainty blossomed. Since the U.S. economy is closely interlinked with the rest of the world, the feedback effect was unprecedented as U.S consumers demanded less, global manufacturers dependent on U.S. consumers also saw a decline in their exports, leading to an increase in unemployment, resulting in a global recession.

IV. Benefits of Financial Deregulation

Rajan argues that technology was the driving force behind financial deregulation and cites that in the 1970s, anticompetitive banking laws forced banks to remain small and inefficient by limiting the competition between instate banks and out-of-state-banks in order to maintain profits. [19] Due to the increasing efficiency and lowered costs that technology afforded banks, competition increased between them which prompted the start of financial deregulation. [20] The repealment of Glass-Steagall and the subsequent consolidation of financial institutions have increased the competition to attract prime borrowers and managed to extend their reach in the market. [21] 

Besides that, he posits that regulatory changes have had beneficial effects citing increased lending and entrepreneurship as well as GDP growth while keeping transaction costs low. [22] 

Additionally, financial deregulation has also made capital flow between markets a lot easier, leading to greater integration between markets which he says have many advantages with one of them being a greater pool of liquidity made up of local and global sources. [23] 

Dudley and Hubbard have also concurred with Rajan, citing that the growth of capital markets has improved the economy by allocating capital efficiently while prudently distributing risk. [24] They also agree with Rajan on the basis of higher returns on domestic capital and consistent inflows of foreign capital into the U.S [25] .

Also, increased foreign confidence has spurred improved macroeconomic performance due to high returns on labor, while the development of capital markets increased the efficiency of the economy by helping it operate at a lower unemployment rate, with proportional gains in wages relative to increases in productivity. [26] 

They end by positing that the structure of capital markets helped reduce the volatility generally inherent in the economy citing that recessions occur less frequently and that the intensity and duration when they do occur are benign. Following that, upward surges in unemployment have been less frequent and severe, resulting non-accelerating inflation rate of unemployment. [27] 

V. Costs of Financial Deregulation

George Soros believes that markets are inherently unstable and pose a great potential to spin out of control if not regulated responsibly. He illustrates this by using the oil tanker as a metaphor, citing their size as a danger to itself and others around it and that in order to maintain the structural stability of the tanker, compartments have to be put in to separate the oil carried in order to prevent the sloshing motion of oil from capsizing the boat. [28] The regulations following the Great Depression serve to compartmentalize the risk inherent in the financial system and by repealing Glass-Steagall, it not only led to the consolidation and mergers of banks, but also consolidated the risk as well.

Meanwhile, Jefferey Sachs acknowledges that while financial deregulation leads to increased efficiency by allocating resources in society productively, efficiency does not necessarily guarantee the fair distribution of income amongst society and financial deregulation does not consider the social costs that it incurs. [29] 

Besides the qualitative costs associated with financial deregulation, I believe the question of how much did the crisis cost American taxpayers should be addressed. A study published recently by the Government Accountability Office (GAO) valued the cost of the crisis at 22 trillion dollars and was also "the most severe economic downturn since the Great Depression of the 1930s". The GAO speculated that the 22 trillion dollar basket was mainly made up of economic output valued at 13 trillion dollars – an entire annual output’s worth of GDP while the destruction of wealth of U.S. homeowners contributed to a total loss of 9 trillion dollars. [30] 

VI. Possible Solutions

Increased Capital Requirements & Tighter Regulations

Tighter regulations and closer supervision of financial institutions should be undertaken in order to ensure than they maintain a sufficient amount of capital relative to the amount of risk they expose themselves to in order to strengthen their capital positions and ability to cope with sudden shifts in the market. Besides that, existing regulations should be revised in order to take into account legal loopholes that allow for the abuses of balance sheet activities, making for a more transparent picture of the health of financial institutions.

Executive Compensation

The blatant awarding of enormous compensations towards bankers for taking huge unprecedented risks have revealed the corporate culture of Wall St. to be driven by greed for the sake of profit. This led to huge public backlash because of the moral hazard and adverse selection these people have displayed. [31] Suggestions should be made to regulators to create a system of centered around effective incentives while taking in account the health of the firm and that bonus payouts should be properly outlined, doing away with the expectations of instant gratification and entitlement.

Revision of Credit-Rating Agencies

The issue of the conflict of interest rating agencies face led to the lax evaluations of market risk that culminated in the financial crisis. [32] I believe that the government should spur credit-rating agencies to be more transparent about their vested or adverse interests towards the debt instruments they evaluate and incentives or punishments should be enacted in order to enforce ownership and accountability of the accuracy of credit-rating agencies.

VII. Conclusions

The trend of financial deregulation leading up to the repealment of Glass-Steagall contributed heavily to the global financial crisis and the ensuing recession by increasing the systemic risk of failure in the banking system with a lack of effective safety nets. This has led to popular sentiment calling for institutional reform in the aftermath of the crisis, in order to minimize the chances of another recession occurring and also to curb the problems perpetrated by the mentality of the financial system itself. The balancing act of regulation is a delicate one as the danger of overregulation could strain the system by hampering the efficiency of financial markets and excessive market liberalization would only serve to deepen the existing problem. In conclusion, a mixed economy that is balanced by the redistribution and appropriate allocation of wealth and strong government legislation based on good fiscal and monetary governance combined with the operational efficiency of free markets is a good model to strive for.