Bank Regulation and Bubbles
The bubbles referred to here aren’t in Champagne or a luxurious bath. They are the rapid inflation of value in an asset class – maybe stocks or single-family homes – to unsustainable levels inevitably followed by rapid, uncontrolled deflation. The unmistakable pop. Those my age have muddled through a number of these bubbles. There was the incredible run-up in value of tech stocks in the 1990s. Then came the sub-prime mortgage lending bubble that popped in 2007.
Bubbles are important to consider these days because a central brake on the conduct of banks in contributing to bubbles, called the Dodd-Frank Act, is under attack by the de-regulators in Congress. Banks and bankers provide a crucial function in our economy. We need them to extend credit, which is the lubricant of the economy, but to do so in a prudent manner. Unfortunately, like most every industry, the banking industry is not self-regulating. Left to govern itself completely, the industry will engage in excessive and risky behavior. This has happened time and again and is just the nature of things.
The image to the right is a statue called Man Controlling Trade installed outside the Federal Trade Commission in Washington. It was commissioned in 1937, before the United States had completely crawled out of the Great Depression. Most historians agree that among the causes of the Depression was the credit banks granted for speculative investment in stocks. This was followed by the stock market crash of 1929, which led to the failure of 9,000 banks. This risky behavior with depositors’ money had been completely unregulated. The statue’s powerful horse is meant to represent the danger of uncontrolled economic behavior.
To bridle this risky bank behavior, Congress passed the Glass-Steagall Act in 1933. The principal feature of this law was a separation of commercial banking from investment banking. Commercial banks, which took in deposits and made loans, were no longer allowed to underwrite or deal in securities. This regulated environment continued until 1999 when it was lifted by the Gramm-Leach-Bliley Act, which allowed banks, securities firms and insurance companies to affiliate with one another through common holding companies.
The conventional wisdom is that deregulation under Gramm-Leach-Bliley led to the sub-prime mortgage crash in 2007. This is incorrect. The two portions of Glass-Steagall that Gramm-Leach-Bliley repealed had nothing to do with the issuance or purchase of mortgage-backed securities. Banks had been issuing mortgages, securitizing them with other financial instruments, and buying mortgage-backed securities for years before Gramm-Leach-Bliley. But unfortunately there was no regulatory structure that prevented banks from lowering underwriting standards on the underlying mortgage loans as the market overheated. This lack of regulatory control led, as it always does, to excessively risky lending and a bubble.
The Great Recession that began in 2007 spurred the adoption of the Dodd-Frank Act, a massive piece of legislation. Dodd-Frank was designed to reorganize government financial oversight and give greater transparency to the finance industry. It sought to address the notion that some financial institutions are “too big to fail” and end taxpayer bailouts of failed banks. It also sought to protect the consumer from abusive conduct in the finance industry. But it has been a regulatory nightmare. One commentator has noted that the Act requires regulators to create 243 rules, conduct 67 studies, and issue 22 periodic reports.
Dodd-Frank has been on the books only seven years and it is too soon to know how successful it has been and can be. We do know, however, that there has been no financial bubble since it was enacted. Nevertheless, Rep. Alex Mooney (WV 2nd) and others whose mission is to dismantle anything created during the Obama administration want a complete repeal of Dodd-Frank. Mr. Mooney is now on the House Financial Services Committee where he can do some real damage.
Rep. Mooney recently met with roundtables of community bankers in Charleston and in the Eastern Panhandle. The bankers complained that Dodd-Frank was designed for huge banks and doesn’t “scale down” to banks the size of most in this state. They claimed that over-regulation has raised their costs and made it harder and more costly to make loans. Maybe this is a legitimate complaint for small community banks, but what regulated industry ever believes that the hand of the regulator lays upon it too lightly? There are even some in the banking industry who argue that community banks are “too small to succeed” because they cannot generate the return on assets of larger banks, a problem that cannot be blamed on Dodd-Frank. Whatever their regulatory burden, community banks do not seem to be hobbled in West Virginia – auto loans and home equity loans are a booming business now.
Michael Barr, University of Michigan Law School professor and a key architect of the Dodd-Frank Act, says that the U.S. financial system is “incredibly healthy” in comparison to 2008 and presently in other countries. But not if you listen to House Financial Services Committee Chair Jeb Hensarling (R, Tex.), who blames a slow recovery from the Great Recession on Dodd-Frank. Hensarling has championed The Financial Choice Act, which would gut a number of important Dodd-Frank regulations. This bill was recently reported out of his Committee on a completely partisan vote of 34-26.
Both sides of this issue have decent arguments. But considering the incredibly damaging effects of bursting asset bubbles, I for one am willing to risk a little sluggishness in bank lending in exchange for solid controls on bank behavior. Perhaps when the Financial Choice Act reaches the House floor, or the Senate, better recognition of the virtues of control will prevail.
