Financial Regulation: Oops, We Did It Again

At a Wall Street Journal conference in 2009, then White House Chief of Staff Rahm Emanuel stated that one should never let a crisis go to waste. In this sense, the 2008 financial crisis is just like any other crisis: a disaster and an opportunity. A disaster because it led to the destruction of $4 trillion worth of global assets, millions of people losing their livelihood, and bringing the whole economic system incredibly close to a cataclysmic meltdown. An opportunity in at least two ways: firstly, in its ability to showcase how the risk-taking nature of the financial system exposes society at large and secondly, in its ability to create pressure on the legislature to address these inherent risks.

The scope and reach of the crisis is reminiscent of the Great Depression – the single greatest economic calamity in recent economic history. Indeed, a closer look reveals that these two periods have more in common than the extent of economic catastrophe. They serve as wake-up calls for society to reconsider the systemic risk that it chooses to shoulder. The Great Depression led to the enactment of the Glass-Steagall Act in 1933 which was the US Congress’ attempt to separate commercial and investment banks. Subsequently, the US experienced one of the largest sustained periods of economic growth, a 60-year expansion of the middle class, the largest increase in productivity, and the largest increase in median income in the US.

Financial regulation is not the only and arguably, not the most important factor for this economic success. Workers moving from agricultural to industrial activities in cities, increased fiscal stimuli of the New Deal, and export opportunities to war-ridden Europe amongst other played a vital role in the economic expansion until the 70s (as did facilitated borrowing opportunities and rising private debt until the late 90s). The Glass-Steagall Act did not prevent this economic success and although the expansion could have been even bigger without it, it shows that the existence of strong financial regulation can in principle be consistent with effective economic expansion.

Yet the Glass-Steagall Act was repealed and replaced by the Gramm-Leach-Bliley Act in 1999 due to concerns over its efficiency and the ability of US banks to compete with other less regulated financial institutions. On the one hand, this allowed commercial banks to invest in financial products that were traditionally reserved for investment banks. On the other, it enabled financial institutions with commercial and investment banking divisions to channel funds between them. This led to an increasing interdependency between the two financial sectors and when the financial crisis deepened in 2008, the linkage was so strong that the security of ordinary people’s pensions and savings depended on the survival and bailouts of systematically important banks.

The problem with this narrative is that it lends itself to the simplistic belief that another financial crisis of this scale can be averted by once again separating retail and investment banking. This is misleading for two reasons. First, the degree of complexity of financial transactions has increased exponentially since 1933. Financial innovation has made the system more efficient in its ability to fund a range of projects that would otherwise go unfunded, but it also increased the complexity of financial transactions, which makes it difficult for current lawmakers to spell out how this separation should be practically implemented. The Glass-Steagall Act of 1933 was 32 pages long. The Dodd-Frank Act of 2010, Congress’ most recent attempt to accomplish the same task, spans 848 pages. Despite its length, many influential commentators and news outlets around the world have correctly pointed out the flaws in the practical details of the Dodd-Frank Act: its questionable call for the creation of even more bureaucracy and its probable failure to provide a more effective basis for pre-emptive financial regulation. But only very few questioned the legitimacy of the effort to reconsider the workings of the financial system and virtually nobody put forward a defence of the status quo until 2010.

Banks may have substantially affected the nature of the financial crisis, but they are neither the only shapers nor arguably the most central ones. Moreover, and despite of their public reputation, investment banks fulfil critical economic functions. They provide funding for vital and sometimes highly complex projects ranging from sustainable energy infrastructure to corporate financing and they lend credibility to governments by underwriting their debt, thus helping them to raise money at reasonable rates. By the end of 2011, Goldman Sachs had arranged $24 billion worth of financing for sustainability projects. They also announced a $40 billion initiative focusing on renewable energy. Until March 2012, Bank of America invested $20 billion in projects related to energy efficiency and environmental businesses. They also announced a further $50 billion worth of green investments last April following JP Morgan’s launch of a values-driven investment platform for customers in the same month.

The solar panels, hydro-electric power plants, and windmills that are being built due to these sustainability investment projects are partially a function of banks’ ability to allocate capital as efficiently as possible, which essentially implies bringing together investors and investment opportunities. The societal benefit of an efficient allocation of capital is substantial: investors earn higher returns on their investment, while their monies work to build new companies, infrastructure projects, and educational institutions. This in turn contributes to economic growth, job creation, and prosperity. Green investment in particular helps communities and companies to adapt to the changing realities of global warming and energy consumption.

A separation of retail and investment banking essentially reduces the pool of capital that could be used to finance some of these projects, which decreases the overall efficiency of the financial and by extension also the economic system. However, this is not necessarily a bad thing because every piece of regulation must be considered by its effect on the efficiency and the stability of the system as a whole. It is likely that a lower efficiency would lead to slower economic growth and a slower rate of adaptation in our energy consumption. Although in itself not desirable, it may be a necessary price to pay in order to prevent a situation in which substantial risk-taking behaviour is encouraged, because some key actors being too big to fail do not face the down-side of this risk. On the other hand, we might argue against the background of frighteningly high levels of unemployment and a feeble economic recovery that we should not sacrifice growth for the sake of more resilience.

It is also worth noting the ambiguities in the use of the term ‘economic efficiency’. In a paper on financial stability in Iceland published in 2006, Frederic Mishkin, former member of the Board of Governors of the Federal Reserve System, described the country’s financial system as efficient due to its contribution to the economic growth. Although the Icelandic economy grew at an average of about 5.4% between 2003 and 2007 following bank deregulation in 2001, the financial system collapsed and led to the bankruptcy of the whole country in the wake of the financial crisis in 2007. This led economic thought leaders such as former chief economist of the IMF Rahuram Rajan to question whether such a system can be accurately referred to as ‘efficient’. Despite this, the second and most fundamental problem in the financial sector seems to be the trade-off between efficiency and resilience. Financial sectors in Ireland, Iceland, the UK, the US, Germany etc., have contributed to the growth of their respective economies for a sustained period of time, but they have also made them more vulnerable to economic shocks and thus exposed society at large to increased liabilities.

Few challenges fit so well with this year’s focus at the World Economic Forum as the nature of the financial system. The instability is an obvious problem; however, it is usually a long and arduous path from stating a problem to finding a solution, especially with a topic that combines so much complexity with vested interest. As some of the most capable minds of the world convene to tackle this issue, the debate should drop its exclusive focus on efficiency and explore the possibility of an economy that is less efficient but more stable and resilient. The result of this inquiry may well be that given the current economic turbulence, we simply cannot afford the efficiency trade-off, but if so, this should be conceded openly and honestly in full recognition of the fact that the degree of economic volatility in our economic system has not changed. The world expects answers and results; it is hoped the global leaders at Davos can provide us with some.