Structural Reform Is More Effective Than Regulation

The discussion on banking reform usually focuses on higher capital requirements, less leverage, and more oversight. In my opinion, this focus is misguided. Repealing the de-regulatory acts of the late 90s might be more effective because structural limitations are generally harder to bypass than something judgement-based, such as risk-weighted capital. I think history is on my side.

Gramm-Leach-Bliley Act (1999). This act played a large role in allowing banks to get "too big to fail." In the early 2000s, Lehman had only about $100bn in assets. By 2008, this number had increased to $600bn. Especially after the creation of Citigroup, size became more of a strategic factor in the industry. There were strong synergies of getting bigger, now completely possible thanks to Gramm-Leach-Bliley. John Reed, the engineer of Citigroup, said recently it was a mistake repealing Glass-Steagall (though he lobbied for it heavily in the 90s), commenting that "When you’re running a company, you do what you think is right for the stockholders. Right now I’m looking at this as a citizen."

"I would compartmentalize the industry for the same reason you compartmentalize ships," Reed said in the interview with Bloomberg. "If you have a leak, the leak does not spread and sink the whole vessel. So generally speaking you’d have consumer banking separate from trading bonds and equity."

Commodities Futures Modernization Act (2000). This bill facilitated what William Poole of the Cato Institute called "too big to liquidate." The CFMA made OTC contracts untouchable in the US. The result? Data from the BIS indicates OTC derivatives grew at an annualized 15.7% from June '98 to June '00. However, from June '00 to June '08, the notional amount of OTC contracts outstanding increased 78.4% annually!

The move to make financial derivatives an exclusion from CFTC oversight rather than an exemption is particularly important. This move greatly hindered the CFTC's response capability once the crisis hit. Treasury Secretary Summers defended this decision with the following statement: "you are clearly correct that an exemption provides more flexibility than an exclusion, but it is precisely the presence of that flexibility and the recognition that it might be used that undercuts legal certainty and creates a greater possibility that these transactions will take place and be booked abroad where they will not be subject to American law."

One comment regarding regulating credit derivatives that is especially interesting comes from Patrick Parkinson of the Board of Governors of the Fed. Parkinson argued an OTC credit derivatives market is better than an exchange one because it makes mispricing and price manipulation less likely:

"Some types of OTC contracts that have a limited deliverable supply, such as equity swaps and some credit derivatives, are growing in importance. However, unlike agricultural futures, for which failure to deliver has additional significant penalties, costs of failure to deliver in OTC derivatives are almost always limited to actual damages. Thus, manipulators attempting to corner a market, even if successful, would have great difficulty inducing sellers in privately negotiated transactions to pay significantly higher prices to offset their contracts or to purchase the underlying assets. Finally, the prices established in privately negotiated transactions are not used directly or indiscriminately as the basis for pricing other transactions. Counterparties in the OTC markets can be expected to recognize the risks to which they would be exposed by failing to make their own independent valuations of their transactions, whose economic and credit terms may differ in significant respects. Moreover, they usually have access to other, often more reliable or more relevant, sources of information on valuations. Hence, any price distortions in particular transactions would not affect other buyers or sellers of the underlying asset."

Parkinson was clearly wrong about the pricing power of an OTC market. What actually happened was that competition among credit derivative dealers drove prices to unreasonable levels, something unlikely to happen in a transparent market.

In 1933, Glass-Steagall forced banks to split their operations into separate entities. Since then, financial crises have been contained. Banks still made bad decisions, but the contagion of their errors was limited. That is, until Gramm-Leach-Bliley and the CFMA turned an industry of many small, specialized players into diversified giants. While structural regulation a la Glass-Steagall would have the most dramatic effect on the financial services industry, history indicates it would also be the most effective.