A persistent myth regarding the 2008 financial crisis is that it was caused by deregulation of financial markets. All such claims are wrong. From an aggregate perspective, the industry has always been regulated, and there has never been a substantial reduction in financial regulations in the U.S. during the past 100-plus years. Instead, this time period has included an ever-expanding regulatory framework in financial markets, both in terms of volume and depth. Congress has imposed more regulation on financial markets and expanded the type of regulation. Over time, the regulatory framework has morphed to allow regulators to micro-manage financial companies to an ever greater extent.
For decades, capital market firms have been among the most heavily regulated businesses in the U.S., and virtually all of their activities—including those that contributed to the 2008 crisis—take place under the watchful eye of federal regulators. Close supervision has even been a main feature of the so-called deregulatory changes enacted by Congress and regulatory agencies. It is, therefore, completely erroneous to blame the crisis on unregulated financial markets. Regardless of how one labels recent changes to the regulatory framework, there is no reason to believe any of those changes will prevent future financial crises.
The False Narrative of Deregulation
The role of deregulated financial markets was central to the political narrative that explained the 2008 financial crisis. For instance, shortly after the crisis, House Speaker Nancy Pelosi stated that “the Bush Administration’s eight long years of failed deregulation policies have resulted in our nation’s largest bailout ever, leaving the American taxpayers on the hook potentially for billions of dollars.” Similarly, in the second presidential debate that year, Barack Obama asserted that “the biggest problem in this whole process was the deregulation of the financial system.” At best, these types of statements are a complete mischaracterization of policy changes during the Bush years.
Regulation can be measured in many different ways, but various metrics show that financial markets were not deregulated during the Bush Administration. In terms of rulemaking—that is, the promulgation of specific rules by regulatory agencies—federal financial regulations imposed a net cost on the economy for the eight years of the Bush Administration. In other words, even though some federal regulations during these eight years reduced burdens, the overall impact of the rulemakings increased the cost of regulation. Data provided by the agencies themselves show that the major regulatory changes (defined as those with an economic effect of $100 million or more) cost the economy more than $2 billion (in constant 2010 dollars) from 2001 to 2008.
It is also helpful to examine the total budget of regulatory agencies because much of their work takes place in day-to-day activities rather than in formal rulemaking activities. Excluding the Securities and Exchange Commission (SEC), the total budget of federal financial regulators increased from approximately $2 billion in fiscal year (FY) 2000 to almost $2.3 billion in FY 2008. During the same period, the SEC’s budget increased from $357 million to $629 million. Total staffing at these agencies basically remained steady during this period, at close to 16,000 employees. Thus, federal financial regulators’ budgets increased, and their staff levels were not cut.
All of these statistics for the Bush Administration are broadly consistent with longer-term trends as well. For example, outlays for banking and financial regulation increased from $190 million in 1960 to $1.9 billion in 2000, while staff rose from approximately 2,500 employees to more than 13,000. That is, long-term trends in both budget outlays and staffing suggest that regulation has been increasing steadily for decades. Not surprisingly, many who claim that deregulated financial markets caused the crisis ignore these types of metrics and, instead, point to specific legislative changes. In virtually all cases, though, these legislative changes have been mischaracterized as deregulatory.
Legislation Did Not Deregulate
In the wake of the 2008 financial crisis, Senator Elizabeth Warren (D–MA) gave reporter Dan Rather the following explanation about the crisis’ cause:
It gets to be the early 1980s…and what do we do? Instead of saying “new products,” we need to change regulations to “adapt,” we take a different path…we say “let’s deregulate”.… We begin to break down the old regulations, we say “who needs regulations, they’re so poky, so old,” so we go with this idea of let’s get rid of regulation and what happens…and where do we end up? In the biggest crisis since the Great Depression.
Again, the notion that financial market participants—whether banks or non-bank financial firms—were allowed to engage in unregulated activity is completely wrong. Ironically, what actually took place was much closer to what Warren insists did not take place. As markets changed, so did the regulations. And there have certainly been many changes to federal rules and regulations during the past few decades.
Broadly speaking—and in many specific instances—these changes gave regulators more authority to tell financial firms what they can do and how they can do it. While some of these changes expanded the types of regulated activities in which certain firms could engage, only an extremely naïve view of the regulatory framework could consider these changes deregulatory. In virtually all instances, federal regulators were the official overseers of financial firms’ activities both before and after the regulatory environments were changed. The following list provides a detailed summary of the most frequently cited regulatory changes that, supposedly, deregulated financial markets.
The 1999 Gramm–Leach–Bliley Act (GLBA). One of the most often-repeated claims is that the GLBA caused excessive risk-taking because it repealed the Glass-Steagall Act, the 1933 law that separated commercial and investment banking. However, the GLBA only amended the Glass–Steagall Act, and it did not create an unregulated segment of the financial industry. Specifically, only four sections of Glass–Steagall implemented the so-called separation of commercial and investment banking. The GLBA repealed Sections 20 and 32 of the 1933 act, and left Sections 16 and 21 intact. Sections 16 and 21 generally prohibited banks from underwriting or dealing in securities and investment banking firms from accepting demand deposits, respectively. Sections 20 and 32, on the other hand, generally prohibited commercial banks from affiliating with investment banks. Each of these Glass–Steagall sections included exceptions, so the separation between commercial and investment banking was never absolute.
After the GLBA, banks could legally affiliate with a company engaged in securities underwriting or dealing, but these different entity types could not engage in unregulated commercial or investment banking. The GLBA also amended the Bank Holding Company Act of 1956, the law which gave the Federal Reserve the responsibility of regulating all bank holding companies (BHCs). The GLBA allowed BHCs to engage in a broader range of financial activities, and it did so by explicitly defining many financial activities. Section 103 of the GLBA, for example, specified various activities and also vested the Fed and Treasury with discretionary authority to determine whether an activity was financial in nature.
The GLBA required BHCs to register with the Federal Reserve if they wanted to legally engage in these activities. Additionally, a BHC could only be approved to operate after the Fed certified that both the holding company and all its subsidiary depository institutions were well-managed and well-capitalized, and in compliance with the Community Reinvestment Act (CRA), among other requirements.
Much More to the GLBA. The Glass–Steagall amendments in the GLBA garner most of the headlines, but the law contained five unrelated titles that, in many instances, increased financial regulations. Title IV of the GLBA prohibited the creation of new thrift-holding companies as well as the sale of existing thrift-holding companies to any non-financial firm. Title V instituted new privacy and disclosure regulations (including new civil penalties), and Title VI amended the capital rules for banks in the Federal Home Loan Bank (FHLB) system. Title VII implemented many provisions, including new CRA requirements for banks and the requirement that ATM operators post fee notices both on the machine and the screen.
The 1980 Depository Institutions Deregulation and Monetary Control Act (DMCA). The DMCA is cited as a deregulatory bill mainly because the act phased out interest rate ceilings on savings and time deposits at commercial banks and thrifts, a price control that had been in place since the 1930s. For roughly 30 years the ceiling had little impact because it was kept above short-term market rates. In the 1960s, however, Congress tried to use this price control to stop interest rates from rising and to expand mortgage credit. The policy failed to achieve either objective, as acknowledged in the DMCA, and by the 1970s interest rates rose sharply. The DMCA left the prohibition of paying interest on demand deposits in place, though the 2010 Dodd–Frank Act eliminated the ban. Thus, even if these price controls are viewed as financial regulations, the DMCA did not remove all such rules.
Regardless, the DMCA also included several provisions which increased regulations. For instance, the DMCA made all depository institutions subject to the Fed’s deposit reserve requirements. Prior to this change, only Federal Reserve member institutions were subject to the Fed’s reserve regulations. As per the DMCA, regardless of whether a bank or thrift chose to be a member of the Federal Reserve System, it was required to hold its reserves in an account at its Fed District Bank, subject to the Fed’s rules. While the question of membership is largely ignored now, the Fed was losing member banks for more than two decades leading up to the passage of the DMCA. The DMCA also established nationwide Negotiable Order of Withdrawal accounts and All Savers certificates, new financial accounts subject to specific regulations. The All Savers certificates, for example, had a floating interest rate ceiling equal to 70 percent of the yield on one-year Treasuries.
The 1982 Garn–St. Germain Depository Institutions Act. The Garn–St. Germain Act is frequently cited as deregulatory because it allowed certain thrifts to make commercial loans, a practice from which they were previously restricted. Viewed in the proper context, however, the act was an acceleration of the 1980 DMCA, an expansion of thrifts’ regulated activities, and a rescue bill for the thrift industry. Titles I and II of the act, for instance, enhanced the powers of the Federal Deposit Insurance Corporation (FDIC) and Federal Savings and Loan Insurance Corporation (FSLIC) to provide aid to failing and failed institutions. Title III—the main source of the bill’s deregulatory characterization—authorized thrifts (and other depository institutions) to undertake several new practices.
Title III authorized, among other activities, federally chartered savings and loan institutions (S&Ls) and savings banks to make commercial loans. Title III also permitted federally chartered S&Ls to offer demand deposits to their loan customers, a practice previously allowed only at commercial and mutual savings banks. However, the statute required that these institutions conduct these activities subject to the rules and regulations of the Federal Home Loan Bank Board. Put differently, the act did not allow thrifts to make loans or offer demand deposits in a deregulated manner. That is, the act did not permit the firms to conduct these activities in the absence of rules and regulations.
Title III also created the money market deposit account (MMDA), a concession designed to allow banks to better compete with (non-bank) money market mutual funds. While there were no interest rate ceilings on these accounts, MMDAs were subject to other rules, such as minimum account balances and limits on the type and number of transfers. Title IV has also been referred to as deregulatory because it “relaxed” certain safety and soundness limitations on the size of loans that national banks could make to any single borrower. It makes little sense to call this change deregulatory, though, because Title IV merely raised the maximum allowed percentage from 10 percent to 15 percent of an institution’s capital and surplus. After the act was passed, all national banks’ loans still had to comply with the rules and regulations promulgated by their primary regulator.
The 1994 Riegle–Neal Interstate Banking and Branching Efficiency Act (IBBEA). The IBBEA is typically cited as deregulatory because it removed restrictions on interstate branching by banks. While the IBBEA did remove the federal restrictions preventing banks from opening interstate branches, the act did not allow these newly branched banks to function in an unregulated environment. In other words, the same banking activities were regulated by the same banking regulators both before and after the IBBEA was passed. The IBBEA stipulated that some of the key branching activities newly allowed, such as a bank holding company acquiring a bank outside its home state, were regulated by the Federal Reserve.
Others, such as interstate bank mergers, had to be approved by the appropriate federal regulator (either the Office of the Comptroller of the Currency (OCC), the Federal Reserve Board, or the FDIC). The IBBEA provided regulators some level of discretion in these new activities, and it also placed several statutory restrictions on interstate banking, such as nationwide and state concentration limits on total deposits at one institution. Before the Civil War, bank regulation was largely a state matter, and a few states allowed interstate banking. However, limited interstate travel and communication opportunities made interstate banking impractical relative to the 20th century. Thus, interstate branching was relatively less important in years past. Regardless, under the new framework implemented by the IBBEA, virtually all banking activity remains regulated, and banks are supervised and examined by more than one regulator.
Currently, state agencies and at least seven federal regulators—the Federal Reserve, the FDIC, the SEC, the Commodity Futures Trading Commission (CFTC), the Consumer Financial Protection Bureau (CFPB), the Federal Housing Finance Agency (FHFA), and various agencies within the U.S. Department of the Treasury—could supervise, examine, or otherwise regulate a bank. In general, federally chartered banks are subject to supervision by the OCC, an independent bureau of the U.S. Department of the Treasury. State-chartered banks that choose to be members of the Federal Reserve System are subject to oversight by both the Fed and state regulators. However, non-Fed member state-chartered banks that are insured by the FDIC are subject to oversight by the FDIC and state regulators.
The 2000 Commodity Futures Modernization Act (CFMA). The CFMA is usually cited as the bill which prevented the CFTC from regulating over-the-counter (OTC) derivatives, such as swaps. The CFMA did, in fact, prevent the CFTC from regulating many OTC derivatives, but the CFTC did not regulate these derivatives prior to the passage of the CFMA. A main purpose of the CFMA was to clarify which regulator—the CFTC or the SEC—would regulate single stock futures contracts. These financial products have features of both securities and commodities, items that fall under the separate jurisdictions of the SEC and the CFTC.
The main issue concerning the CFTC’s regulatory authority over swaps dealt with legal uncertainty for swaps that could be construed as futures under the Commodity Exchange Act, possibly voiding the contracts if they were traded off exchange (that is, in the OTC market). While the CFMA did prevent the CFTC from regulating OTC swaps, it did not prevent these swaps from being regulated. In fact, the bulk of the swaps market, even the infamous credit default swaps (CDS) associated with the 2008 financial crisis, were regulated by banking regulators.
Over-the-Counter Swaps Were Regulated. Historically, the interest rate and foreign exchange swaps used by large banks have accounted for more than 80 percent of the OTC derivatives market. Federal banking regulators, including the Federal Reserve and the OCC, constantly monitor banks’ financial condition, including the banks’ swaps exposure. Even the very first iteration of the Basel capital requirements, implemented in the late 1980s, required banks to account for their swaps when calculating regulatory capital ratios. In particular, capital had to be held against the credit-risk equivalent to the swaps, essentially treating them as other loans in their risk-adjusted assets.
Simply put, none of these transactions took place outside of bank regulators’ purview, and there is no shortage of public acknowledgements attesting to this fact. For instance, a 1993 Boston Federal Reserve paper notes, “Bank regulators have recognized the credit risk of swaps and instituted capital requirements for them and for other off-balance-sheet activities, as part of the new risk-based capital requirements for banks.” Similarly, a 1996 OCC guidance bulletin notes:
Bank management must ensure that credit derivatives are incorporated into their risk-based capital (RBC) computation. Over the near-term, the RBC treatment of a credit derivative will be determined on a case-by-case basis through a review of the specific characteristics of the transaction. For example, banks should note that some forms of credit derivatives are functionally equivalent to standby letters of credit or similar types of financial enhancements. However, other forms might be treated like interest rate, equity, or other commodity derivatives, which have a different RBC requirement.
Just before the recent crisis, a 2006 OCC report stated:
As a result, derivatives activity is appropriately concentrated in those few institutions that have made the resource commitment to operate the business in a safe and sound manner. Further, the OCC has examiners on site in these large banks to evaluate the credit, market, operational, reputation and compliance risks in the derivatives portfolio on an ongoing basis.
Even the controversial CDS used by the failed company American International Group (AIG) took place under the watchful eye of the Office of Thrift Supervision, a federal banking regulator whose responsibilities Dodd–Frank transferred to the OCC, the Fed, and the FDIC. The notion that these swaps transactions took place in some shadowy room where regulators had no clue what was going on, is absolutely false. Furthermore, banking regulators remain responsible (under the new Basel III requirements) for certifying that banks are meeting their regulatory capital ratios, even when they use swaps. Nonetheless, Title VII of Dodd–Frank gives the CFTC and the SEC explicit authority to regulate the OTC swaps markets.
The 2004 Amendment to the SEC’s Net Capital Rule. Sections 8(b) and 15(c)(3) of the 1934 Securities Exchange Act introduced a net capital rule for broker-dealers, a rule that dictated the type and amount of liquid assets that broker-dealers had to maintain. The rule was amended several times after 1934, including a major adjustment in 1975 after a series of firm failures in the late 1960s and early 1970s, and also in 2004. The 2004 rule change has been blamed for allowing broker-dealers to raise their leverage, but data show that major investment banks were actually more highly leveraged in 1998 than in 2006, just prior to the 2008 crisis.
Regardless of how the rule change impacted firms’ leverage, it is, once again, highly misleading to characterize this amendment as deregulatory. The main component of the rule change was one that permitted an alternative method for computing deductions under the broker-dealer net capital rule. It is true that the rule allowed firms to use mathematical models to calculate their net capital requirements, but these firms were still subject to a minimum capital rule. Furthermore, companies electing to use the alternative approach were also subjected to “enhanced net capital, early warning, recordkeeping, reporting, and certain other requirements.” Firms electing the alternative method were also required to implement and document an internal risk-management system.
The overall intent of the rule change was to allow the SEC to regulate holding companies on a consolidated basis, much like the Federal Reserve does with bank holding companies. As such, the change only applied to holding companies that did not already have a principal regulator, and it did not undo any leverage restrictions. If anything, the rule change represents a clear case of regulatory failure rather than deregulation. In fact, the SEC’s Inspector General Report stated that “it is undisputable that the CSE [Consolidated Supervised Entities] program failed to carry out its mission in its oversight of Bear Stearns because under the Commission and the CSE program’s watch, Bear Stearns suffered significant financial weaknesses and the FRBNY [Federal Reserve Bank of New York] needed to intervene…to prevent significant harm to the broader financial system.”
More directly, the report noted:
Overall, we found that there are significant questions about the adequacy of a number of CSE program requirements, as Bear Stearns was compliant with several of these requirements, but nonetheless collapsed. In addition, the audit found that TM [the SEC’s Division of Trading and Markets] became aware of numerous potential red flags prior to Bear Stearns’ collapse, regarding its concentration of mortgage securities, high leverage, shortcomings of risk management in mortgage-backed securities and lack of compliance with the spirit of certain Basel II standards, but did not take actions to limit these risk factors.
In fairness, there is no reason to think that regulators have superior knowledge compared to other market participants when it comes to measuring financial assets’ risk. In fact, regulator-assigned risk weights under the Basel rules proved incorrect and contributed to the meltdown in the banking sector.
Lack of Focus on Systemic Risk Also a Myth. A common response to financial disturbances is that regulators have to do a better job of regulating firms’ safety and soundness to prevent the next crisis. This view is related to the deregulation myth because its proponents claim that the absence of particular types of regulations caused market instability. In the wake of the 2008 crisis, sympathetic policymakers argued that regulators could improve market stability in the future if only they would broaden their focus to monitor systemic risk, rather than simply concentrate on individual firm risk. Supposedly, this new focus can better prevent financial difficulties at any one institution from carrying over into the broader economy. At best, the claim that this policy shift is a new focus is highly misleading, while true on technical grounds. Otherwise, it is demonstrably incorrect that regulators have not previously monitored systemic risk.
It is true, for example, that the new Basel III capital rules employ some systemic risk (macro-prudential) regulations that were not previously used in the U.S. But this fact is barely relevant because the concept of regulators focusing on systemic risk is anything but new. One of the main justifications for creating the Federal Reserve and instituting federal banking regulations in the first place was to prevent problems in the financial sector from spilling over to the broader economy. These new macro-prudential tools are only the latest attempt at finally creating the “right” set of regulations.
The Fed, Congress, and the U.S. Treasury have openly discussed their roles in stemming economy-wide systemic risk and financial stability for decades. Regulators’ explicit focus on systemic risk was clear during, for example, the 1984 congressional hearings related to the bailout of the Continental Illinois National Bank. At those hearings, Todd Conover, head of the OCC, testified that the bank supervisor’s role was to maintain systemic soundness. Conover went on to testify:
Our [the OCC’s] supervision of banks of all sizes has been enhanced by the establishment of an Industry Review Program. This program includes a computerized information system to collect data on industry concentrations in individual bank portfolios and the banking system as a whole. (Emphasis added.)
In addition to the more frequent examinations we have undertaken, the examiners will also monitor trends and developments in the banks between examinations. This new approach results in near-constant supervision of each of our large banks. We are now better able to identify and devote attention to items of supervisory concern in individual large banks and significant practices emerging in the large bank population as a whole. (Emphasis added.)
Furthermore, the OCC was not the only federal regulator concerned with systemic risk prior to the 2008 crisis. For example, in 1996, the Federal Reserve specifically accounted for system-wide risk in its new rating system for financial institutions known as the CAMELS rating. Prior to this change, the Fed used a “CAMEL” rating; the 1996 change merely added the “S” which stood for sensitivity to market risk. Another popular response to financial disturbances is that regulators only need to implement higher or better capital requirements in order to prevent the next crisis.
A Cautionary Tale on Capital Requirements. Many policymakers believe that instituting higher statutory capital requirements will result in increased financial stability. As with the macro-prudential focus, the increased capital requirement is really just another attempt at imposing the “right” rules and regulations to reduce financial instability. While plausible, history suggests that policymakers should not depend on better statutory capital requirements to prevent future crises. One major effort toward accomplishing such a goal was the 1983 International Lending Supervision Act, a law that gave federal regulators the explicit authority to regulate banks’ capital adequacy, and to define what constitutes adequate capital levels. Soon after the act was passed, OCC director Todd Conover testified in a congressional hearing:
Under regulations proposed by the OCC and the FDIC, all banks, regardless of size, would be required to maintain a minimum ratio of primary capital to total assets of 5.5 percent. The implementation of this regulation will require over 200 national banks to raise a total of over $5 billion in new capital. The Federal Reserve has proposed similar guidelines on capital.
Stricter regulatory capital requirements will strengthen the trend towards stronger capitalization of the nation’s largest banks. For example, in the first quarter of 1984 the average ratio of primary capital to total assets stood at 5.67 percent for the holding companies of the 11 multinational banks supervised by the OCC. This is almost 16 percent higher than the average level at those banks two years ago.
In 1988, federal regulators adopted the first iteration of Basel rules, requirements specifically designed to better match capital requirements to the risk level of financial assets. Regulators were in the process of implementing the supposedly improved Basel II rules, but the 2008 financial crisis exposed those rules as flawed. Regulators then stopped that process and, instead, went to work on developing Basel III.
There is little reason to expect the latest set of Basel rules to perform better over the long term because all three iterations rely on similar types of subjective risk assessments based on historical events. No similar set of rules or requirements can fully protect the market from unforeseen financial disturbances. In one sense, instituting higher capital requirements is the equivalent of requiring firms to hold enough capital to cover the losses experienced in the previous crisis. At the very least, mandating legally required capital ratios should not be viewed as superior to allowing market participants to determine which levels of capital are adequate.
The myth that the 2008 financial crisis was caused by financial market deregulation has persisted for far too long. There has been no appreciable reduction in either the scope or the volume of regulation in U.S. financial markets during the past 100-plus years. Even the regulatory changes that did take place during the Ronald Reagan and George W. Bush Administrations cemented an ever-expanding financial regulatory framework. Some of these changes did allow financial firms to engage in activities that were previously prohibited, but they were only permitted to do so under the watchful eye of regulators.
True deregulation would establish a market where no government agency regulates the types of products and services people are allowed to produce and purchase. This type of financial market does not exist in the U.S., and Congress has increasingly moved the regulatory framework in the opposite direction since at least the 1930s. Virtually all financial firms’ activities—even those that contributed to the 2008 crisis—take place in an extensive regulatory framework. It is completely erroneous to blame the crisis on unregulated financial markets. Doing so has only allowed Congress to further expand regulators’ authority to micromanage financial companies’ activities, and Americans are not better off because of it.—Norbert J. Michel, PhD, is a Research Fellow in Financial Regulations in the Thomas A. Roe Institute for Economic Policy Studies, of the Institute for Economic Freedom and Opportunity, at The Heritage Foundation.