Thank you to Kim for organizing this forum and inviting me to join a group of scholars whose work I have enjoyed tremendously.
One of the framing questions that Kim asks, is “how is financial reform” different from other areas of reform or law and regulation making?” In one sense it is not. We can use many of the standard tools in the political economy tool box to make predictions about who is likely to win and loses as the sausage gets stuffed into the casing.
Regulatory Fights within the Financial Sector
For some of the vast number of Dodd-Frank rulemakings, there will be more cohesive industry groups on both sides of a fight. Think the Durbin Amendment -- debit card interchange fee issue. In those cases, well-worn theories (going back to interest group pluralism) would suggest that at least there will be a fair (if not evenly matched) fight. The more cohesive the interest group and the more it has at stake, the more likely it is to solve collective action problems and win a Beltway brawl. (If I were making odds on this fight, I would say that the banks and payment industry may have more cohesion, but there are plenty of merchants in every Congressional district who feel the pinch of being charged each time a consumer buys Cheetos with a debit card. In the end, I think the financial side will still win out, but not necessarily because of interest group dynamics. The caps on interchange fees boil down to price controls; even if the controls bite, ultimately the payment industry will find other ways to charge for their oligopoly.)
We can certainly find examples from financial regulatory history in which two financial industry groups squared off over regulation/deregulation. I’ve been doing a fair amount of research on how regulatory arbitrage and deregulation contributed to the “shadow banking system” (what’s that? for now – think of it as “securitization.”) One thing I am looking at in particular, are ways in which bank regulators slowly changed their interpretations to allow banks to participate in securitization (I am following in the footsteps of some great work that Saule has already done on incremental change in bank regulator interpretations). In one series of interpretations, the OCC gradually and creatively re-interpreted the Glass Steagall Act to allow banks to participate in securitization whether through investment, securitizing their own assets, or dealing in asset-backed securities. The securities industry trade group opposed many of these interpretations, but ultimately lost out in court.
Why is ”Deregulation” the Trend?
What is interesting is that ultimately the fight between banks and securities firms netted out to widespread financial deregulation -- not increased regulation of some categories of financial institutions or some rough equilibrium . Why did this occur? Part of this is because as Glass-Steagall slowly dissolved (it is grave intellectual error to blame its demise only on Gramm Leach Bliley – the Glass-Steagall wall started to be dismantled over two decades with regulatory actions big and small) the larger firms moved from a “if you can’t beat ‘em, merge with them” attitude. (For a comprehensive account on the tectonic shifts in financial regulation in this period, see Art Wilmarth).
Shadow Banking and Why Regulatory Walls Crumbled
But there are other reasons that explain deregulation triumphant from the 1980s through the current crisis. The compartmentalization of financial institutions into Depression-era regulatory boxes faced an onslaught from both economic and technological factors. As I noted above, I am writing on how legal change contributed to shadow banking. Although above I limited the “shadow banking system” to securitization, I actually define it more broadly to include a range of additional financial instruments – asset-backed commercial paper, shares in money market mutual funds, credit derivatives, repos – that connected household and commercial borrowers to investors in capital markets. These instruments thus formed bypasses around traditional depository banks that borrowed from depositors and loaned to businesses and households. The rise of the shadow banking system is really the history of the demise of financial regulatory compartmentalization. Again, legal change mid-wifed the birth of these instruments and helped them grow together from disparate financial markets into a system that pumped credit in one direction and credit risk in the other.
Legal change is not the only part of the story, however. The unleashing of financial risk in the 1970s, including because of the collapse of Bretton Woods, oil shocks and inflation generally, created demand for financial products that would allow individuals and businesses to manage risks via markets while mitigating market risk. At the same time technological advances, both “software” (think finance theory like Black Scholes) and “hardware” (think computers and telecom innovations), enabled capital markets to become more “complete.” (See Gilson & Whitehead).
These various forces combine to give rise to the array of shadow banking instruments that provided fresh competition for banks. This competition and economic conditions disturbed the Depression era balance and bargain in which banks received a both a regulatory license (which was protected by various laws that restricted entry and dampened competition among banks) and government subsidies (including deposit insurance) – but were subject to an array of laws designed to limit bank risk-taking (among other things). Borrowers and lenders flocked to the new instruments (this capital flight representing one form of regulatory arbitrage) and old regulations on bank competition and risk taking turned into straightjackets. So regulatory arbitrage set the stage for calls from banks for deregulation. This in turn prompted cycles of calls by non-banks and banks for deregulation and fresh regulatory arbitrage.
The turning of this great wheel of regulatory change can be seen in the origin story of the first shadow banking instrument: shares in money-market mutual funds. These funds first stole business from banks because they offered safe and liquid investments to rival bank deposits, but were not subject to Regulation Q, which capped the interest rates banks could offer depositors. Losing business, banks lobbied for the 1980 Depository Institutions Deregulation and Monetary Control Act, which demolished Regulation Q. A few years later, money market mutual funds responded by successfully convincing the SEC to allow them to price their shares with a fixed Net Asset Value, which would give investors the impression (or illusion) of the safety of bank deposits. (For more, see Birdthistle)
The Big Reason Financial Institution Regulation is Different: Externalizing Cost onto Taxpayers
But there is more to the “deregulation” picture than regulatory competition in both financial and political markets. Perhaps the biggest driver of deregulation and the most important reason financial regulation is different than other forms of regulation is the presence of government subsidies, particularly government guarantees. Whereas interest group competition might check regulatory change, financial institutions have every incentive to externalize cost onto the most diffuse political group of all – taxpayers.
These government guarantees provide some of the thorniest problems in regulatory design. Even explicit guarantees – like deposit insurance – are difficult to measure and therefore difficult to counter. Implicit guarantees (Too-Big-To-Fail) are hard to detect with certainty ex ante. Yet they may also become self-fulfilling prophecies: if enough market participants act like the guarantee exists, they will structure their financial investments accordingly and make it hard for a government not to bail out the firm. At the same time, their implicit nature gives them plausible political deniability for the guaranteed and the government guarantor alike.
Now everyone and their tio understands this Big Picture point today in the wake (or in the interlude) of the financial crisis. But financial regulation is an ongoing process. At some point, the spotlight turns off (and many legal scholars will move on to other things). Where will everyone and their tio be in ten years when bank regulators issue interpretations of obscure statutory and regulatory provisions? Saule’s work is so important because it reminds us that incrementalism – including bad incrementalism – is a persistent feature of financial regulation.
Now put that insight together with Kim’s recent research on what is happening with the Volcker Rule rulemaking process – a process that is high profile, backed by a prominent policy entrepreneur, and coming relatively soon after a financial crisis. Regardless of what you think of the merits of the Volcker Rule, the greatest and ever present challenge for the financial regulatory process is countering the incredible incentives for financial firms to externalize risk onto the taxpayer.