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How Deregulation Eviscerated the Banking Sector Safety Net and Spawned the U.S. Financial Crisis

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How Deregulation Eviscerated the Banking Sector Safety Net and Spawned the U.S. Financial Crisis
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The systematic dismantling by greedy bankers of fundamental and pragmatic banking regulations, which arose from the devastating financial collapses of the Great Depression, began in earnest in 1980, peaked in 1999, and finally climaxed with an insane Securities and Exchange Commission ruling in April 2004, a final decision that paved the way for the implosion of everything regulation was designed to protect.

The motivation for bankers to undermine and inhibit prudent regulation is inherent in banker compensation incentives. The September 1993 Journal of Financial Research sums up the problem on compensation by concluding: “Firm characteristics that influence managerial compensation include leverage (as a measure of observable risk) market-to-book ratio of assets, size and shareholder return. Evidence suggests that Bank Holding Companies may be exploiting the deposit insurance mechanism because leverage is a significant factor in our results for incentive-based components of compensation. Our results strongly support the view that fundamental shifts in business activities of Bank Holding Companies have influenced their compensation strategies”. No one would tempt an alcoholic by putting one in charge of a liquor store and neither would anyone put a fox in charge of a henhouse. So why are greedy bankers being allowed to rewrite banking regulations to enrich themselves while leveraging taxpayers, destroying trillions of dollars of hard-earned savings and sinking us into a potential depression?

Just how did we get here? Wall Street bankers, their exorbitantly well-paid lobbying army of former congressmen and former regulators, their greatly contributed-to sitting legislators and, most egregiously, the self-righteous and still mega-rich “former” Street executives have systematically eviscerated the muscle and bones from the regulatory bodies charged with protecting us from banks’ self-destructive greed. An inordinately powerful group of executive insiders from the once-deeply respected House of Goldman Sachs (GS) have served as U.S. Treasury secretaries and in innumerable other administrative capacities.

The Depository Institutions Deregulation and Monetary Control Act of 1980, signed into law by President Jimmy Carter, was the first major reform of the U.S. banking system since the Great Depression. While touted as a boon to consumers, the law was actually a gold mine for bankers.

In 1980, in a virtual landslide, Ronald Reagan was elected and grabbed the conservative mantle. A year later, the shock troops of the heralded Reagan Revolution launched their attack and embarked on a massive, systematic de-regulatory campaign.  President Reagan’s first treasury secretary, former Merrill Lynch & Co. Chief Executive Officer Donald T. Regan, became chairman of the Depository Institutions Deregulation Committee.

In 1987, Alan Greenspan replaced Paul A. Volcker - the stalwart Federal Reserve Board chairman, national inflation-fighting hero and active proponent of Glass-Steagall (and now economic confidant of President-elect Obama). In its twilight days, the Reagan administration was determined to further fertilize the seeds of deregulation and Greenspan’s Ayn Rand-inspired “objectivist,” free-market philosophies would be the perfect embodiment of the deregulatory movement.

A year later - in 1988 - two very quiet revolutions sprouted that would ultimately hand bankers twin throttles to rain terror on us all. That year, the Basel Accord established international risk-based capital requirements for deposit-taking commercial banks. In a byproduct of the calculations of what constituted mortgage-related risk (by nature of the loans’ long maturities and illiquidity) lenders should be expected to set aside substantial reserves; however, marketable securities that could theoretically be sold easily would not require significant reserves. To obviate the need for such reserves, and to free up the money for more-productive pursuits, banks made a wholesale shift from originating and holding mortgages to packaging them and holding mortgage assets in a now-securitized form. Not inconsequentially, this would lead to a disconnect between asset-quality considerations and asset-liquidity considerations.

Meanwhile, over at the U.S. Commodities Futures Trading Commission (CFTC), the appointment of free-market disciple Wendy Gramm, wife of U.S. Sen. Phil Gramm, R-Tex., as chairperson, would result in her successful 1989 and 1993 exemption of swaps and derivatives from all regulation. In 1993, with her agenda accomplished, Wendy Gramm resigned from her CFTC post to take a seat on the Enron Corp. board as a member of its audit committee. We all know what happened there. Enron’s fraud and implosion became the poster child for deregulation run amok and ultimately helped spawn Sarbanes-Oxley legislation, which has its own issues.

Phil Gramm - the fire breathing free-marketer, Texas senator, and chairman of the U.S. Senate Committee on Banking, Housing and Urban Affairs - helped complete the deregulation orgy, propelled by a sea of more than $300 million in lobbying and campaign contributions. In 1999, in the ultimate proof that money is power, U.S. President Bill Clinton signed into law the Gramm-Leach-Bliley Financial Services Modernization Act, at once doing away with Glass-Steagall and the 1956 BHC Act, and crowning Citigroup Inc. as the new “King of the Hill.”

From his position of power, Sen. Gramm consistently leveraged his Ph.D in economics and free-market ideology to espouse the virtues of subprime lending, where he famously once stated: “I look at subprime lending and I see the American Dream in action.”  But if helping struggling borrowers pursue their homeownership dreams was such a noble cause, it might have been incumbent upon the senator to not block legislation advocating the curtailment of predatory lending practices. From 1989 through 2002, federal records show that Sen. Gramm was the top recipient of contributions from commercial banks and among the top five recipients of campaign contributions from Wall Street.

On April 28, 2004, in a fitting and perhaps flagrant final act of eviscerating prudent regulation, the SEC ruled that investment banks may essentially determine their own net capital. The insanity of that allowance is only surpassed by the fact that the SEC allowed the change because it was simultaneously demanding greater scrutiny of the books and records of what were the holding companies of investment banks and all their affiliates. The tragedy is that the SEC never used its new powers to examine the banks. The idea was that Consolidated Supervised Entities (CSEs) could use internal models to determine risk and compliance with net capital requirements. In reality, what the investment banks did was essentially re-cast hybrid capital instruments, subordinated debt, deferred tax returns and securities with no ready market into “healthy” capital assets against which they reduced reserve requirements for net capital calculations and increased their leverage to as much as 30:1.

Original URL
http://www.moneymorning.com/2009/01/13/deregulation-financial-crisis/

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  • Public Comments

    • JDP JDP
      12 months ago


      Financial services deregulation and free market objectivism (a la Ayn Rand) - rather than being a real "engine of growth and wealth creation", has now been revealed to be one gigantic, complex, greed-driven "Ponzi" scheme for the criminal enrichment of a few (mainly bankers and brokers) at the expense of the many / taxpayers / "we the people" - via government enabled wealth redistribution policies bought and paid for by financial lobbyists! All of that "wealth" the deregulationists touted as having been created has now disappeared (some to the inevitable ether associated with such Ponzi schemes, but much into the pockets of the perpetrators). Sadly, the disappearance of that fake wealth has also sucked along even more real wealth (out of IRAs, 401Ks, mutual funds, pension plans, etc.) down the maw of its financial black hole. This calamity belies the previously glowing claims of that deregulation releasing the "entrepreneurial innovativeness" of "free market" capitalism, and thoroughly eviscerates the supposed "great free market economic gains" Republicans and free marketeers used to smokescreen the colossal theft that was occurring.

      The deregulatory trend
      + tentatively began under Jimmy Carter,
      + was vastly accelerated by Ronald Reagan and Alan Greenspan,
      + reached its peak led under the husband and wife team of Senator Phil and U.S. Commodities Futures Trading Commission chairman Wendy Gramm (with the acquiescence, if not active concurrence, of Bill Clinton),
      + and "came home to roost" under the Bush2 administration's total lack of oversight - despite repeated warnings by such proven financial luminaries as Warren Buffet (who famously identified several key deregulation facilitated "innovations" as "instruments of financial mass destruction").

      Whatever one might think of the current brand of Chinese government corruption (much from local party officials but some from the national Communist Party), at least that government's leaders occasionally have the "decency" (or is it just public relations moxie!?) to punish (sometimes execute!) the various figureheads who presided over scandals and incompetence of lesser proportions (lead toys, poison pet food, etc.). Will the democracies of "law and order" make some similar gesture toward the criminal elements of deregulation and banking - many of whom "remain at large", continue to enjoy their ill-gotten gains, and some of whom even still spew this discredited "party line" of deregulation and laissez-faire capitalism? One should probably not "hold their breath" on any such justice anytime soon (if ever).
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    • lynn-ecg lynn-ecg
      12 months ago


      prosecute? they are still getting their enormous salaries and outrageous bonuses. they trashed the economy in much of the world with nothing changing for them. the bailout money received has no strings therefore did not go to propping up the credit market which was the point.

      there needs to be accountability - in the financial sector and the politicician/appointees/employees in the federal government that allows the situation to be created and continued, and for accountability of bailout money that we the people supplied.
      *Changing America?

    • JDP JDP
      12 months ago


      Yes, outrage is too tame an emotion. Unfortunately, wresting the reins of finance (if necessary from their cold, dead hands) from these criminals will be a long, hard process. Giving it too them didn't happen all at once, nor will taking it from them happen all at once.

      For one thing, transparency must be forced (more like dug up and resurrected) to know exactly how much damage has been done and where the skeletons are hidden. While it is highly tempting to take the Chinese approach (line all of them up and shoot them), there may be a few slightly innocent actors, AND we unfortunately need the criminals to "come clean" about what rocks to turn over (that may be the only way some of the stolen wealth gets partially returned). Too, they have no scruples about taking down as much of the financial world with them (see Enron, for instance), which - as cathartic as that might feel - could hurt even more innocents.
      *Changing America?

    • lynn-ecg lynn-ecg
      12 months ago


      agreed.

      i heard yesterday, and confirmed by a friend, the whisper on the street is more bad news soon.
      *Changing America?
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