Why Deregulation and Bailouts Cannot Coexist

It is commonplace these days to read scathing reports on the “lax” federal regulation of the financial companies and markets. The financial press and popular publications are full of assertions that the government could have prevented this crisis. Alan Greenspan, once hailed as a hero, is now reviled for his perceived failure to anticipate and prevent the unmitigated disaster being faced by the common investor. These beliefs are ignorant and misdirected.

Everyone certainly has a right to be upset over the current situation; indeed, year-to-date losses of 34.5% in the Dow Jones and 39.5% in the S&P (as of December 9) are enough to make even the most ardent believer in the benefits of stock-market investing irate and dumbfounded. But the fact of the matter is that the crisis resulted largely from the enormously disappointing performances and decision making of the private sector banks, not failure of the government to regulate them. Indeed, deregulation is preferable to regulation, as the market disciplines and punishes far more effectively than the government can.

But deregulation must allow for failure in order for the discipline of the market to work. When deregulation and bailouts coexist, then fear of the consequences of risks is diminished, and crises such as the current one are inevitable. The government must choose regulation and bailouts or deregulation and failures; there is no third option. Specifically, the government must enact regulatory legislation as quickly and effectively as possible, or stop its haphazard lending to financial institutions and let the market do its job of punishing failure with bankruptcy and liquidation.

In regards to regulation, many opinions are expressed on how greater regulation is needed in the future. People envision a world in which commercial banks are regulated heavily and not allowed to engage in business activities that are considered too fundamentally risky and potentially catastrophic to the rest of the market. No more will mortgage-backed securities and collateralized debt obligations haunt the balance sheets of commercial lenders and wreak havoc on the financial system. Many people hope this vision will become a reality within a few months. But it already was a reality for over six and a half decades and it was only in 1999 that it was changed.

The Glass-Steagall Act of 1933 was a reaction by the government to the huge losses in, and systemic failure of, the commercial banking system. It is almost eerie to read the description of a provision of the law given by Milton Friedman and Anna Jacobson Schwartz in A Monetary History of the United States, 1867 – 1960. “[T]he Banking Act of 1933 made member banks subject to severe reprisal for undue use of bank credit ‘for the speculative carrying of or trading in securities, real estate, or commodities, or for any other purposes inconsistent with the maintenance of sound credit conditions.’” This stipulation prohibiting trading in assets and securities of dubious credit-worthiness may sound familiar, for it is exactly what many believe the government should have been doing to prevent this crisis, and what those same people believe it should do in the future.

But these regulations proved problematic to a large extent. The stifling legislation led to inefficiencies among U.S. banks, as well as to loss of business to foreign banks, which had greater independence. The final repeal of Glass-Steagall came in 1999 with the Gramm-Leach-Bliley Act. Many hailed the repeal as ushering in a brave new world where banks were free from intrusive regulation and could invest in areas that would strengthen their bottom lines, and hence the value of their shares. Truly, many felt, the best and the brightest of Wall Street would be able to use their new freedoms to compete with foreign banks and to improve market efficiency in this country, while simultaneously earning positive returns on behalf of their investors. A more deregulated system thus came into being.

So what went wrong with deregulation? Put simply, investment banks and commercial banks alike undertook bets that either were not well understood or were well beyond acceptable limits of risk, or both. Some will quip that great reward comes only with great risk, but it is unlikely that the average investor would have been onboard with these concentrated and leveraged positions in markets as arcane and risky as subprime mortgages, for instance. One of the beauties of allowing banks to branch out into other businesses in the first place was to allow for greater diversification of their portfolios and thus lower the probability of a bank failure or banking crisis. Yet it is precisely this venture into uncharted territories that became the banks’ undoing. The diversification did not happen adequately and the positions proved to be untenable.

Moreover, when disaster struck, the banks were coy to describe their financial health, and the pronouncements that were made often turned out to be misleading or false. If it seems like only a few weeks ago that Citigroup’s CEO Vikram Pandit was reassuring the world that Citi had “plentiful capital, abundant liquidity” and strong revenue, it’s because it was only a few weeks ago, shortly before Citigroup’s bailout. Now, $250 billion of taxpayer money later, those “reassuring” comments are rather frustrating to re-read.

The question thus becomes what is to be done about the failures of the financial institutions. To be sure, a revised Glass-Steagall is not necessarily the answer. What is necessary is for the government to decide whether banks are too important to the overall economy to be allowed to fail. Moreover, commercial banks’ freedom to dabble in areas outside of those traditionally associated with bank holding companies (i.e. activities other than borrowing and lending) should be debated, given that that freedom has led to problems. The government must answer these questions definitively and clearly in order to avoid further market turmoil. The government must not continue to pick winners and losers as it has seemingly done rather haphazardly with the investment banks.

If it is determined that these institutions are too essential to the economy and the financial markets to be allowed to fail, then they must be regulated. As painful as it is to admit, there is no other option: businesses that are vital to our continued economic survival cannot be left to laissez faire economics, which allows for failure, because such failure would consequently destroy the economy. The regulations in question must limit the scope of the banks’ enterprises or limit the various assets that can be held, or both. This would amount to a revised Glass-Steagall act. The potential inefficiencies that such heavy-handed regulation would result in must be weighed against the cost of a catastrophic collapse.

But if banks are not too important to fail, then fail they should when the time comes. The FDIC has already increased to $250,000 from $100,000 the amount in a savings or checking account that is insured by the government. That is more than enough to prevent the run on banks that some people puzzlingly seem to believe may happen if banks are allowed to fail. Moreover, those who seek more discipline for the banks should realize that the market provides the most discipline of all. Setting an example of allowing banks to fail will provide much more of a disincentive to take excessive risk than enacting more legislation to regulate the banks. In fact, the current system of buying troubled assets is simply rewarding the banks for their misguided ventures into risky and complicated markets.

The government therefore must choose regulation and bailouts or deregulation and failures. It cannot have deregulation and bailouts without creating perverse incentives for financial institutions to undertake even greater and riskier positions, knowing that there is limited possibility of failure. It can either prevent these risky ventures with legislation, a la Glass-Steagall, or through the threat of failure.

While regulation existed in the past and led to a limit on crises, it also led to market inefficiencies and loss of business to foreign banks. In addition, regulations, unless perfectly crafted, also lead to the profitable business of finding regulatory loopholes, which nullifies the effect of legislation in the first place. Such loopholes would not exist to a large extent when the market is the ultimate regulator and enforcer.

There is no better place to punish and reward risks than in a free market. Deregulation is preferable for this reason. However, the problems and poor decisions of the deregulated commercial and investment banks over the last few years cannot be understated or condoned, let alone rewarded with bailouts. Several banks have failed their investors, the government, and the American people. It is time that we leave them to fail.