Is the Financial System Stable Without Regulation?

In recent weeks, the Fed has been pressing the SEC to tighten the regulation of money market mutual funds (MMFs)-a step which surveys show could substantially reduce the value of this $2.6 trillion industry to corporate investors. But there is much more at stake in this controversy than the future of an industry. The real underlying question is whether our financial markets are stable without the extensive regulation imposed by the Dodd-Frank Act.

This MMF issue came to the fore earlier this month when Mary Schapiro, the SEC chair, testified before Congress that new regulation is necessary. Speaking for herself because she has been unable to muster a majority of the commission, she argued that there could be a general run on money market funds if one or more of them should "break the buck" in the future-that is, fail to maintain a $1 net asset value per outstanding share. A run on other funds would be a serious problem, as it was in the 2008 financial crisis, because these funds-which today hold more than trillions of dollars in cash invested by individuals and businesses-are themselves major investors in commercial paper and other short-term securities of financial and nonfinancial corporations. If shareholders in these funds should flee, many firms in the real economy might not be able to fund their short-term cash needs.

The Federal Reserve has leverage over the SEC because of certain key provisions of the Dodd-Frank Act. Under the act, a new agency called the Financial Stability Oversight Council (FSOC), composed of all the federal financial regulators, can designate any financial firm as "systemically important" if its failure could create instability in the U.S. financial system. If a firm is designated as systemically important, the Fed becomes the firm's regulator and is directed by the act to impose "stringent" regulation. Recently, two Fed officials-Daniel Tarullo of the Board of Governors, and Eric Rosengren of the Boston Federal Reserve Bank-threatened that if the SEC fails to act the Fed will bring the matter to the FSOC for decision. Thus, if the SEC does not vote to impose more extensive regulation, it is possible that the SEC could lose its jurisdiction over at least some of the larger MMFs.

In her testimony, Ms Schapiro noted that in the chaos after the failure of Lehman Brothers in 2008 one MMF-the Reserve Primary Fund-broke the buck because of the losses it suffered on Lehman commercial paper. Investors then ran from other funds. She warned that this could happen again if another MMF should break the buck in the future.

The trouble with this argument is that it completely ignores the context in which the Reserve Fund event occurred, and thus raises the fundamental question whether our financial system can be stable without the extensive regulation imposed by the Dodd-Frank Act.

A rising tide may raise all boats, but a panic will sink even the soundest. The Reserve Fund broke the buck in the middle of a panic. At the same time, investors-who didn't know which financial firms held the mortgages or mortgage-backed securities that the media had labeled "toxic assets"-were also running on insured banks like Wachovia and Washington Mutual and on healthy investment banks like Goldman Sachs. It shouldn't be surprising, in this context, that they would also run on MMFs.

What's more, what happened in 2008 was the first panic in over 80 years-at least since the Depression era, and maybe the first since the panic of 1907. The only other time that a MMF broke the buck was in 1994, and no runs occurred on other funds. Similarly, in 1990, Drexel Burnham, a major securities firm, filed for bankruptcy-just like Lehman-and there were no runs on other funds or signs of panic. This tends to bolster the view that the financial system is inherently stable, and that events like MMFs breaking the buck or other financial firms filing for bankruptcy will not cause a financial crisis unless they occur in the midst of a panic-a market condition that seems to be extremely rare.

This is not the view of those who designed Dodd-Frank. They believed that an unregulated financial system is inherently unstable. That's why Title I of Dodd-Frank provides for the stringent regulation of nonbank financial institutions that have been designated as systemically important. The failure of any one of them, it was feared, will bring on another another financial crisis.

And that's why there is much more at stake in the MMF issue than merely the question of how much regulation the MMF industry should receive. Ultimately, the issue is whether the financial crisis of 2008 was a crisis of capitalism-as the left initially called it-or the result of a mortgage meltdown brought about by government housing policy, implemented largely through Fannie Mae and Freddie Mac. Mitt Romney and virtually all the Republicans in Congress believe that the financial crisis was caused by government housing policy, and without that policy there would not have been a financial crisis-in other words, the financial system would have remained stable. But the Dodd-Frank Act is the practical application of the left's view that unregulated capital markets are inherently unstable and require government regulation to protect the public.

There is little historical support for this proposition, and even less for the idea that regulated markets are more stable than unregulated markets. For example, the so-called shadow banking system-a term bank regulators now apply to those elements of the securities markets that are not subject to prudential bank-like regulation-had never experienced a systemic breakdown of any kind until 2008. However, the prudentially regulated banking system not only suffered several systemic events in that year-Wachovia, WaMu and IndyMac-but also saw the rescue of a large bank, Continental Illinois, on systemic risk grounds in 1984, and the collapse of the S&L industry in the late 1980s and early 1990s. Moreover, since the onset of the mortgage meltdown, more than 400 insured banks have failed and more than 300 received support under the Troubled Assets Relief Program (TARP) and have still not repaid the advances they received.

If, in the absence of a panic, the financial system is stable without regulation, it would not be good policy to impose more regulations on the financial system in order to protect against something as unlikely as another panic. That would reduce economic growth without good reason. The costs would be far greater than the benefits.

Indeed, we are seeing the results of this now in the economy's slow recovery from the recession that followed the financial crisis. As the accompanying chart shows, the economy was experiencing a modest recovery in the last two quarters of 2009 and the first quarter of 2010, but as soon as it became clear that the Dodd-Frank Act would pass the Senate, early in the third quarter of 2010, the incipient recovery was stopped in its tracks and has never resumed its prior rate of growth.

If the Dodd-Frank Act is to be repealed, as Romney and many congressional Republicans have called for, the first step is to recognize that the financial system is stable without regulation, and that the financial crisis of 2008 was not a crisis of capitalism but the result of government housing policy gone wildly awry.