Too Regulated to Succeed

The United States’ financial sector has historically been extremely competitive globally, as is evident from the dominance of Wall Street in world financial markets. This competitive edge, however, can be lost all too easily if destructive regulatory and tax regimes are put into place. Decreasing transparency, increasing probability of bailouts and a higher regulatory burden can all work to erode competitiveness.

Last month, despite the fact that the financial sector has remained heavily regulated for the past several decades, and was further regulated during the 2008 crisis, Sen. John McCain  and Sen. Elizabeth Warren introduced legislation they call the 21st Century Glass Steagall Act, which would require banks to split federally insured commercial banking from all other diversified financial activities.

This is a classic case of piling on another layer of regulation following a crisis, regardless of whether the deficiency the regulation is meant to fix actually played a role in the crisis or will be effective in preventing another crisis. The purpose of the legislation is to force banks to split off the part of their activities that are federally insured, and is supposedly aimed at the banks that are considered “systemically important” under the Wall Street Reform and Consumer Protection Act (Dodd-Frank) and, therefore, too big to fail.

Deposit insurance goes back to the bank runs and widespread panics during the Great Depression of the last century. When it started out in 1934, the federal government limited insurance of deposits to $2,500 and raised the limit to $5,000 the same year. Dodd-Frank boosted that limit to $250,000, per account. When the federal government starts insuring that large an amount, which adds up close to 80 percent of bank deposits — up from around 45 percent in 1934 — it creates the problem that all insurance does. When someone else assumes the risk of loss, it frees the bank to take on riskier activity without the fear of loss imposed by market discipline. Ultimately, as we discovered in the wake of the past crisis, the taxpayers get stuck with the bill for the losses.

The “new” Glass Steagall Act attempts to correct this by forcing banks to split off insured deposits from other activities. A much simpler solution would be either to eliminate federal insurance entirely or reduce it sharply so that it is insuring only small depositors against losses, not well-off investors with the resources and access to expert advice.

Reintroducing the wall between commercial banking and other financial activity does not reduce the risk of a recurrence of another financial crisis. It does not address Dodd-Frank’s effective enshrinement of “too big to fail,” which is driving the growth of the large banks, not the lack of Glass Steagall. Dodd-Frank explicitly states that some banks will be considered systemically important. That can be read as a signal that these banks will be bailed out in the future.

A far better solution would be to let the market impose its own strict discipline. A market cannot function once the relationship between risk and reward is severed, and each successive intervention by the government succeeds in weakening that relationship. In the non-deposit-banking financial markets more than in others, where all the actors are sophisticated parties with access to expert advice, there is no justification for government intervention to protect against losses resulting from market trading.

Equally troubling is the creation of the single oversight body in the form of the Financial Stability Oversight Council, whose membership is made up primarily of the heads of various federal agencies supervising different functions of financial firms. Instead of the multiple layers of regulatory oversight, which formerly existed, the council now oversees the entire sector. The former arrangement might have been unwieldy, but at least agency errors were limited to that agency’s bailiwick. Now, not only will errors ripple through the entire financial sector, the discretion granted to the agencies under Dodd-Frank decreases transparency and moves us further away from a rules-based system.

Whatever caused the 2008 crisis, it wasn’t lack of regulation. According to the Code of Federal Regulation, more than 47,000 regulations apply to the financial sector, and that number hasn’t declined recently. It is past time to examine the perverse effect of this thicket of regulations on financial-sector performance and global competitiveness. Fewer and better regulations may improve the chances of preventing another crisis — or at least a taxpayer-funded bailout — in the future.