"Liberalisation’s Limit"

Martin Wolf says he's been under a "delusion" about the ability of securitization to carry risks outside of the traditional banking system and reduce the need for regulation:

The rescue of Bear Stearns marks liberalisation’s limit, by Martin Wolf, Commentary, Financial Times: Remember Friday March 14 2008: it was the day the dream of global free-market capitalism died. For three decades we have moved towards market-driven financial systems. By its decision to rescue Bear Stearns, the Federal Reserve ... declared this era over. ... Deregulation has reached its limits.

Mine is not a judgment on whether the Fed was right to rescue Bear Stearns... I do not know whether the risks justified the decisions... Mine is more a judgment on the implications of the Fed’s decision. Put simply, Bear Stearns was deemed too systemically important to fail. This view was, it is true, reached in haste, at a time of crisis. But times of crisis are when new functions emerge, notably the practices associated with the lender-of-last-resort function of central banks, in the 19th century.

The implications of this decision are evident: there will have to be far greater regulation of such institutions. The Fed has provided a valuable form of insurance to the investment banks. Indeed, that is already evident from what has happened in the stock market since the rescue: the other big investment banks have enjoyed sizeable jumps in their share prices... This is moral hazard made visible. The Fed decided that a money market “strike” against investment banks is the equivalent of a run on deposits in a commercial bank. It concluded that it must, for this reason, open the monetary spigots in favour of such institutions.

Greater regulation must be on the way. The lobbies of Wall Street will ... resist.... But, intellectually, their position is now untenable. Systemically important institutions must pay for any official protection they receive. Their ability to enjoy the upside on the risks they run, while shifting parts of the downside on to society at large, must be restricted. This is not just a matter of simple justice... It is also a matter of efficiency. ...

I greatly regret the fact that the Fed thought it necessary to take this step. Once upon a time, I had hoped that securitisation would shift a substantial part of the risk-bearing outside the regulated banking system, where governments would no longer need to intervene. That has proved a delusion. ...

Yet the extension of the Fed’s safety net to investment banks is not the only reason this crisis must mark a turning-point in attitudes to financial liberalisation. So, too, is the mess in the US ... housing markets. ... Again, this must not happen again... The ... aftermath will surely be much more regulation than today’s. ...

One note: Free markets is not the point. Producing well-functioning, competitive markets is the goal, that's when our models say the outcome is optimal. If removing restrictions gets you in the vicinity of the competitive outcome, and most often it does, then that is the right thing to do. But if making markets as free as we can doesn't produce a competitive outcome, then another approach is needed (and the extent to which an intervention that overcomes a market failure and produces a more competitive market reduces freedom is a debate for another day, but I don't see why it necessarily does).

Martin Wolf says regulation is coming, but "lobbies of Wall Street will ... resist" any change. That's what happened when financial markets were subjected to new regulations during the New Deal, but bankers are lucky - we're all lucky - their objections didn't stop the changes from being enacted. Daniel Gross notes the ways in which those changes are still helping us today:

The New New Deal, by Daniel Gross: In the 1930s, Franklin Delano Roosevelt saved American capitalism from its own self-inflicted wounds by erecting a new financial infrastructure—often over the vociferous opposition of the bankers and investors whose poor judgment had helped precipitate the Great Depression. During the New Deal, the government reacted to a disastrous systemic failure by creating the sort of backstops, insurance, and risk-spreading mechanisms the market had failed to develop on its own, such as deposit insurance, federal securities registration, and federally sponsored entities that would insure mortgages.

Despite sustained efforts to tear down the New Deal ... the 1930s-vintage infrastructure has proved remarkably durable. ... Although the Tennessee Valley Authority has yet to pitch in, four 70-year-old agencies are helping to cushion the blow of the housing bust. Let's count them.

1. The Federal Home Loan Bank system. Last year, the model of originating and securitizing mortgages began to break down... Mortgage companies that relied on the capital markets (rather than deposits) to raise the money for mortgages suddenly found themselves starved for cash. Many of them turned to the FHLB, which was created in 1932 (so let's give that one to Herbert Hoover) and provides capital to lenders. Indeed, had it not been for the FHLB, it's possible that the nation's largest mortgage lender, Countrywide Financial Corp., might have gone under. ... On Monday, the FHLB pitched in again ... to ... double the number of mortgage-backed securities issued by Fannie Mae and Freddie Mac...

2. The Federal Housing Authority. The FHA, which was created in 1934, insures mortgages made ... to borrowers who are creditworthy but not particularly affluent. As the mortgage market grew ... and subprime lenders peddled credit to underserved markets, the FHA may have seemed outdated. But in the wake of the subprime debacle, the FHA has suddenly become an important part of the effort to stanch the rising tide of foreclosures. ...

3. The Federal National Mortgage Association (Fannie Mae), which was created in 1938. Fannie Mae purchases ... mortgages under a certain size ... and packages them into securities, which it effectively insures. ... Fannie Mae and its brother government-sponsored enterprise, Freddie Mac, are playing a central role in the federal response to the housing crisis. ...

4. The Federal Deposit Insurance Corp. The FDIC, which was founded in 1933 and insures bank deposits, is playing more of a passive role. Many of the financial institutions that have failed or suffered near-death experiences in the current crisis—subprime lenders, jumbo lenders...—essentially fell victim to runs on the bank. ... But one sector has been largely immune from runs on the bank—banks themselves. Even as banking companies have racked up significant losses..., and even as some tiny banks have failed, Americans haven't rushed to yank their cash out of their checking and savings accounts. ...

Quoting Martin Wolf once more, he says "times of crisis are when new functions emerge." This article is something I came across in a search - it's an "interview" of Carter Glass by the Minneapolis Fed - that discusses how crises cause change (you'll see why interview is in quotes).

Two additional topics are discussed in the "interview" that have come up here recently, the erosion of the "walls between commercial and investment banks" that occurred in the late 1990s (that's when this interview was conducted), and the erosion of regulatory authority as banks found ways to evade regulations, i.e. "national banks had created affiliates as a way of doing precisely those things that the National Bank Act prohibited them from doing." Thus, in that respect, the motivation for the regulatory change that produced the Glass-Steagall act is the same as the motivation for more regulatory control today - the existence of a shadow banking system outside of regulatory authority that has the ability undermine faith in the financial system, or to produce feedback effects that can cause banks under the Fed's authority to fail:

A Conversation with Carter Glass, The Region, December 1997: Since Carter Glass has been dead for over 50 years, we were naturally surprised that he agreed to be interviewed by The Region. ... Woodrow Wilson claimed that Glass, as a member of the House of Representatives, had "snarled the Federal Reserve Act through Congress out of one side of his mouth" and speculated that Glass might have accomplished even more using his whole mouth. ... Out of deference to his extreme advanced age of 139 and perhaps worried about his reputation for being easily provoked, we eased into the following conversation as gently and graciously as we knew how.

REGION: Senator, thank you very much for coming. It's a wonderful privilege to meet the man who invented the Federal Reserve System.

GLASS: It's nice to be here; I don't get out much any more. As to my inventiveness... The true mastermind of the Federal Reserve banking system was Woodrow Wilson..., but many others made constructive contributions...

REGION: ...The Federal Reserve has been dismantling the Glass-Steagall Act's walls between commercial and investment banks. As one of the architects of those walls, do you regret the changes?

GLASS: If you put yourself in my place and time, you would have done as I did. Our subcommittee did not act out of any prejudice or in a whimsical or inadequate way. We consulted practical bankers and experts extensively. We did everything but sleep with experts, and we learned that national banks had created affiliates as a way of doing precisely those things that the National Bank Act prohibited them from doing..., affiliates were the slippery conjurations of lawyers. Shrewd men operated them and entwined the parent banks in great difficulties. Banks lent their names, prestige and tradition of sound banking operations to these affiliates, and on that basis did people invest and transact business with them. When calamity struck, not all bankers felt a responsibility to the citizens they had enticed. Not all bankers could afford to.

Our subcommittee heard testimony about many virtuous affiliates, but we also heard of abuses, especially in securities dealings, and the weight of informed opinion was that the affiliate system was riddled with vicious practices. Two of the country's most eminent bankers who testified had already got rid of their affiliates without any governmental prompting, but opinion varied about whether affiliates should be liquidated, or whether they should be separated from the commercial banks, or whether their powers should be trimmed and they should be subjected to more or less severe supervision, as banks were.

We could not single out exceptional cases. Congress must act by general legislation, and in the end we aimed for a happy medium. We allowed a decent period for banks and their securities affiliates to uncouple, and we subjected other affiliates to greater or lesser safeguards and supervision, depending on their activities. We hoped those measures would answer the public's loss of confidence, protect depositors and investors, and help prevent Federal Reserve facilities from being used in support of stock and commodity gambling, which had brought on the Depression and about which I had been warning for 14 years or more...

REGION: ...The insurance of S&L deposits put the government to great expense not long ago. ...

GLASS: "Great expense" is a tepid description of a catastrophe. The best reform of government insurance would be to wash the land entirely clean of it, though it take all the waters of Abanah and Pharpar to do it. If it were not so tragic, it might be amusing how many people discovered the problem of moral hazard only after the savings and loan associations went bust. When we passed the Federal Reserve Act, we knew all about moral hazard. One version of our currency bill would have devoted half the Reserve banks' excess earnings to deposit guaranty, but every plan that experts and politicians devised was either a sham or would have visited the sins of reckless banks either upon the government or upon banks that themselves bore no taint of wickedness or improvidence, and would thus encourage sin. No one ever proposed a solution to that problem that satisfied me, or has yet. When I stood before the House of Representatives in 1913 and declared that not one dollar of government funds should ever go toward the guaranty of bank deposits, the welkin rang with applause from both sides of the aisle.

REGION: But surely the government bears a responsibility. Bank failures impose calamitous losses on individuals who are not well positioned to protect themselves.

GLASS: In my experience, once a man learns that he is at risk, he will find a way to protect himself. And there is no better learning experience than to see his neighbor lose a portion of his deposits in a panic. ...

President Wilson, the best educated president we have ever had in political philosophy, deplored philanthropic government, but the country has grown accustomed to it. Protecting citizens against loss is a philanthropic goal, but as we predicted in 1913, the national government cannot keep bank losses at a tolerable level, once it has shifted risk to itself—or, rather, to its taxpayers—without a mammoth and expensive bureaucracy to dictate banking practices in ever more minute and oppressive detail to experienced and practical bankers. I am more persuaded than I ever was that the government should not be in this business.

REGION: That confuses me. Isn't your name on the bill that put the government in this business?

GLASS: A legislator may sponsor a bill for different reasons...; and in emergencies he may support emergency measures that are unsuited to calmer times. It was clear that the country needed prompter and more orderly arrangements for liquidating banks. A man wrote me from Missouri, for example, that his bank had been six years in the hands of a manipulative receiver and he had not seen one cent of his money. I also recall a Montana bank whose affairs could not be wound up in under 28 years. Those problems deserved legislative correction.

REGION: It's too bad you needed a banking crisis to get that legislation.

GLASS: It is nearly impossible to get banking reformation in this country without a crippling national emergency, and even then, bankers tell us to wait for better times because their situation is precarious and reform will break them. But when better times arrive, they tell us to wait yet awhile, because reform will upset their fragile prosperity. Bankers and their myrmidons and hired pigwidgins always threaten a torrent of disasters. They think the time is always right to reform others and the time is always wrong to reform them. Furthermore, if Congress waits as bankers instruct and gives some new villainy time to take hold and become familiar, bankers then defend the practice as if it were a birthright of finance handed down to them from Justinian by way of the Medicis and Alexander Hamilton himself, with which it would be impious and disruptive for the government to interfere.

In this fog of selfish rhetoric, all a poor member of Congress can do is keep a list of needed improvements and bide his time until a financial catastrophe gives him his chance, and then he must legislate at once or wait for the next debacle. This is a wasteful, unscientific process. It delays useful remedies until the banking system is racked with infection, and it brings in desperate cure-alls, quack nostrums and overdoses that may be worse than the disease and, though meant to be temporary, often continue for decades after the fever breaks. ...