The myth of US financial reregulation

The regulatory reform bill currently before the US Congress will supposedly impose financial reregulation, reversing the alleged deregulation of the past 30 years. What deregulation? Can anyone point to the removal of a particular legal or regulatory barrier in the last two decades as a cause of the recent financial crisis? If so, will the new legislation restore this barrier, asks Arnold Kling, an adjunct scholar with the Cato Institute.

The financial crisis is often blamed on Gramm-Leach-Bliley, a 1999 law that ratified the de facto breakdown of the separation between commercial banks and investment banks (which raise capital and market securities for governments and corporations):

  • Repealing the law would return restrictions on banks' lines of business back to the Glass-Steagall Act passed in the Depression.
  • But the new bill does not repeal Gramm-Leach-Bliley, and there is not much connection between it and the crisis.
  • In fact, to restore the distinction between commercial banking and investment banking would require an entirely new law.

    This is because Glass-Steagall did not contemplate such financial market innovations as money market funds, mortgage-backed securities or credit default swaps – all of which raise the question of whether they fall under commercial banking or investment banking.

    Some point to government policies that encouraged home ownership as the cause of the crisis. However, property bubbles took place around the same time in many other countries, including the United Kingdom and Spain. These property bubbles cannot be blamed on U.S. housing policy. Moreover, this bill does not repeal any of the subsidies, such as the income tax deduction for mortgage interest, that encourage home buying, explains Kling.

    Two federally chartered financial institutions, Freddie Mac and Fannie Mae, bought and sold mortgage-backed securities, and provided financing for individuals without the income necessary to repay them. But the proposed law does nothing to rein-in the mortgage giants, says Kling.

    Federal Reserve monetary policy helped fuel the housing bubble with low interest rates, but the most important cause of the crisis was a change in capital regulations. That was not deregulation, and it will not be reversed by the legislation, says Kling.

    Source: Arnold Kling, The Myth of Financial Reregulation, National Center for Policy Analysis, Brief Analysis No. 711, June 24, 2010.

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    First published by the National Center for Policy Analysis, United States

    FMF Policy Bulletin/ 29 June 2010
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