Banks: Regulation vs Free Market
Since the 2008 financial crisis, the financial sector has come under criticism for its behavior leading to the crisis, generating a classic economics debate of regulation versus free markets and highlighting the predator-prey relationships between the government, businesses, and the people. The government argues that businesses prey on the people, while businesses argue that the government preys on them through regulations. So we again face the age-old question of how much (if any at all) regulation is good or necessary?
Glass-Steagall Act: 1933
After the bank failures during the Great Depression, the Glass-Steagall Act was passed with the intention of separating commercial banking activities from investment banking activities. Many considered the growing involvement of commercial banks with stock market investments to be both highly inappropriate and one of the main causes of the stock market crash. The banks took on excessive risk by investing depositors' money into high risk assets. As a result, the objectives of banks came under scrutiny. The companies that banks invested in were given shady loans by those same banks.
This was seen as a major conflict of interest. The Glass-Steagall Act aimed to solve this conflict by forcing banks to specialize in either commercial banking or investment banking, but not both, setting a maximum of 10% on the amount of income a commercial bank could get from securities. Most of the banks reacted harshly to the regulations; many argued that some diversification is necessary to help banks reduce risk.
As the years passed, banks became more transparent about their practices. Consumers and regulators came to believe that this growing transparency would keep banks from assuming too much risk. As a result, in 1999, Congress passed the Gramm-Leach-Bliley Act, which repealed the Glass-Steagall Act.
Period of Deregulation
Repeal of Glass-Steagall through the Gramm-Leach-Bliley Act has often been attributed with contributing to the financial crisis of 2008. This argument stems a concept everyone will remember: sub-prime loans! Sub-prime loans are those given to people who are not very credit-worthy. A higher interest rate is placed on these loans to compensate for the higher risk of lending. In general, sub-prime loans are considered risky loans. Before the Glass-Steagall Act was repealed, sub-prime loans made up about 5% of all loans. After its repeal, by the peak of the crisis in 2008, sub-prime loans had grown to 30% of all loans.
Post-Crisis impact
There have been several attempts to re-enact the Glass-Steagall Act, most notably by Senator John McCain in 2010. President Obama also supported the "Volcker Rule," which proposed several laws similar to Glass-Steagall. The main goal of the "Volcker Rule" is to ban proprietary trading, which is trading on the banks' accounts with customers' deposits. Proprietary trading was very common in the period leading to the crisis and firms such as Goldman Sachs made as much as a quarter of their profits from proprietary trading.
In 2010, President Obama signed into law the Dodd-Frank Act, which includes many provisions of the Volcker Rule. Dodd-Frank was meant to reform Wall-Street and protect consumers from the type of predatory lending that led to the sub-prime crisis. However, there has been much debate about this law. Although the law passed, bankers still are arguing that the law imposes regulations that are too strict, while consumers maintain it does not offer enough regulation to protect the borrowers. So far, the main components of the act have yet to be felt, although they are certainly in progress.
Stress Tests
Recently, there have been further developments on the regulation of large banks. For instance, there will be a heavy emphasis on using stress tests to determine how banks would do under conditions like those seen in 2008. The EU already has implemented such tests, and major European banks have been struggling to meet them due to the illiquidity of the markets.
Additionally, by 2013 financial firms will be required to hold at least 5% of their assets in reserves at all times, or face a surcharge penalty for assuming too much risk. In the years leading to the crisis, most banks were holding only around 3% of their assets as reserves. The increase in the capital requirement was adopted because a greater reserve could be used as a cushion in periods of high distress on the markets. However, banks argue that greater reserve requirements will stall growth by reducing lending.
Basel III
Many of the Dodd-Frank regulations are based upon the Basel III, an international regulatory standard, although they are not nearly as severe as Basel III. In fact, some U.S. banks fall under both US and the Basel III regulations and therefore will face stricter capital requirements. Both the U.S. and the Basel regulations are targeting banks deemed "systematically" important, or important enough to impact the market as a whole.
There are concerns that the regulations will result in less liquidity in the markets, and increase costs for banks at the absolute worst time. But the Fed believes the benefit of reducing the chances of another crisis outweighs the short-term costs of making loans available at cheap rates.
How Will This Impact U.S. Markets
In the short run, I feel that most of the impact from regulations is already built into the stock market price. We saw the markets struggle immediately after the announcements of further regulations, and the financial firms impacted by the regulations took the biggest hits. It is still important to note that all the provisions of the regulations are not finalized. The Fed is expected to release further details in the months to come (likely by March). Pay close attention to all details released and the reaction of lenders to those details. If the regulations turn out to be more severe than expected, then I would certainly expect more of a short term hit to the financial sector.
As Jon pointed out to me, the next few years look to be very gloomy for banks until the business cycle repeats itself (regulation vs deregulation). Until there is more stability in the markets, a large concern for banks is that they will have to find new ways to make profits without making risky investments.
Guest Commentator: Ralph Vaz
President of the Society of Individual Investors (SII)
http://www.sii.org.vt.edu/
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