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The U.S. “Bank Deregulation Caused the Crisis” Myth
Thanks to the new open source platform called QuantGov, we can measure concepts such as regulatory restrictions, regulatory complexity and…
Thanks to the new open source platform called QuantGov, we can measure concepts such as regulatory restrictions, regulatory complexity and even deregulation. In forthcoming short posts, I will build on my colleague Patrick McLaughlin and co-authors’ short posts on financial regulation (see here, here, here, here and here) to show why the “bank deregulation caused the crisis” hypothesis can be falsified. I’ll show that rather than deregulation, the number of words and the restrictions embedded in the Code of Federal Regulations for the Federal Reserve, the Office of the Comptroller of the Currency, and the Federal Deposit Insurance Corporation has increased substantially since 1970, the first year in which the data’s available.
I do believe that regulatory changes can contribute to a crisis. I discussed one case in a recent post that summarized a newly released working paper that I wrote. In the paper I use empirical evidence from all financial holding companies with at least $1 billion in total assets to show how a particular regulatory change, known as the Recourse Rule, could have contributed to the crisis. The rule changed bank capital regulations in late 2001 by lowering the amount of capital (think equity and/or long-term debt) that banks needed to fund holdings of the highly rated securitization tranches (think “CDOs” and “private label mortgage backed securities”).
I would classify the Recourse Rule as a case of “more lax” regulation, rather than deregulation, because word counts and regulatory restrictions overall continued to rise during this period. You can undo the “more lax” regulation by increasing capital requirements rather than writing many new regulations, as we typically see following a crisis, which offers yet another example of the ubiquitous tradeoff between quality and quantity.
Saying that changes in regulation contributed to the crisis is very different from saying “deregulation caused the crisis.” The former implies that the rules somehow changed, which in turn could have changed peoples’ incentives, and they accordingly may have changed their behavior. The latter implies that we went from a world of some rules to fewer rules, or perhaps even no rules at all, as if we suddenly returned to that long-lost world of “laissez faire” anarcho-capitalism.
You only need to read through Charles Calomiris and Stephen Haber’s book Fragile by Design to see that “laissez faire” hardly characterizes the U.S. banking landscape, which was shaped early on by state laws prohibiting branching and interstate banking (since the constitution prohibited states from issuing their own currency, they turned to bank chartering as a revenue source). These laws explain why the U.S. has had so many crises (at least 10 major ones and 20 minor ones since 1825). After each crisis, you tend to see more laws and regulations that attempt to fix what was identified as a cause of that crisis. Stay tuned for more.