What was financial deregulation

You can help correct errors and omissions. When requesting a correction, please mention this item's handle: RePEc:wbk:wbrwps See general information about how to correct material in RePEc. For technical questions regarding this item, or to correct its authors, title, abstract, bibliographic or download information, contact:.

If you have authored this item and are not yet registered with RePEc, we encourage you to do it here. This allows to link your profile to this item. It also allows you to accept potential citations to this item that we are uncertain about. We have no bibliographic references for this item.

You can help adding them by using this form. If you know of missing items citing this one, you can help us creating those links by adding the relevant references in the same way as above, for each refering item. If you are a registered author of this item, you may also want to check the "citations" tab in your RePEc Author Service profile, as there may be some citations waiting for confirmation.

This would simplify the rule, enhance its impact, and improve its adherence to statutory intent. This trading carries risks that financial regulators may find hard to analyze and that can be proprietary in nature.

It should also be noted that the Volcker rule was included in the Dodd-Frank Act not just for financial stability purposes but also to limit the types of conflicts of interest witnessed during the crisis. Furthermore, regulators stated that the exemption for trading in physical commodities and currency was included because the statute did not explicitly include these transactions.

That justification misses the mark. Absent regulatory action, Congress should pass legislation directing regulators to close these loopholes. Regulators should also address the fact that the current Volcker rule regulation does not cover bank investments in merchant banking activities. These activities, in which a bank takes an equity position in a nonfinancial company, can pose indistinguishable risks from impermissible private equity investments.

Merchant banking activities expose the bank to credit risk, market risk, and other risks stemming from the activities conducted by the commercial company in which the bank has an equity stake. These investments can also be highly illiquid. In September , the Federal Reserve recognized the risks that merchant banking poses to bank holding companies and their affiliates in a report required by Section of the Dodd-Frank Act.

The Federal Reserve recommended that Congress repeal the statutory provision established by the Gramm-Leach-Bliley Act—also known as the Financial Services Modernization Act—that allows banks to engage significantly in merchant banking activities. It is clear that some banks are using their merchant bank activities to take risky proprietary positions.

Merkley and Levin intended. If regulators choose not to exercise this authority, Congress should pass legislation classifying merchant banking assets as high-risk assets or repeal the statutory provisions permitting merchant banking activities altogether. As an alternative, regulators or Congress could significantly increase the capital requirements for merchant banking activities. This is a less desirable approach compared with outright prohibition but would be an improvement over the status quo.

Regulators should also engage in close scrutiny of bank sponsorship or investment in BDCs to ensure that the prohibitions on private equity investing are not evaded through those vehicles, and Congress should require regulators to report on those findings.

Another way to strengthen the Volcker rule is to further restrict the compensation arrangements for those bank employees principally responsible for trading, as well as for their supervisors. In theory, true market-making should only earn banks profit through bid-ask spread, fees, and commissions—not the appreciation of inventory asset prices. Losses on inventory should be just as likely as profits in pure market-making, keeping the profit and loss on inventory reasonably flat.

The current Volcker rule, while a step in the right direction, still allows banks to invoke the market-making exemption and compensate traders in part on appreciation of inventory asset prices.

The traders that provide the best customer service and earn the bank the most market-making revenue from bid-ask spreads, fees, and commissions should be compensated the most. But allowing banks to invoke the market-making exemption, while still rewarding traders for price appreciation in compensation arrangements, leaves an incentive for proprietary trading.

As a minimum first step, regulators should provide significantly enhanced transparency regarding Volcker rule implementation to enable outside observers to evaluate whether compensation arrangements are working sufficiently to constrain proprietary risk-taking. Again, Congress should take action on this proposal if regulators fail to act. The perceived costs of the Volcker rule have not materialized. Multiple academic and regulatory studies have thoroughly refuted the banking industry-led drumbeat of deterioration of market liquidity under the Volcker rule.

Furthermore, the current rule does limit the compliance burden on small banks. If there are sensible ways to further reduce this compliance burden, those changes should be pursued.

Small banks, however, should by no means be exempted from the Volcker rule. It is true that a main goal of the statute was to safeguard financial stability—but a related goal was to refocus banks on the traditional business of banking. Small banks still have FDIC-insured deposits and should not be allowed to make speculative bets with that government-insured cash. If regulators continue to pursue changes to the Volcker rule, they should proceed with an eye toward simplifying the rule through closing loopholes.

The end of this process must be a stronger Volcker rule, not a rule that undermines the very intent of the statute. A watered-down rule would be detrimental to the financial stability that the U. Proprietary trading by banks and their affiliates, as well as bank entanglement with hedge funds and private equity funds, helped fuel the staggering buildup of financial sector risk in the run-up to the financial crisis.

In addition to the drastic undercapitalization of the banking sector in the run-up to the financial crisis, the financial system had a lack of adequate liquidity safeguards and was overly reliant on short-term runnable liabilities. The topic of liquidity in banking gets to the core of finance. Fundamentally, banks issue short term, highly liquid liabilities such as customer deposits that, along with equity, fund investments into longer-term illiquid assets such as loans.

This liquidity transformation is a vital banking sector service, as both long-term loans and short-term liabilities have useful economic functions. While it is a necessary part of banking, however, the mismatch can be tenuous. Prior to the banking reforms of the Great Depression, bank runs were common. If banks have to start selling their assets quickly at steep losses to raise cash to pay their short-term liabilities, they may go bankrupt as the losses eat through their capital. Knowing that the federal government stands behind their bank deposits, customers do not have a reason to question their bank as a store of value for their cash, limiting incentives for a run.

But insured bank deposits are not the only short-term liabilities used to fund banks, especially larger banks that have active trading operations. This was demonstrated during the financial crisis.

The crisis also showed that banklike maturity transformation that poses the same type of liquidity risks outside the traditional banking sector can cause severe damage to the financial system. In this way, banks and other financial institutions can meet their obligations in times of financial stress without having to revert to asset fire sales that can threaten solvency and transmit risk throughout asset markets and across counterparties. Significant progress has been made since the crisis, but more can be done to complement postcrisis liquidity requirements to make the system more resilient to the risk of a run.

To make the financial system less vulnerable to the types of runs experienced in the crisis, regulators should enhance the G-SIB capital surcharge calculation to further incentivize less reliance on short-term funding and require that repo agreements, a type of secured short-term funding that featured prominently during the financial crisis—as well as other securities-financing transactions—be centrally cleared.

In the lead-up to the financial crisis, banks were highly dependent on less stable forms of short-term credit to fund their assets. Lehman funded its long-term, illiquid assets primarily through repos and commercial paper—two types of short-term liabilities. In a repo transaction, the lender provides cash to the borrower and the borrower pledges a security as collateral for the loan. The value of the collateral is typically in excess of the value of the loan. This overcollateralization is known as a haircut and protects the lender against the possibility of asset price declines in the collateral if the lender must sell the collateral in the case of borrower default.

The maturity of repos is typically overnight or a few days. Maturity may be fixed in the contract, or either counterparty could close out the transaction whenever they wish. Lehman also used commercial paper, another form of unsecured short-term debt, with maturities ranging from less than 30 days to up to days. When the subprime mortgage market cratered and cracks started to appear in the collateralized debt obligations CDOs market, the financial system started to show signs of weakness. On September 15, , Lehman could not roll over enough loans and indeed filed for bankruptcy, sending shock waves throughout the global financial system.

The freezing of short-term credit markets caused this type of run throughout the financial system. In addition to its effects on Lehman, the freezing had a severe impact on banks such as Bear Stearns and Merrill Lynch, which also relied mostly on short-term funding while holding toxic assets.

The financial crisis showed that the maturity transformation occurring outside the traditional banking sector, known colloquially as shadow banking or market-based finance, is susceptible to the same type of creditor runs that plagued traditional banks prior to the establishment of the FDIC. These institutions were large and highly interconnected with the rest of the financial system, so the stress they experienced was transmitted to other financial institutions.

The runs on the highly leveraged investment banks were an example of how systemic risk built up beyond the walls of the traditional banking sector. Deposit-taking banks were also significantly exposed to the short-term credit markets directly through their broker-dealer subsidiaries and through guarantees made to off-balance-sheet vehicles.

It was quite popular for banks to set up structured investment vehicles SIVs and other similar vehicles off their balance sheets. These vehicles would issue short-term liabilities such as commercial paper to fund long-term assets such as CDOs, packed with subprime mortgages with a layer of investor equity. The sponsoring banks offered explicit or implicit liquidity guarantees to the SIVs, meaning that the bank would purchase the short-term liabilities if the market for them dried up.

The run on repo and commercial paper crushed the SIVs, and many banks took the SIVs and other vehicles back onto their balance sheets at steep losses.

The MMF investors viewed their accounts as basically high-yield checking accounts, but when they experienced losses, they immediately pulled their funds—as one would do if questioning the safety and soundness of a traditional bank pre-FDIC. The financial crisis showed that with this type of funding, when the risk of liquidity mismatch is not properly managed or regulated, runs in the financial sector can be debilitating.

Liquidity requirements also help guard against traditional bank runs on deposits, which can still occur—and which did occur at some banks during the crisis.

Massive, rapid deposit withdrawals at Washington Mutual and Wachovia helped lead to the demise of both banks. Banks can use a tiered mix of cash; federal or foreign government securities; and other liquid and readily marketable securities to meet this requirement.

Congress is also correctly pushing, on a bipartisan basis, to add liquid municipal securities to this categorization. If banks hold enough liquid assets during a stressed period, they will not have to revert to selling off longer-term illiquid assets at losses that threaten their solvency.

Banks have already started to shift their funding profiles toward more stable, longer-term liabilities. In , the current G-SIBs funded 35 percent of their assets with short-term liabilities. Today, that number has dropped to 15 percent of assets. In addition to these two liquidity rules, the Federal Reserve analyzes the liquidity of the largest banks through the Comprehensive Liquidity Assessment and Review, as well as in the annual stress tests and the living-wills process.

The resolution-planning, or living wills, process required by the Dodd-Frank Act has also been an important avenue for regulators to affect the liquidity position and liquidity planning at banks and systemically important nonbanks.

In fact, the Federal Reserve and FDIC have deemed some living wills not credible due in part to liquidity-related concerns. The movement to roll back regulations such as the Volcker rule and capital requirements has also targeted these new liquidity rules.

While capital requirements are vital and should be higher, liquidity requirements are a necessary piece of a stable and healthy financial sector.

Absent liquidity requirements, even relatively well-capitalized banks that rely heavily on short-term liabilities could face steep losses if they need to resort to asset fire sales in the face of a run. Moreover, large regional banks with hundreds of billions of dollars in assets, which tend to be the focus of many deregulatory proposals including the bipartisan Senate banking bill, tend to have balance sheets that consist of a higher percentage of loans. In terms of asset liquidity, these traditional loans are typically illiquid—meaning liquidity requirements are arguably more important for these institutions compared with larger banks that hold more liquid securities as part of their trading businesses and should not be rolled back.

Weakening liquidity requirements or letting banks opt out of them altogether would be a dangerous reversal—ignoring the painful yet clear lessons of the financial crisis. In addition to the proposed changes to the liquidity rules, the Treasury report recommends changing the living-wills process to a two-year cycle, instead of the current practice of an annual cycle, as well as removing the FDIC from the process. Liquidity and other deficiencies can arise rapidly, and submitting the resolution plans every two years would create a regulatory blind spot.

Moreover, removing the FDIC from the process makes little sense. The FDIC has considerable experience and expertise in winding down failed banks and is the regulator in charge of dealing with the failure of a large, complex financial institution, if the OLA is used.

The LCR and NSFR are two much-needed liquidity rules that require banks to hold more liquid assets and better match their illiquid assets with stable funding. These asset- and liability-focused requirements can be supplemented with additional equity requirements that vary depending on the extent to which a bank utilizes short-term wholesale funding.

Higher levels of capital increase creditor confidence, thereby reducing the incentives and likelihood that creditors will run. Even if short-term creditors pull back their funding, increased equity cushions help banks better absorb any losses associated with asset fire sales to meet the short-term liability demands.

The G-SIB surcharge is meant to limit the chance of failure at banks that could threaten the financial stability of the U. Currently, the surcharge calculation is broken up into two parts. The first part, known as method 1, is used to determine which banks are G-SIBs and will therefore be subject to the surcharge. The wholesale funding factor is weighted equally with the other four factors and counts toward 20 percent of the score.

The bank is then subject to the G-SIB capital requirement that corresponds to the higher of the two scores. While it was wise of the Federal Reserve to include short-term funding as an element of the calculation, that element should play a more important role in determining the capital surcharge. G-SIBs with a heavy reliance on short-term funding should face significantly higher capital surcharges relative to G-SIBs with more stable sources of funding.

It is important to note that based on the earlier recommendation in the capital requirement section of this report, the variable institution-specific G-SIB surcharge is added to the systemic risk capital buffer that would apply across all G-SIBs. The Federal Reserve, or Congress absent regulatory action, should make this recommended change. Liquidity rules that require banks to hold more liquid assets; fund illiquid assets with more stable funding; and increase equity levels depending on their reliance on short-term funding certainly increase resiliency against crippling runs.

One additional way to enhance the resilience of the system is to reform the short-term funding markets directly.

For years, the Federal Reserve has considered, and at least started developing, a regulation requiring minimum margin requirements for all repo and securities-lending contracts across markets.

This approach would be an improvement over the status quo but would not be enough. To that end, Congress should pass legislation mandating that all repo agreements and securities-lending transactions be cleared through CCPs. CCPs serve as the lender to the borrower and as the borrower to the lender, contracting with both sides of a transaction. Funneling repo agreements—a key funding source for maturity transformation outside the traditional banking sector—and economically similar securities-lending transactions through CCPs would improve the transparency surrounding their risks for regulators, as well as price transparency for market participants.

Under this approach, the CCPs play a risk management role in determining collateral quality; imposing haircut and margin minimums; and facilitating the timely execution of contractual obligations compared with the disparate bilateral market.

The CCP establishes a shared liability with its clearing members, and Congress should require it to charge the members a risk-based fee to fund a default pool that covers losses given a member default. This prefunded default protection, based on riskiness of the repo and securities-lending agreements and counterparties, would look similar economically to the deposit insurance provided by the FDIC and paid for by depository institutions.

If a counterparty failed to meet its repo or securities-lending obligations, and the collateral haircuts did not adequately cover the losses, the CCP could dip into the default pool and its own equity to cover the losses. The default protection requirement would force the clearing members of the CCPs to internalize the potential systemic externalities that this form of short-term, uninsured runnable credit poses.

CCPs typically use a waterfall approach to handle a clearing member default, using margin, CCP equity, a default fund, and additional member assessments to cover potential losses. The OFR and the Bank for International Settlements note that the netting of repo positions between counterparties through the CCPs may make this proposal attractive to market participants, lowering their credit exposures, while further enhancing financial stability by minimizing the number of positions that need to be unwound given a default.

Moving OTC derivatives onto exchanges and requiring central clearing for large swaths of the market has brought risk and pricing transparency; enhanced risk management through margin and collateral standards; and more reliable contract execution. Similar proposals regarding regulated CCP risk-based default funds have also been developed in the OTC derivatives context.

While not the focus of this report, if CCPs were to take on an increased role in promoting financial stability, they would have to face corresponding rigorous supervision and prudential requirements. CCPs should face strong capital and liquidity requirements; margin and collateral frameworks; and default-planning mandates, including a risk-based prefunded default pool and post-default authority to charge clearing members additional funds.

They should also be required to provide resolution plans and face robust stress testing. Some of these requirements already apply to CCPs in the derivatives context, while others are currently being formulated and debated internationally and would only increase in importance if all repo and securities-lending transactions were funneled through these institutions. Currently, regulators have authority under Title VIII of Dodd-Frank to require enhanced standards at systemically important financial market utilities.

The reflex to revisit regulations after the passage of time is not an inherently deregulatory undertaking; in fact, it is quite healthy, as stagnant regulatory regimes fail to adapt to new research, experiences, and risks. Unfortunately, the policy debate during the last eight months has revolved around loosening financial reforms, an undertaking that history has not treated kindly. The painful memory of the financial crisis is clearly fading for some policymakers in the Republican-led Congress and the Trump administration.

The memory has not faded, however, for the workers who lost their jobs, the families who lost their homes, and the retirees who lost their life savings—the very citizens whom policymakers are supposed to look out for and represent. Progressives must defend the progress of financial reform, as the economy needs financial stability to promote sustainable and equitable economic growth.

The economy has recovered significantly since the financial crisis, bank lending and bank profits are at all-time highs, and market liquidity is healthy. Banks are better capitalized, hold more liquid assets, undergo annual stress tests, and plan for their orderly failure.

But defending this progress and critiquing conservative plans to unwind these much-needed reforms is not enough. Progressives must offer affirmative ideas to better implement financial reform in a way that strengthens financial stability. While some bold proposals to redefine the financial sector and financial regulatory structure have merit, the focus of this report is on meaningful improvements to the current regulatory regime that the Dodd-Frank Act established.

This report aims to contribute to the recent policy debate on modifications to banking regulation by offering policy proposals on capital requirements, the Volcker rule, and liquidity safeguards that would better implement the Dodd-Frank Act. There are certainly other banking policies that could be improved upon, so this report should be viewed as only one part of the progressive contribution to this debate.

CAP will offer more affirmative proposals on other topics within the umbrella of financial regulation in other publications, including consumer protection, financial markets, and housing. Any effort to change banking regulation, or financial reform more broadly, that leaves the system more vulnerable to another crisis betrays the reality of the Great Recession—the reality that is still evident in the lasting economic scars that people across the country bear to this day.

By its very nature, financial regulation forces policy experts to dive into the esoteric weeds of complex policymaking and debate. But the goal of financial regulation is to promote the financial stability necessary for a healthy economy—and to make sure that Wall Street does not leave the economy in shambles again. The goal of financial regulation is to ensure that millions of workers do not lose their jobs and that millions of families do not lose their homes.

Proponents of deregulation argue that overbearing legislation reduces investment opportunity and stymies economic growth, causing more harm than it helps. And, indeed, the U. Banking Act of , otherwise known as the Glass-Steagall Act. The Securities Exchange Acts required all publicly traded companies to disclose relevant financial information and established the Securities and Exchange Commission SEC to oversee securities markets.

The Glass-Steagall Act prohibited a financial institution from engaging in both commercial and investment banking.

This reform legislation was based on the belief that the pursuit of profit by large, national banks must have spikes in place to avoid reckless and manipulative behavior that would lead financial markets in unfavorable directions. Deregulations proponents argue that overbearing legislation reduces investment opportunity and stymies economic growth, causing more harm than it helps. Over the years proponents of deregulation steadily chipped away at these safeguards up until the Dodd-Frank Act of , which imposed the most sweeping legislation on the banking industry since the s.

So how did they do it? The following year the Fed ruled that commercial banks could engage in underwriting, which is the method by which corporations and governments raise capital in debt and equity markets. In the Commodity Futures Modernization Act prohibited the Commodity Futures Trading Committee from regulating credit default swaps and other over-the-counter derivative contracts.

In the SEC made changes that reduced the proportion of capital that investment banks have to hold in reserves. This spree of deregulation, however, came to a grinding halt following the subprime mortgage crisis of and the financial crash of , most notably with the passing of the Dodd-Frank Act in , which restricted subprime mortgage lending and derivatives trading. However, with the U. The bill passed both houses of Congress with bipartisan support after successful negotiations with Democrats.

Fiscal Policy. Actively scan device characteristics for identification. Use precise geolocation data. Select personalised content. Create a personalised content profile.