Financial Regulation after the Global Recession

One of the most cited legal scholars observes the regulatory environment of the credit/dollar crisis as:¹

A natural response is to tighten up regulation. In the case of commercial banks, this would not require new legislation. The bank regulators have virtually plenary control over banks: thus the crack “what does a bank say when a regulator tells it to jump?” Answer: “How high?”

There is significant government intervention in financial markets. The economic theory of the state or regulation does not provide unique and generally accepted principles. There are many approaches. Finance is singled out for regulation because financial entities provide services instead of goods for final consumption, creating the impression that financial institutions are merely intermediaries that do not add to out-put. In addition, financial crises have been accompanied by declines in production and rising unemployment. This chapter provides a comprehensive review of these approaches to regulation that helps to understand the issues relating to financial regulation. The final sections elaborate the reasons for existence of financial markets and their role in economic growth. An appendix introduces present value concepts.

The first few sections in this chapter consider the approaches to bank regulation. The emphasis in policy proposals is on the approach of prudential and systemic regulation, which is based largely on collective or government action to correct market failures, such as the current credit/dollar crisis. The competing approach focuses on the functions of finance allowing structural changes, including regulation, with the objective of facilitating innovation to promote effective financial systems. Bank functions are then analyzed, providing foundations for the analysis of banking crises. Housing finance is overwhelmingly important in the current crisis. The innovations in securitization and credit-risk transfer have been profound, motivating regulatory proposals. Two important regulations of banks, minimum capital requirements and deposit insurance, are also considered. The final section provides an overview of the political economy of banking regulation. A final section briefly summarizes the chapter.

There are two general themes in this chapter. First, a group of sections focuses on the issue of monopoly in banking markets. The relaxation of entry in local markets reduced significantly the measurement and need for regulation of market power. Second, financial stabilization to prevent and resolve banking and financial crises is managed by central banks. The paradigm of modern central banking is the BOE.

The first section considers the traditional trade-off between universal banks engaged in all aspects of banking and financial markets and specialized banking focused only on taking deposits to provide loans. Two sections consider the political economy and the economic analysis of the Glass-Steagall Act, which separated investment and commercial banking in the United States. The Financial Modernization Act eliminated the final existing barriers between commercial and investment banking. Hedge funds deserve significant coverage because their regulation is included in most proposals. Corporate governance analyzes the conflicts of interest between management and shareholders. The remuneration of executives has become a critical issue in research and politics. Corporate law provides the legal framework for the market for corporate control.

There is a contrast between the SEC in the United States, operating with rules and self-regulatory organizations (SRO), such as securities exchanges, and the FSA in the United Kingdom, functioning under principles. There are proposals by both systems for significant regulatory change. SOX is the most drastic recent regulation of corporate governance by capital markets regulators. The choice of jurisdiction where to list securities is discussed in the final section.

The forecast of the International Monetary Fund (IMF) in April 2009 is for world output declining by 1.3 percent in 2009, bouncing by 1.9 percent in 2010 after growing by 5.2 percent in 2007, and 3.2 percent in 2008.⁴⁹¹ Output in advanced countries is forecast to decline by 3.8 percent in 2009, growing by 0 percent in 2010. US output would decline by 2.8 percent in 2009, growing by 0 percent in 2010. The volume of world trade of goods and services is forecast to decline by 11 percent in 2009, bouncing by 0.6 percent in 2010 after growing by 7.2 percent in 2007 and by 3.3 percent in 2008. Recession in the form of contraction of output or sharp reduction in the rate of growth affects the entire world. The first section below reviews the experience and analysis of the Great Depression and the New Deal. The critical issue for the regulatory agenda is what caused the credit crisis and resulting global recession. Several sections analyze the monetary and fiscal policies. Bank nationalization is an important issue in regulatory debate. The final section outlines the heavy regulatory agenda.

There are two main views on the origin of the credit/dollar crisis and the new measures for regulatory reform. The first view is based on the public interest or official regulatory view proposing tight regulation to avoid financial instability and resulting loss of output and employment. The second view is based on the finance view or FSF approach.⁵⁹³ These two approaches are discussed in turn.