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A blog on financial markets and their regulation
Normally, one thinks of regulation as a response to market failure, but Luigi Zingales has a piece (behind a paywall) in the Financial Times earlier this week (“Why I was won over by Glass-Steagall”) in which the principal argument seems to be that a regulatory separation between commercial banking and investment banking is required to deal with a state failure. Zingales argues that:
Under the old regime, commercial banks, investment banks and insurance companies had different agendas, so their lobbying efforts tended to offset one another. But after the restrictions ended, the interests of all the major players were aligned. This gave the industry disproportionate power in shaping the political agenda.
The result according to Zingales was “a demise of public equity markets and an explosion of opaque over-the-counter ones.”:
With the repeal of Glass-Steagall, investment banks exploded in size and so did their market power. As a result, the new financial instruments (such as credit default swaps) developed in an opaque over-the-counter market populated by a few powerful dealers, rather than in a well regulated and transparent public market.
Adam Levitin at Credit Slips makes the same point in greater detail with some good examples:
Glass-Steagal also split the financial services industry politically and enabled the different parts of the industry to be played against each other. Commercial banks, investment banks, and insurance companies fought each other for turf for decades. This mattered in terms of regulation because regulation is a political game.
Because of Glass-Steagal, the financial services industry did not present a monolith in terms of lobbying, and a Congressman could afford to take a stand against one part of the industry because there would be campaign contributions forthcoming from the other parts of the industry. This is how William O. Douglas got the Trust Indenture Act of 1939 passed – he made concessions to the commercial banks in order to get their support for legislation that kept the investment banks out of the indenture trustee business. In the agencies, each part of the industry had its pet group of regulators who would push back against other regulators when they thought that there was an encroachment on their turf, which is the basic nature of deregulation – allowing greater activities than previously allowed. And it even mattered in the courts, as the insurance and investment banking industries financed major litigation challenges to commercial bank deregulation.
… Sarbanes-Oxley passed in part because of a split between the Business Roundtable and the US Chamber of Commerce. And in the financial institutions space, the Durbin Interchange Amendment passed because it posed banks against another heavy duty group, retailers.
One can dispute several elements of this narrative. Zingales’ CDS example is perhaps easiest to refute. Insurance companies should according to the Zingales-Levitin theory have strenuously argued that CDS is an insurance contract and therefore should be their exclusive preserve. Their lobbying and litigation should have prevented the commercial and investment banks from walking away with the CDS market. Despite the repeal of Glass Steagall, most of the big insurers were independent of the leading players in the CDS market, yet they made no serious attempt to block the growth of CDS prior to the crisis. Even after the crisis, much of the movement for regulating CDS as insurance has come from academics and regulators and not from insurance companies.
Yet, I think the idea that market fragmentation guards against state failure is a very interesting perspective on how one should go about designing a regulatory architecture. After all, the life cycle of financial market bubbles is much shorter than that of political bubbles (to borrow an elegant phrase from the George Soros speech about Europe earlier this month). Market failures can be very ghastly, but perhaps they correct faster than state failures.