Abstract
In this chapter, we look at regulation of financial institutions and how it differs from regulation in other industries.
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Notes
- 1.
Atlas Shrugged is the 1957 novel by Ayn Rand that describes a dystopia in which society’s most successful businesspeople abandon their fortunes and the nation in response to aggressive new regulations.
- 2.
John Maynard Keynes, The General Theory of Employment, Interest and Money (New York: Harcourt, Brace: 1936).
- 3.
Market failures are commonplace and economists have broadly identified five causes. The first is when there are differences in information between two sides of a bargain, where one side knows less than the other. There could also be the nonexistence of competitive markets, which could limit profit or expand the production of a monopoly. Then, there may be “public goods” where people can benefit from or access something without having to pay to do so, like clean air or a public park in the city. The next cause of market failure is private contracts failing to fully internalize their effect on others, such as the effects of noise or pollution on neighbors. The final broad cause of market failure occurs when there are conflicts of interest between principals and agents—for example, when proprietary traders bet shareholders’ funds to boost their own bonuses.
- 4.
I was in Washington at the time of the G-20 Summit that took place shortly after Lehman’s failure in September 2008. I recall, amid the debris of the Lehman fallout, Lorenzo Bini Smaghi, the Euro-area G-20 deputy, coming out of a meeting and saying to the assembled officials and journalists something like, “We have decided not to let any important financial institution fail” and someone posing the question, “Why didn’t you decide that before the collapse of Lehman Brothers?” Without pause, Bini responded, “Before Lehman Brothers, there was not the political mandate to save the banks.” Whatever the judgment on whether Lehman should or should not have been saved, I think he was correct in his assessment of the change in political climate.
- 5.
Rand is the author of Atlas Shrugged among other books espousing a free market perspective (see also Footnote 1).
- 6.
The English Parliament approved “An Ordinance for the Regulation of Hackney-Coachmen in London and the Places Adjacent” in June 1654 to remedy what it described as the “many Inconveniences [that] do daily arise by reason of the late increase and great irregularity of Hackney Coaches and Hackney Coachmen in London, Westminster and the places thereabouts.” In Acts and Ordinances of the Interregnum, 1642–1660, ed. C. H. Firth and R. S. Rait, reprint edition (Abington, UK: Professional Books, 1982).
- 7.
George Akerlof’s classic paper from 1970, “The Market for Lemons: Quality Uncertainty and the Market Mechanism” The Quarterly Journal of Economics, vol. 84, no. 3 (August 1970)—sometimes described as a take on Gresham’s Law, which is commonly summarized as, “The bad drives out the good”—is well worth a read if you have never done so.
- 8.
This is a modernization of the phrase “the man on the Clapham omnibus” used by courts in English law, where it is necessary to decide whether a party has acted as a reasonably educated and intelligent, but nonexpert, person.
- 9.
Caveat emptor, Latin for “let the buyer beware,” implies that the person who buys something is responsible for making sure that it is what he wants and that it will work to his satisfaction.
- 10.
Taken from Avinash Persaud and John Plender, All You Need to Know About Ethics and Finance: Finding a Moral Compass in Business Today (London: Longtail, 2007).
- 11.
See Persaud and Plender, All You Need to Know About Ethics and Finance, for more on these scandals.
- 12.
Much has been written about the conflict of interest between credit-rating agencies, issuers of credit instruments, and investors. I think the case, while legitimate, is overstated given that the vast amount of credit ratings on single issues where the same issuer-pays business model did not fail. However, the point is that there is great pressure for rules to address the issue. In November 2012, Australia’s federal court ruled that the credit-ratings agency Standard & Poor’s (S&P) misled investors prior to the Global Financial Crisis by giving its safest credit rating, AAA, to complex securities, which later lost most of their value. At time of writing, S&P has stated its intention to appeal the decision.
- 13.
Indeed, the sector can play an important role in absorbing systemic risks, which I discuss in Chapter 6.
- 14.
This is a fair approximation of what is going on, but in reality banks create deposits when they give loans.
- 15.
See Carmen M. Reinhart and Kenneth Rogoff, This Time is Different: Eight Centuries of Financial Folly, reprint edition (Princeton, NJ: Princeton University Press, 2011).
- 16.
Some would say that Citibank turns up more regularly than most in post-1970s banking crises in the United States.
- 17.
The South Sea Company was founded in 1711 as a public–private partnership to consolidate and reduce the cost of the British Government’s war debts. The company was granted a monopoly to trade with South America; hence its name. Essentially, it was a bet on the future outcome of the War of the Spanish Succession, which Britain was involved in, over Spain’s control of trade with South America. Company stock rose greatly in value as it expanded its operations dealing in government debt, peaking in 1720 before collapsing.
- 18.
The Mississippi Company of 1684 was founded earlier than the South Sea Company, but it was only converted to a similar purpose in 1718 at the height of the euphoria around the South Sea Company, an early version of international contagion of financial euphoria and despair and of Parisian financiers following in the footsteps of their counterparts in London. Even without the help of 21st-century communication, both companies collapsed together. In 1718, John Law’s Banque Royale had subsumed the Mississippi Company and others with a monopoly on trade in French possessions as well as the right it had been given to issue notes guaranteed by the king.
- 19.
Karl Marx wrote The Communist Manifesto in 1848 and Das Kapital between 1867 and 1894. In the latter, he expounded the idea that human societies progress through class struggle and that capitalism created internal tensions, which would lead to its own destruction. Nineteenth-century financial panics were seen as symptoms of this impending doom.
- 20.
The defining feature of the postwar Bretton Woods system was an obligation for each country to adopt a monetary policy that maintained its exchange rate parity to the US dollar. The International Monetary Fund was established to help bridge temporary balance of payments shortfalls, and there was provision for an adjustment of parities if an imbalance of international payments were to be persistent.
- 21.
The formal name is the Financial Services Modernisation Act. However, even before this act the demise of the Glass-Steagall Act had effectively occurred through increased liberal interpretations.
- 22.
President Harry Truman signed the Marshall Plan on April 3, 1948, granting $5 billion in aid to 16 European nations. During the four years that the plan was operational, the United States donated $13 billion in economic and technical assistance (especially for rebuilding transport networks) to help the recovery of European countries that had joined in the Organisation for European Economic Co-Operation, the forerunner to today’s OECD. In current dollars, that would be approximately $150 billion, which represents around 5 percent of what was then the US GDP. And it worked. GDP in 1951, for Marshall Plan recipients, was at least 35 percent higher than in 1938.
- 23.
See Reinhart and Rogoff, Eight Centuries of Financial Folly.
- 24.
See Carmen M. Reinhart and Kenneth S. Rogoff, “Recovery from Financial Crises, Evidence from 100 Episodes,” American Economic Review 104, no. 5: 50–55.
- 25.
Ibid.
- 26.
See Steven Block, “Maternal Nutrition Knowledge and the Demand for Micronutrient-Rich Foods: Evidence from Indonesia,” Journal of Development Studies 40, no. 6 (2005).
- 27.
The combined costs of the UK’s Prudential Regulation Authority (PRA) and Financial Conduct Authority reached £664 million (circa $1 billion) in 2013.
- 28.
Think of this type of liquidity as cash flow. A bank may have assets that exceed its debts and so is solvent, but it may not be able to sell those assets overnight to meet an interest payment or a cash withdrawal and so is illiquid. Of course, in the dynamic of a crisis these neat conceptual distinctions become blurry.
- 29.
Norman S. John-Stevas, ed., The Collected Works of Walter Bagehot, vols. 1–15 (New York, Oxford University Press, 1986).
- 30.
A scandal in which banks appeared to manipulate the survey that set the benchmark interest rate: the London Interbank Offered Rate (LIBOR).
- 31.
The Banking Act of 1933 created the US Federal Deposit Insurance Corporation (FDIC). Today, it insures deposits up to $250,000 for approximately 7,100 institutions.
- 32.
In the United States, where there is one of the longest histories of deposit insurance, the original limit in 1934 was $2,500. This was doubled in 1935 and held at that number until being doubled again in 1950 to $10,000. By 1980 it had been increased in four increments to $100,000, where it stood for an unprecedented gap of 28 years before being raised to $250,000 on October 3, 2008 in the aftermath of the Lehman collapse and signs of mini-bank runs developing.
- 33.
In 1988 the Basel Committee on Banking Supervision (BCBS) of G-10 central banks and regulators published a set of minimum capital requirements (Basel I) for international banks in their member countries.
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© 2015 Avinash D. Persaud
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Persaud, A.D. (2015). Why Do We Regulate Finance?. In: Reinventing Financial Regulation. Apress, Berkeley, CA. https://doi.org/10.1007/978-1-4302-4558-2_2
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