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Financial Sector Reform

Britain gets it right

The British get it right

Last December, the British Chancellor of the Exchequer, Mr. Osborne, announced a series of measures to reform and strengthen the British banking industry. These reforms are part of a continuing focus that the British government, both Labor and Tory, have maintained financial firms in the City of London.

Like their American counterparts, British banks had severely overextended themselves in the decade before the crisis. Subprime lending, easy mortgage terms for dubious applicants, a real estate bubble, exotic financial instruments – all the ills found on Wall Street could be found in the City as well. Northern Rock, a commercial bank, was allowed to founder and the shock to the system was enough to convince the British government to move aggressively. The Royal Bank of Scotland, once the darling of UK banking, was nationalized to prevent its implosion.

Some of the early efforts to improve the dire situation in Britain’s financial sector were marginal at best. Limiting executive compensation may be socially equitable and politically expedient, but it is unlikely to enhance a bank’s sense of fiduciary responsibility. Other ideas were more potent, like a Tobin tax or a greater harmonization of international financial regulations and oversight. These measures required major changes to the global financial infrastructure, which in the end proved too ambitious for the leaders of other nations.

Britain has led the way in these reform efforts and has demonstrated that they are determined to sanitize their financial sector, one of the most critical in the UK economy. Britain is today reviled in the European press for vetoing the proposed fiscal union amendment to the Treaty of Lisbon, but David Cameron was right to argue that a unilateral imposition of a Tobin tax on financial transactions in Europe alone would only see banks move to New York, Hong Kong, Dubai or some other leading global financial center – a result which would disproportionately impact the British, who account for nearly two thirds of Europe’s financial services.

What Mr. Osborne announced in Parliament sounds very much like the Glass-Steagall Act of 1933, which was a keystone in US financial regulation for 66 years. In Mr. Osborne’s own words:

“The reforms to the banking sector mean the deposits and overdrafts of ordinary consumers and small businesses will be handled only by ring-fenced parts of banks, which will not be allowed to embark on risky investment activities.”

“Our objective is clear. We want to separate high street banking from investment banking, to protect the British economy, protect British taxpayers and make sure that nothing is too big to fail.” (1)

Mr. Osborne does not go as far as Glass-Steagall: the Chancellor’s proposal creates a “ring-fence” within an organization that would act as a firewall between the “risky parts” – corporate and investment banking and exotic financial products – and the “safe parts” – deposits, mortgages, consumer loans. Contrast this with Glass-Steagall, which prohibited those activities taking place in the same company, with or without a ring-fence. The devils are in the detail and it remains to be seen how the British could prevent contagion from spreading to all parts of a beleaguered organization.

Nevertheless, these measures are a step in the right direction.

The Great Recession

The British have gone a long step further than the US has.

The 2008 crisis had a number of diverse causes:  

  • An overly soft monetary policy and high, persistent current account deficits that fueled a speculative credit bubble;
  • Lax lending standards in consumer loans and mortgages;
  • Complex (dishonest?) asset securitizations that bundled different risk classes into opaque securities that diversified risk away from the lenders;
  • A unregulated shadow banking system that burgeoned into a systematic risk factor;
  • Shoddy scrutiny even of the regulated financial system. (2)

The crisis was worsened by the highly concentrated nature of global finance and its interconnectedness in a globalized world, leading to the identification of banks that were “too big to fail”.

Many proposals were made on both sides of the Atlantic to deal with these issues, but both Americans and Europeans have settled for tepid measures that do not address the underlying structural problems which gave rise to the 2008 financial crisis.

The Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 that was eventually voted into law has some good provisions: it establishes a financial consumer protection agency that was long overdue and it extends government regulation to the “shadow” banking sector of hedge funds and certain classes of excluded derivatives. However, it fails to address the problem of banks that are “too big to fail”, and it fails to address the moral hazard of institutions underwriting their investment banking activities with funds from their (publically insured) depositary activities. Asset securitization was not adequately addressed either, again creating a moral hazard of institutions taking credit risk off of their books and distributing it to third parties who are not adequately prepared for or informed of the risks they are taking. (3)

“History will teach us nothing”

Dr. Paul Krugman asserts that the Great Recession was made inevitable by the dismantling of the US regulatory framework that was created in the wake of the Great Depression of 1929 . (4) He wrote the book in 2000, which lend his arguments a considerable degree of prescience. But what does Krugman mean by a return to depression economics? A (very brief) foray into the financial history of the US is necessary.

The history of US financial markets and regulation can be divided into three periods defined by the regulatory framework that government them:

  • The Era of Free Banking (1836 to 1929): In this period, the Federal Government had almost no participation in or oversight of the nation’s financial markets. Financial institutions were chartered and regulated by state governments. There was no legal separation between different types of banks and banking activities, and deposits were not insured;
  • The Federal Reserve Era (1935 to 1999): Although the Federal Reserve was created in December 1913, it was not until the Great Depression that the modern regulatory we are familiar with came into being. The Federal Reserve Act was expanded and strengthened: the Federal Depository Insurance Corporation Act (1933) , the Glass-Steagall Act (1933) , the Federal Credit Union Act (1934), the Federal Home Loan Bank Act (1932), the Banking Reform Acts of 1933 and 1935. Banks were divided into a number of mutually exclusive categories: Savings and Loans, commercial depository banks, and investment banks were prohibited from engaging in the same types of business and were subject to different regulatory bodies. Consumer deposits in S&Ls and commercial banks were insured to prevent bank runs;
  • The Return to Depression Economics Era (1999 to ): Beginning in 1980, Congress dismantled important parts of the New Deal-era regulatory infrastructure. The Depository Institutions Deregulation and Monetary Control Act (1980) and the Garn–St. Germain Depository Institutions Act (1982) removed the restrictions on types of products and investments offered by and available to savings & loans; the Gramm-Leach-Bliley Act (1999) ended the separation between commercial depository banks and corporate investment banks established in 1933 by the Glass-Steagall Act. This deregulation was ostensibly to improve the efficiency of financial markets and make more credit available to consumers. In both cases, what actually happened was a major collapse in the US banking system.

If it ain’t broke, don’t fix it

Two questions remain to be answered:

  1. Was the “old” system really successful in regulating financial markets? and,
  2. Has the “new” system really made that much of a difference for the worse?

Let’s take a look at the some data on recessions from 1834 to 2011:

Average length of US recession and expansions in months and peak change in GDP (5) 






It is clear from the table is that the Federal Reserve system was a vast improvement on the “Era of Free Banking”. The average length of recessions was halved to 10 months and the average length of economic expansions was doubled to 53 months. We don’t have comparable measures of the depth of the recessions between the two periods, though it is a pretty safe bet to say that recessions were milder under the Federal Reserve system. So much for laissez faire in finance.

It is more difficult to answer the second question. At first glance, the periods appear quite comparable. We should note that we only fully entered the “new era” in 1999, so we have a very limited sample of recessions to compare with previous periods. Not to worry – we are guaranteed to have more and more frequent recessions in the future.

Even so, it is significant and disturbing to note that since 1982, the United States has had two major crises in the banking sector, in contrast to none in the previous 10 business cycles between 1937 and 1982. Not a single one of them was directly caused by a break down in the financial system.

  • Four were significant fiscal contractions coming after periods of high government spending – mostly military (1937, 1945, 1953, 1969);
  • Two were oil shocks (1973, 1980);
  • Four were pure monetary contractions to deal with high inflation (1949, 1958, 1960, 1981) – though monetary policy also played a significant role in three more recessions (1945, 1953, 1969).

In contrast:

  • In 1989, the Savings & Loans industry, which was already under pressure before deregulation, collapsed in spectacular fashion 5 years after Garn-St.Germain, requiring a massive Federal bailout and costing taxpayers approximate $124 billion by 1996 ($170 billion in 2011 dollars). (6)
  • In 2008, within a decade of Gramm-Leach-Bliley, we suffered the worst financial crisis since 1929, the effects of which are still being calculated.

This is what Krugman means by a return to “Depression Era” economics. It is a good lesson in the power of lobbies – specifically the bank lobby, which has always hated Glass-Steagall. (7) The net effect of this legislation was the rebirth of the universal bank: a bank of national even international reach, touching every part of the economy, with federally guaranteed consumer deposits funding the far more risky and speculative activities of the corporate and investment banking divisions. The very definition of both “too big to fail” and “moral hazard”.

If we want to go back to the stability in financial markets we enjoyed for 60 years, we have to go back to the regulatory framework that served us so well. By reinstating the separation of commercial and investment banks of Glass-Steagall we will ensure that no bank is too big to fail. 

The British are on the right track, but it seems that America will have to wait for the next Great Recession before learning the lesson – a lesson that should never have been forgotten in the first place. I fear we will not have long to wait.


(1) http://www.bbc.co.uk/news/business-16239255
(2) http://www.nytimes.com/2011/01/26/business/economy/26inquiry.html?_r=2&scp=1&sq=financial%20crisis%20was%20avoidable,%20inquiry%20finds&st=cse
(3) “Bill Summary & Status – 111th Congress (2009–2010) – H.R.4173 – All Information – THOMAS (Library of Congress)”. Library of Congress. http://thomas.loc.gov/cgi-bin/bdquery/z?d111:HR04173:@@@L&summ2=m&#major%20actions. Retrieved July 22, 2010. 
(4) Krugman, Paul. “The Return of Depression Economics”, W. W. Norton & Company, May 15, 2000
(5) “Modern” economic statistics have only been kept in the United States since the period after the Second World War. For prior periods, economists are forced to rely on different measures produced and published by private companies for the most part. This makes inter-period comparison extremely difficult. 
(6)  “Financial Audit: Resolution Trust Corporation’s 1995 and 1994 Financial Statements” (PDF). U.S. General Accounting Office. July 1996. pp. 8, 13. http://www.gao.gov/archive/1996/ai96123.pdf.
(7) A year before the law was passed, Citicorp, a commercial bank holding company, merged with the insurance company Travelers Group in 1998 to form the conglomerate Citigroup, a corporation combining banking, securities and insurance services under a house of brands that included Citibank, Smith Barney, Primerica, and Travelers. Because this merger was a violation of the Glass–Steagall Act and the Bank Holding Company Act of 1956, the Federal Reserve gave Citigroup a temporary waiver in September 1998. Source: Broome, Lissa Lamkin; & Markham, Jerry W. (2001). The Gramm-Leach-Bliley Act: An Overview. Retrieved from http://www.symtrex.com/pdfdocs/glb_paper.pdf.

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