Banking Regulation
Captain -- You Do See That Blinking Light, Don't You?
An apocryphal story about an unnamed navy captain goes like this. The ship in question is sailing at a not insignificant clip on a very overcast night close to shore in preparation for docking. A number of sailors who are above deck see a blinking light in the distance that clearly -- to them -- appears to be a lighthouse. The captain, however, gives no orders either to slow or turn the boat. Each of the sailors thinks that perhaps he should ask the captain if he does indeed see what is becoming with each passing minute ever more clearly the lighthouse. But each in turn says to himself: "He's the captain. He must see the light. He'll make sure that we don't run aground." And then there is the terrible sound of the bow of the ship being shredded on the reef below the lighthouse.
Something rather like this happened during the American financial crisis of 2008, the consequences of which are still very much with us in the ongoing recession, which at this moment may well be transforming itself into a double-dip recession. While there were certainly signs that to those who are educated about the financial markets were as clear as a lighthouse beacon that there was something fundamentally rotten and systemically so about the American financial system, those who were tasked with turning the financial ship aside in time were derelict.
This paper examines how the leadership of U.S. regulatory agencies failed their constituents during the run-up to the horribly spectacular conflagration that overtook the U.S. financial sector, and especially the U.S. housing market. Those constituents included essentially the entire American population, but they also included everyone in other countries whose life and livelihood is affected by the state of the American economy, which is effectively a very large portion of the earth's population. The failure was in no way a simple misunderstanding of the rules of economics or a misapplication of them: It was a failure of human leadership and human intelligence, and its cost must be counted in human terms.
A number of forces came together to produce what is usually referred to as the financial meltdown of 2008 -- a meltdown that is often compared to various natural disasters, perhaps most commonly a tsunami. The invocation of natural disasters to explain (or excuse) the financial devastation of that year is significant, because it suggests that what happened was not something that could have been prevented by any human intervention. Like a volcano rising from the sea to spew forth lava, the financial institutions (primarily banks, but others as well) that support the nation's economic health were overtaken by unexpected and uncontrollable forces.
The limits of such analogies should be obvious, of course, for financial institutions, unlike volcanoes, can in fact be controlled by human intervention. And even in the case of actual natural disasters, there are things that humans can do, such as not building near fault lines or in flood zones. As the American financial system unraveled throughout 2008 and into 2009 (and arguably continues to do so), it was clear that the regulatory agencies that should have stepped in and warned about those economic seismic zones and been paying attention to the seismographs on their desks had been astonishingly inattentive.
The Players
Part of the reason that the U.S. banking and financial system came so thoroughly undone in 2008 was that there was no single regulatory agency that oversaw the entire system. This fact resulted from the historical way in which the regulatory system has been built up, with different agencies being added as the financial landscape itself changed. (The Framers did not have to worry about hedge funds, after all.) The regulatory system thus existed as something of a patchwork, with many aspects of the financial system being covered while other aspects fell between the cracks.
The regulatory system was also generally limited in its effectiveness -- and this was far more significant in the case of the current economic downturn than the historically less-than-linear path taken by the formation of federal agencies -- by the fact that the previous eight years had led to significantly increasing laxity in the system (Frank, 2010). The Bush Administration, being true to its conservative ideology, had fought to reduce the amount of regulation throughout American society. While some conservatives have argued in the wake of the economic collapse that the recession (the pernicious effects of which the federal government has attempted to reduce) was the result of over-regulation and a lack of trust in the free market, in fact the opposite was the case.
The following summarizes this...
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