Regulation Philosophies Differ For Banking & Financial Markets

Regulations in banking and the financial markets have been moving in opposite directions over the past three decades.  In the 1980’s and 90’s, lobbyists for the banking industry were pushing deregulation of the banking industry on the premise that the restrictions imposed upon U.S. commercial banks by the Banking Act of 1933 were outdated and holding the industry back from being competitive in the global banking scene.  Closely following the deregulation of banking in 1999, accounting scandals such as those at Enron and WorldCom, led to a massive overhaul of corporate oversight and internal controls in public companies now governed by the Sarbanes-Oxley Act of 2002.  Almost simultaneously, different portions of the financial industry were calling for more regulation in some instances and less in others.

Banking Regulation

From the Great Depression arose the Banking Act of 1933, also known as the Glass-Steagall Act, which laid down the regulatory laws for banks that would ultimately direct the course of banking in America for the rest of the 20^th century.  One of the main edicts of the Banking Act of 1933 was that commercial banks were no longer allowed to engage in the practice of underwriting securities.  Commercial banks are those that accept deposits from customers in the form of savings, checking and money market accounts, as well as Certificates of Deposit.  The intent of this separation was to ensure that depositors would not lose their money if the bank entered into a failing securities underwriting transaction, which was a large part of what was happening during the Depression.  This meant that only investment banks could engage in the underwriting of securities.  And since investment banks do not accept deposits from customers, the risk was being accepted entirely by the bank and not its depositors.

This same set of facts led to the formation of the Federal Deposit Insurance Company (FDIC), also a part of the Banking Act.  Banks are required to pay insurance premiums to FDIC so that if the bank fails, the depositors will still get their money back from FDIC.  Current FDIC insurance limits are $250,000 per account.  This means that as long as you have less than $250,000 in any one account and that bank goes bankrupt, FDIC will return all of your money.  This limit is currently in effect until December 31, 2013, and on January 1, 2014 the limit will be lowered back to the historical standard of $100,000 per account (except for IRA and certain other types of retirement accounts, which will remain at $250,000).

For about fifty years these regulations went mostly unchallenged and were viewed positively, being as these regulations helped to stabilize the U.S.’s banking industry and strengthen consumers’ confidence in the system.  In the early 1980’s, the banking industry began to get restless and became frustrated with the restrictions imposed by the Banking Act.  Industry leaders argued that European and Asian banks were not forced to segregate the businesses of deposit acceptance and securities underwriting.  As such, many corporations globally and in the U.S. were defecting to the so-called “full service” banks of Europe and Asian where they could satisfy all of their banking needs.  The thinking was that the U.S. banking industry was no longer able to be competitive in a global banking arena, and that the regulations needed to be lessened in order to help U.S. firms remain global banking players.

In the end, the banking industry’s lobbyists won the deregulation battle, and in 1999, the Gramm-Leach-Bliley Act was signed into law by President Clinton.  This Act effectively reversed the portion of the Banking Act of 1933 that separated the duties of commercial and investment banks, allowing for umbrella companies (called holding companies in the industry) that could set up children companies for commercial banks, investment banks, and insurance.  The result was the formation of financial giants, such as JP Morgan Chase and CitiGroup, that could provide all banking services including depository accounts, underwriting stock or bond issuances, and underwriting insurance policies.

Once the bank holding concept became a reality, big banks rushed to incorporate holding companies and form conglomerate financial services firms.  It was at this time that depositors’ monies at commercial banks were no longer distinct and separate from the investment banking business.  The practice that was specifically banned by the Banking Act was now fair game once again, opening the door for risk to be accepted by consumers’ deposits.  Ultimately, the big banks were unable to control themselves in the gluttonous period of lending during the early to mid 2000’s, and continued to develop increasingly risky and creative lending practices.

Creative lending and lax credit standards contributed to the mortgage default crisis that the U.S. has been experiencing since late 2007.  The deregulation of banking can also claim its share of the blame.  The concept of the mortgage-backed security (MBS) was a result of the deregulation of banking, which was now possible because the commercial banking division of a financial services conglomerate could accept deposits and then lend mortgages, while the investment banking division bundled up a population of mortgages into a pool and sold shares of this mortgage pool to investors as a mortgage-backed security (MBS).

The MBS was considered a great investment because they bore solid interest rates for their investors and were not very risky since it was unthinkable at the time that people would be en masse defaulting on their mortgages given the heavy consequences to one’s credit rating.  The banks were wrong, and when economic pressures and rising interest rates made many of the mortgages unaffordable, people defaulted at an inconceivable rate forcing down the value of the MBS.  The massive losses incurred by the MBSes held by banks and insurance companies from mortgage defaults are directly related to the deregulation of banking.

Financial Markets Regulation

Regulation in financial markets is enforced by the Securities and Exchange Commission (SEC), in conjunction with the Financial Accounting Standards Board (FASB), who assists in laying down guiding principles for accounting and requirements for disclosures.  Both organizations came under fire in the aftermath of the swarm of accounting scandals associated with Arthur Andersen, LLP.  The result was a new set of rules laid out in the Sarbanes-Oxley Act of 2002 (SOX), which affected broad changes to the formalization of internal controls, corporate oversight and accountability, and transparency in financial disclosures.

The intent of Sarbanes-Oxley (SOX) was to enforce executive accountability for financial disclosures and ethical treatment of shareholders through sound business practices.  In reality, the effect of SOX in the marketplace was to balloon corporate administrative expenses through increased finance and accounting payrolls and consulting fees paid to accounting firms to become SOX compliant.  Many of the requirements brought about by SOX were practices that companies already performed, but perhaps not as rigidly or formally as required by SOX.  This meant businesses were now forced to enlist the help of high-paid professionals just to be compliant with mostly redundant accounting regulations.

Not that SOX is a bad set of rules.  In fact, the premises within SOX are all quite important and valid, but where the regulation failed was a lack of articulating expectations and implementation guidance.  Quite suddenly, all public companies were required to adhere to a new set of guidelines that had vastly different interpretations depending on who you asked.  Accounting firms and SOX specialists all had their own, differing, interpretations and implementation suggestions.  This lack of uniformity has wrought a good deal of havoc upon public companies, who have mostly adopted the regulations without objections.  This is a testament to public companies and their commitment to providing the investment community with accurate, transparent financial information.

Despite the pros and cons of SOX, one thing is for sure: we will never be able to assess the true efficacy of SOX.  There have never been any plans to assess how effective the SOX regulations have been in elevating financial transparency or reinforcing confidence in the financial data filed by corporations.  While the regulations do help in preventing some types of accounting mishaps that have occurred in the past, they are certainly not foolproof.  Scandals in the past have typically been committed by individuals circumventing the current regulations and systems in place, and therefore it is reasonable to assume that those with fraudulent intent will find a way to do the same with SOX.

The Future of Regulation

It is certain there will be continuous updates to the financial industry regulation landscape in the future.  As a community, it is up to us to decide what level of regulation should be enforced to provide U.S. businesses with the opportunity to remain competitive while mitigating risk associated with criminal intent.  At a time when our economy is struggling and the stock market is sluggish at best, we need to focus on regulations that have material impacts on the marketplace, not regulations for the sake of regulating.  We should also not be deregulating industries that have failed us in the past, causing widespread economic turmoil in the same exact way that occurred eighty years ago.

Image used in this post:

Causes of the Great Depression / FDR Memorial Site image courtesy of Flickr user Tony the Misfit under the CC license.