Byline: Shanker Singham, SPECIAL TO THE WASHINGTON TIMES
As the financial crisis unfolds around the world, triggered by the subprime mortgage mess in the United States, those in favor of regulation headed by Chairman Barney Frank of the House Financial Services Committee claim to have won a victory over the deregulators they claim are avatars of a now defunct ideology - free and unfettered markets. Now that Congress has passed the financial bailout package, enquiring minds can try to figure out what climate will exist for financial services businesses in the new post-bailout operating environment.
Has deregulation caused the mess we are in, and will greater regulation ensure that we won't be here again in 10 years? This really is the wrong question, and the assumptions on which the question is based are also wrong. First of all, the assumption there is (or was) a free market in financial services could not be farther from the truth. The financial services sector has always been massively regulated, sometimes in ways that make sense and sometimes in ways that do not.
The Bank Holding Companies Act subjects banks to rigid capital adequacy requirements, supervised by the Federal Reserve. There was a strict separation between investment and commercial banking under the Glass-Steagall Act, which was mercifully replaced by Gramm-Leach-Bliley in 1999. As noted elsewhere, banks were directed under the Community Reinvestment Act, and its predecessor laws dating back to the 1970s, to grant mortgages in poor communities with very low deposits, in order to spread the American dream of homeownership to many segments of society. These worthy goals took banks ever further from the profit-maximizing mandate that is the core of business activity.
We now see the catastrophic results of this meandering. A series of market distortions were imposed on the industry by changes in accounting practices (post-Enron, mark-to-market accounting is one example), and the activities of nontransparent rating agencies that seemed to change the rules of the game on AIG with spectacular results.
These further market distortions prevented needed corrections that would have occurred in a competitive market.
But perhaps the largest distortion of all was the activity of the government sponsored enterprises (GSEs), Fannie Mae and Freddie Mac. Not only did they vastly increase demand for subprime mortgages, they were able to create a market for them by their implicit government guarantee that they would not be allowed to fail, no matter how catastrophic their internal decisionmaking. …