Challenges to Business in the Twenty-First Century

Chapter 5: Questioning Deregulation as a Cause of the Crisis

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Gerald Rosenfeld, Jay Lorsch, and Rakesh Khurana
Challenges to Business in the 21st Century: The Way Forward

Simon M. Lorne

Recent scholarship on the history of financial regulation—including David Moss’s thoughtful, provocative, and useful paper in this volume—suggests that the period of relative financial stability from approximately 1933 to 1980 was a golden age of regulation. The corollary, of course, is that we now need to resurrect the regulatory policies of that era. I think that analysis, which is based solely on the low number of bank failures during the era—either in absolute numbers or in assets as a percentage of GDP—ignores too much of the universe.

Although the period in question was not one of general stagnation, there certainly were stretches of less-than-robust growth between 1933 and 1980. Given that the first decade was not a moment in economic history that anyone would like to repeat; that mobilization for World War II distorted the 1940s; and that pent-up demand and the early impact of the baby boom were driving factors in the 1950s, economists should be hard-pressed to draw generalizable conclusions. Moreover, it was a period of little, if any, financial innovation; what innovation there was took place outside of the world of financial regulation—as in, for example, the initial formation of hedge funds, attributed to sociologist and financial journalist Alfred Winslow Jones in the late 1940s. In short, I am not inclined to accept, at least without more convincing evidence, that the 1933–1980 period was, in fact, a golden age of bank regulation.

I would also note that an extended period in which there are few or no bank failures could give rise to at least three analytical hypotheses other than the one on which David Moss rests his case. First, the low failure rate might simply be the result of little or no business activity. Substantially reduced business activity necessarily makes bank failures unlikely, so that one can deduce little from the observation. Nor should it necessarily lead one to believe that effective regulation caused the dearth of failures. As Moss observes, the best way to eliminate automobile accidents is to reduce the speed limit to zero and ensure that the law is enforced. But there are (almost certainly unacceptable) social costs associated with such an approach.

From a different perspective, and even more troublesome, it might be that an absence of bank activity (and hence an absence of bank failures) was the cause, not the result, of an absence of business activity. To the extent that bank regulation was responsible for a low level of bank activity, perhaps we should damn it as the cause of relative economic stagnation, rather than praise it.

Finally, of course, there is a measurement problem. We can ascertain an economic activity level of X and a bank failure rate of Y—with Y being close to zero in this case—but we cannot determine what a bank failure rate of Y + Z would imply for the level of economic activity. I rather suspect that we should affirmatively embrace some level of bank failure as a necessary accompaniment to a robust economy. To the extent one can reduce failures without sacrificing the level of economic activity, so much the better. But as with most such measures, we should be wary of trying to eliminate failures entirely, and we should recognize that attempting to do so entails costs. We do not, of course, need to accept the level of failures that characterized 1929 to 1930 or 2008 to 2009; it may well be, however, that we should desire a greater rate of failure than that we experienced in the period from 1933 to 1980.

In much of the current literature, there seems to be a consensus (albeit one that I shall challenge) that deregulation was a root cause of the financial crisis of the last two years. Moss’s claim is more subtle: he argues not that too much deregulation was adopted, but that the prevalence of an antigovernment mindset led to a failure to regulate. We should look not at the regulations that were repealed, he suggests, but at the regulations that might otherwise have been adopted and were not. That hypothesis, of course, is largely untestable.


In my view, only three significant elements of actual deregulation were at all relevant to the 2008–2009 crisis. The first was the adoption of the Gramm-Leach-Bliley Act and the repudiation of the Glass-Steagall Act. (I should note that I have always thought that the repudiation of Glass-Steagall was ill-advised. I also believe that the separation of investment and commercial banking that Glass-Steagall mandated—which in many ways is what Chairman of the Economic Recovery Advisory Board Paul Volcker is currently urging, with his suggestion to deny trading authority to banks—was and remains sensible.) However, while passing Gramm-Leach-Bliley may have been a bad idea, it was not a root cause of the crisis, except insofar as it allowed the universal banks to be bigger and necessarily more interconnected, and, therefore, more easily deemed too big or too interconnected to fail.

The second instance of deregulation (at least it is typically viewed as such) was the decision by the Securities and Exchange Commission (SEC) to allow the five largest brokerage firms, the Consolidated Supervised Entities (CSE)—Goldman Sachs, Morgan Stanley, Merrill Lynch, Lehman Brothers, and Bear Stearns—to be governed by Basel II standards rather than by the SEC’s standard net capital rules. The condition for this allowance was that the firms voluntarily submitted to the CSE regulatory regime, which was itself based on Basel II but administered by the SEC. Too much has been made of this move. It was not—as some have argued—an inherently weak “voluntary” submission to regulation. The SEC retained all the authority over those firms any regulator could want. Moreover, if the broker-dealer subsidiaries of the firms had remained under traditional net capital standards, there would have been very little, if any, difference in outcome. The problem was that the SEC had only a handful of people to oversee the regime across all five institutions—far too few to administer a Basel II regime. By comparison, many times that number were embedded within Fed-regulated institutions. Furthermore, it came to light that the SEC was not any better than the Fed at administering the standards. After all, it is not as though Fed regulation distinguished itself during the crisis.

The third arguably relevant area of deregulation was the congressional legislation that denied the SEC and the Commodity Futures Trading Commission (CFTC) regulatory authority over certain derivatives. This issue is usually discussed in the context of credit default swaps and the fall of AIG. True, the legislation was specifically deregulatory—one of the few examples, in fact. However, if credit default swap (CDS) transactions had been subject to full regulation as securities, the broader outcome would have been the same. Under SEC regulation, all the CDS contracts written by AIG would have been considered “private placements” and thereby exempt from SEC registration and review. Moreover, they all were written in London, beyond SEC jurisdiction. Centralized clearing might well have been helpful, although not without its own issues: indeed, the centralized clearing agency becomes a single point of failure and is inherently too big—or better said, too interconnected—to fail. In any event, a lack of SEC and CFTC jurisdiction over CDS transactions was never an element in any failure of regulation that might be identified as a cause of the financial collapse.

In short, the deregulatory mindset—congressional acceptance of the Chicago School—was not nearly as pervasive as recent analyses might lead one to believe. Even less, I think, was deregulation (or a deregulatory mindset) a cause of the crisis. Put differently, I do not believe the academic writings were nearly as influential in the political sphere as Moss and others suggest, nor do I think that branches of academic writings were as uniformly accepted as those critics propose. Here, I offer an analogy: we have a tendency in this country to elect presidents based on one candidate’s earning 51 or 52 percent of the vote to the opponent’s 49 or 48 percent. Inexplicably, we then act as though the victor has received some sort of overwhelming public mandate. I think Moss and others do much the same when they perceive a ruling economic ideology. It may be—and, indeed, quite possibly is—accurate to say that the Keynesians held sway and then the Chicago School held sway. But the two sides were always fairly evenly balanced; the opposing view was never very far from the scene.

I cannot help but note that the one area of the financial system that did not contribute to the crisis was hedge funds, which are commonly described as an unregulated segment of the market. Hedge funds did not fail in any large numbers during the years of the crisis and clearly were a negligible factor as a cause of the crisis. In my view, that was because lenders would not allow hedge funds to acquire the amount of leverage that was common in the large, regulated institutions, and those high levels of leverage were an essential ingredient of the failures. This experience could easily, and fairly, be described as one in which the unregulated markets worked far more effectively than the regulated markets. It could also be seen as an example of moral hazard played out—that is, in the unwarranted reliance on the regulatory structure. After Long-Term Capital Management’s failure and bailout in 1999, lenders were generally aware that lightly regulated hedge funds posed a significant credit risk and did not permit them to take on a great deal of leverage. By contrast, in the presumably well-regulated financial institutions, leverage was allowed to reach significant heights simply because lenders trusted in the efficacy of regulation.


At bottom, I believe the crisis should properly be seen neither as a market failure nor a regulatory failure, but as a failure of people in both private institutions and regulatory agencies. At the level of the firm, people were charged with recognizing risk; they simply failed to do so or, equally offensive, they failed adequately to do anything about it. In some instances, it was risk-cognition failure. In others, it was willful blindness. At the regulatory level, actively involved regulators, primarily the Fed, simply failed to realize what was happening. I am reminded of Citigroup CEO Charles O. Prince’s statement: “If the music’s playing, we have to dance.” People made the unwise decision to dance.

After an incident occurs, it is easy to conduct a forensic examination and identify the points, and often the causes, of failure. Over time, we will reach that stage with respect to the recent crisis. As for firms that did not fail, it is much more difficult to ascertain which factors were critically important to their not failing, and which, although necessarily a drag on productivity, did not much add to the ultimately beneficial result. I liken such an endeavor to Leo Tolstoy’s opening of Anna Karenina, roughly translated as: “All happy families are alike; each unhappy family is unhappy in its own way.”

I cannot quarrel with David Moss’s historical data—there were fewer bank failures in the 1933 to 1980 period than in the post-2007 period. I can, however, question whether that fact is evidence of an unadulterated good in the earlier period, and I can also question what lessons should be drawn from it. The body politic will no doubt respond in the manner that Moss recommends; whether that will improve the public weal over time will probably never be known.