While the Regulators Fiddled ...

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The result was the growth of what's now often termed the shadow banking system of securitization and derivatives, which took over many of the responsibilities of banks but was not subjected to the same kind of risk controls or oversight. This process began in the 1970s, as the rigid New Deal approach of segmenting financial institutions into narrowly defined boxes began to crack under the pressure of inflation, globalization and floating exchange rates. The money market mutual fund, invented in 1971 as a way to get around federal limits on savings-account interest rates, was among the first of many innovations that undermined the old ways.

The anti-regulation ideological bent of the Reagan administration sped this transformation, but the Clinton years were the really interesting ones. In the aftermath of the savings and loan collapse and a banking-industry near-miss there was a flurry of activity aimed at keeping banks healthy, not by shoving them back into their New Deal box but by reasserting their central role in the financial system. Glass-Steagall repeal can best be understood as part of this effort. So was 1994 legislation allowing interstate branching. This was a bipartisan movement: The Gramm-Leach-Bliley legislation passed the Senate 90-8 (Joe Biden was for it; John McCain didn't vote, but had supported the bill in an earlier roll call).

There's an argument to be made that if this kind of regulatory approach had continued into the Bush years, some emerging financial market excesses might have been nipped in the bud. Until very recently, the Bush Administration has showed no interest whatsoever in tightening financial regulation, and at the Federal Reserve Alan Greenspan was if anything even less interested. The Fed had the power to impose stricter mortgage lending rules even on non-banks, which it finally did earlier this year — banning, among other things, the making of loans "without regard to borrowers' ability to repay the loan from income and assets other than the home's value." Greenspan, though, rejected pleas from his Fed colleague Edward Gramlich to crack down earlier.

But even before 2001 there was a widespread, bipartisan Washington consensus that financial markets knew best. And even when some in government suspected that they didn't, the territorial lines between regulatory agencies often stood in the way of doing anything about it. The Securities and Exchange Commission, well versed in investor protection but not so much in safety and soundness, remained as lead regulator of brokerage firms even as they evolved into giant investment banks whose failure could endanger the financial system. The Office of the Comptroller of the Currency battled state regulators over who had the right to impose consumer protection rules. And in a struggle that has taken on special resonance this week, Commodity Futures Trading Commission chief Brooksley Born — a Clinton appointee — tried after the collapse of the hedge fund Long-Term Capital Management in 1998 to impose some kind of federal oversight on the over-the-counter derivatives market, and was thwarted by a less-than-holy alliance of anti-regulation types in Congress and colleagues in the Clinton administration who didn't want to see the CFTC get authority over a business then dominated by banks.

Maybe the CFTC, a strange little agency overseen by the Congressional agricultural committees, had no business regulating OTC derivatives. But the fact that nobody regulated them, even as the business grew and migrated from banks to firms like Bear Stearns and AIG, is a big reason why the world's financial markets are in such crisis this week. Bear and AIG were bailed out in part because they were big players in the market for credit default swaps, derivatives that are meant to insure against loans gone bad. Regulators have such an unclear picture of who's on the hook to whom in this market that they feared the collapse of either firm would spark a chain reaction of defaults, and investors are so panicked by the unknown that they are selling shares in even seemingly healthy investment banks Goldman Sachs and Morgan Stanley.

One positive sign in this week's mess is that both the turf battles and unyielding attachment to deregulation have been abandoned, perhaps forever. The Fed and Treasury have together seized de facto control of the regulation of all financial institutions of significance, and nobody at either agency seems willing to believe anymore that financial markets are invariably right. In March, Treasury Secretary Hank Paulson proposed a system in which there would be one regulator (the Fed) in charge of market stability, another tasked with prudential regulation of institutions that rely on government guarantees (at the time it meant just banks and insurers, but these days it could be anybody), and another responsible for consumer protection and other "conduct of business" matters. This sounds like an improvement. But what really matters most is that any new regulatory system dispense with the perverse practice of exempting new products and institutions from the rules that apply to the tried and the true.

(See the winners and losers of the Wall Street mess here.)
(See photos of the troubled economy here.)