The reform bill that appears headed to enactment is designed to address problems that produced the 2008 financial crisis. A major premise behind the legislation seems to be that the crisis resulted in large part from regulators’ lack of adequate tools. Thus the bill provides the Securities and Exchange Commission, the primary regulator of mutual funds, and the Federal Reserve Board with even greater authority than they now possess. It also creates entirely new regulatory bodies such as the Consumer Financial Protection Bureau and the Financial Stability Oversight Council.
However, the record indicates that the key problem behind the financial crisis was not so much regulators’ lack of regulatory tools, but rather regulators’ refusal to utilize tools they possessed. Thus the SEC exempted asset-backed pools from regulation, repealed the uptick rule for short sales, and lessened capital standards for broker-dealers. Meanwhile, the Fed declined to crack down on unscrupulous subprime lending practices and refused to raise interest rates to dampen the housing bubble.
If there is any lesson to be learned from the 2008 experience, it is: “Put not your faith in regulators.”
The bill implicitly rejects this lesson, apparently in the belief that regulators somehow will do a far better job in the future than they have in the past. While we all hope that this optimism will prove justified, experience indicates the opposite. Regulators, being human, are not clairvoyant, and are bound to make mistakes. They did so in the great crisis of the late 1920s and early 1930s, during the New Deal, and in subsequent years.
As Justice Brandeis warned back in 1933, “Remember, the inevitable ineffectiveness of regulation.”
For this reason, Brandeis urged another route to reform. He believed that instead of fruitlessly seeking to control financial excess though regulation, Congress should enact laws that automatically limit the size and activities of financial firms so that problems in one firm do not threaten the overall system. Many New Deal laws reflected Brandeis’ approach: the Glass-Steagall Act separated commercial and investment banking; and the Public Utility Holding Company Act imposed a death sentence on giant utility holding companies.
Further, the Revenue Act of 1936 limited mutual fund investment in operating companies; and the Investment Company Act limited fund investment in financial firms. These laws have worked far better than those that rely on discretionary action by regulators.
During the recent debate on financial reform, there were those — in the academy, in the media, in Congress, and even in the financial industry — who urged legislation incorporating the Brandeis approach. They specifically wanted to restore Glass-Steagall prohibitions and limit bank size.
But the key players had reasons to ignore this advice: It’s easier for members of Congress to buck responsibility to regulators rather than make difficult decisions. Agency officials are not inclined to admit fallibility and give up turf. Further, financial firms prefer to deal with regulators having broad discretion than abide by fixed statutory limits.
So the Obama Administration and the Senate and House committees rejected the Brandeis approach and opted for granting regulators even more authority than they possess today.
I hope that this reliance on regulation works. Experience indicates that it won’t.
was with the Investment Company Institute from 1971 to 2004 and served as its president from 1991 to 2004. He is the author of a history of mutual funds, The Rise of Mutual Funds: An Insider's View, published by Oxford University Press and set to be revised next year. He can be reached at firstname.lastname@example.org.