Too Big to Fail? The Top 5 Most Useless Banking Regulations in History
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- By Chad Fisher
- January 3, 2014
The United States is currently struggling to pull out of the economic morass that has held firm for several years, but financial disasters are nothing new to the country. In fact, ever since 1819, the U.S. has suffered repeated financial meltdowns followed by prolonged periods of economic depression. New government regulations surrounding banking, created in the wake of these disasters, are then intended to protect and stabilize the fragile economy — some of which have worked as intended, while others have had disastrous consequences.
Recessions and Banking Regulations Throughout History
In 1791, Alexander Hamilton created a centralized banking system that stabilized the financial system, issued banknotes and financed the federal government. The bill he introduced was hotly contested in Congress, but it ultimately passed.
The Bank of the United States succeeded in solving many of the country’s monetary problems at the time. Unfortunately, the central bank only received a 20-year charter, which was allowed to expire. This ended up being a financial disaster of the first magnitude: Inflation soared and the federal government issued a prolific number of treasury notes.
After just five years, another central bank was established, but was considered by many to be vulnerable to manipulation and corruption. When that bank’s charter expired, another period of runaway inflation began.
The creation of the Federal Reserve in 1913 helped stabilize the U.S. economy from 1929 until the 1980s. New regulatory agencies were created to monitor the thousands of individual banks across the U.S. By the end of 2011, the pages of new and proposed rules increased more than 40 percent between 2009 and 2011.
In fact, over 169,000 pages fill the Code of Federal Regulations. Many of these regulations are simply outdated, ineffective, contradictory or redundant. The cluttered book makes doing business in this fragile economic climate difficult, complicated and confusing.
However, thanks to the country’s bumpy financial history, ineffective and dangerous banking regulations are nothing new.
Most Ineffective Banking Regulations in History
1. The Michigan Act of 1837
One of the first regulatory missteps was The Michigan Act of 1837, which is considered the first of the free banking laws enacted in the country. Rather than imposing greater regulations on banks, the Michigan Act allowed any qualified person or group to create a bank with virtually no governmental oversight. Banks were then allowed to create their own currency, which was backed by bonds or real estate. Inflated appraisals and the subsequent flood of available real estate resulted in bank runs and financial instability.
2. Community Reinvestment Act of 1977
Although the Community Reinvestment Act of 1977 was designed to encourage affordable home ownership, particularly for those in underserved socioeconomic groups, multiple revisions increased its complexity. Regulators focused on process instead of outcome, and banks had to jump multiple regulatory hurdles in order to maintain compliance.
While evidence has shown that the CRA has substantially decreased the gap between white and minority homeowners, it is also believed to have contributed to the subprime mortgage crisis as banks were pressured to make increasingly riskier loans.
3. The Recourse Rule of 2001
The Recourse Rule of 2001 was poorly considered regulation that required banks to hold significantly more capital reserves against commercial loans and bonds than mortgage-backed securities and individual mortgages. By privileging mortgages and making commercial loans more expensive, banks were virtually set up to fail when the housing bubble burst. The resultant frozen credit deepened and drew out the financial crisis.
4. The Dodd-Frank Wall Street Reform and Consumer Protection Act
The Dodd-Frank Wall Street Reform and Consumer Protection Act was passed in 2010 in reaction to the financial meltdown and subsequent recession. It was intended to create consumer protection from predatory and abusive lending practices, consolidate regulatory agencies, develop a new oversight council, end the era of banks that were too big to fail and increase compliance with various international regulations and standards.
The chief executive of JP Morgan Chase has estimated that the act, which reaches into nearly every aspect of the banking industry, may cost his bank between $400m and $600m every year to ensure compliance. The credit card industry (Visa, MasterCard, AMEX, Green Dot Credit Cards and more) was forced to curtail easy credit and impose more stringent standards before issuing a credit card to anyone with a pulse. Although Dodd-Frank was designed focus on ending abusive credit practices, it also resulted in reducing available credit, which ultimately slowed down the U.S. economy’s recovery.
5. The Basel Accords
Some regulations can have a positive initial effect, which is later complicated by the addition of new rules and regulations. In 1988, Basel I, the first of the Basel Accords, was introduced. A mere 30 pages in length, it provided a regulatory framework for international banking, created a standard based on five risk weights and was intended to support banks’ own decisions.
Basel II was introduced in 2004, due in part to complaints regarding Basel I’s simplicity and supposed lack of risk sensitivity. Unlike Basel I, Basel II weighed in at nearly 350 pages, created a more complicated regulatory risk management system and incentivized risk underestimation.
After large international banks began to suffer great losses, Basel III, which weighed in at an incredible 616 pages, was born. It requires banks to hold more liquid investments, institutes risk-based capital requirements, creates tighter limits for credit exposure and requires earlier remediation for troubled institutions.
Stimulating Real Recovery
The knee-jerk increase in regulations surrounding the financial industry may well be inhibiting our economic recovery, preventing small businesses and banks from competing and prolonging the recession. Regulators must strike the right balance between protecting consumers while stimulating the credit flow that currently drives the U.S. economy.
According to Karen Petrou, managing partner of Federal Financial Analytics, which analyzes bank regulations,
“…regulation has to serve two fundamental purposes: to punish the guilty and to protect the innocent. And social engineering, financial market engineering, and many of the much more complicated goals that the new regulatory framework seeks to meet (are) so complex and untried. There is often no academic research or market history for those goals and doing them all at once is not only risky … but is also a serious distraction from those two fundamental purposes of protecting the innocent and punishing the guilty.”
This article was written by Chad Fisher who enjoys writing about financial and environmental subjects. With so many large construction projects going on around the world, many companies are in the market to find excavators for sale online.