After the financial crisis in 2008, politicians and regulators pointed to the need for more regulation to steady the world’s markets and get big banks back in line.
“The aftermath of a financial crisis is a bad time to overhaul financial regulation,” said Mahoney, an expert in securities regulation and corporate finance. “Right after a crisis, politicians and regulators are trying hard to avoid blame for what happened. And so when they’re looking for causes of what happened, they’re going to ignore any decisions or policies that could be associated with them.”
Instead, politicians and regulators argue the crisis was caused by bad actors – such as banks – doing bad things.
As the story goes, “they were allowed to do those things because there wasn’t sufficient regulation, and if we add in more regulation, that’s going to solve the problem,” said Mahoney, who coined the phrase “market-failure narrative” to describe the frequently peddled explanation.
It’s a tale that’s been repeated by politicians and regulators since the late 17th century, as Mahoney discovered while researching his book, which offers a legal and economic history of securities regulation.
But the narrative doesn’t hold up, Mahoney found, when examined through objective measures of the market’s performance and how regulations changed the financial industry. In reality, he said, the most powerful banks are well-positioned to shape hasty reforms in their own favor.
“Businesses themselves are interested players in the regulatory process and usually they come in with an advantage because they know more about what the real issues are than the legislator or the regulator does, and they tend to shape regulations in ways that help themselves,” Mahoney said, a concept known by economists as the regulatory capture hypothesis.
“One of the key takeaways from my book is how effective financial firms have been at shaping regulations in ways that harm their competitors, don’t necessarily give any help to their customers and help improve their own profitability.”
The book highlights the Great Depression as a unique example of what happened to lightly regulated markets after Congress enacted a substantial number of new regulations.
“It’s the clearest shift in regulatory systems that one is really likely to see,” he said.
Yet most misunderstand the history. Though the financial market is popularly understood to have crashed in 1929, stocks actually bounced back significantly in early 1930 and didn’t hit a true low until 1932, when markets dropped to 80 percent below their late-1920s peak.
Rather than serving as a salve to everyday Americans, New Deal securities reforms concentrated power among powerful interests, Mahoney argues in the book.
“One very clear effect of the New Deal securities reforms that I show in a number of different ways throughout the book is that they increased concentration in the market for financial services,” Mahoney said. “So the major investment banks turned out, counterintuitively, to be real winners from the Securities Act of 1933.”
At the time, competing models for financial services were at stake. New entrants to the financial services market had compressed the wholesale and retail phases that bigger banks favored.
“The established banks essentially wanted to drive that model out of the market, and what they did was to essentially legislate it out of the market,” Mahoney said, by codifying the wholesale and retail phase. “It actually gave the major investment banks exactly what they wanted.”
The same pattern is repeating today with the Dodd-Frank Act, Mahoney said. The omnibus bill was marketed as a solution to what caused the 2007-08 financial crisis.
“The Dodd-Frank Act will make the largest commercial banks in the United States even bigger by formalizing the previously informal government guarantee,” Mahoney said.
Rather than act quickly to respond to a crisis with significant legislation, Mahoney argues in his book that legislators and regulators should take the long view with reforms.
“It’s actually a good thing to revise regulations over time as we learn more about their effects, but that should be done gradually and continuously, not in a spasmodic burst of activity after every market crisis,” he said. “Any regulations that are written right after a crisis ought to have a sunset provision and that will enable us to take a more careful look at them down the road.”
He pointed to how some proposed Dodd-Frank regulations are yet to be written as a sign that they shouldn’t be.
“A big part of it is they’re having a very hard time avoiding bad consequences,” he said. “When you’re looking at a set of regulations you’re supposed to write, and, as judges say of an opinion, ‘This just won’t write’ – then I think you’ve got a problem.”
Mahoney said he hopes the book will help readers become more skeptical when they hear the standard market-failure narrative.
“We often don’t look at those stories skeptically enough and we end up accepting regulations that could make things worse, rather than better,” he said. “We ought to look at individual issues, and come up with individual, modest incremental fixes to them. If you stick to basics, you’re much more likely to get it right.”
Mahoney, the David and Mary Harrison Distinguished Professor of Law and the Arnold H. Leon Professor of Law, joined the Law School faculty in 1990 after practicing law with the New York firm of Sullivan & Cromwell and clerking for Judge Ralph K. Winter Jr. of the U.S. Court of Appeals for the Second Circuit and Justice Thurgood Marshall of the U.S. Supreme Court. Mahoney is a member of the Council on Foreign Relations and a fellow of the American Academy of Arts and Sciences. He became dean in 2008.
SIDEBAR: What Caused the 2008 Financial Crisis? A Primer from Dean Mahoney
Mahoney said explanations for the financial crisis usually fall into three categories: too little regulation, government housing and monetary policies, and moral hazard arguments. In his book, he focuses on the third.
“Starting in the 1980s and increasing all the way up to the crisis, the banking regulators, the Fed and the Treasury had created an expectation that any large and interconnected financial institution would not be allowed to go through the ordinary bankruptcy process, which might delay or threaten payments to short-term creditors – that phenomenon is commonly known as ‘too big to fail.’
“Short-term creditors play an incredibly important role in disciplining financial institutions, because when short-term creditors become nervous that an institution has problems, they refuse to roll over their loans. Now, that’s a bad thing from a stability perspective, but it’s a really good thing from a discipline perspective, and that discipline was undercut in the years running up to the financial crisis by decisions and policies that insulated financial institutions from the consequences of their own behavior.
“Once regulators allowed Lehman Brothers to go under, there was this sudden recognition, ‘My goodness, they don’t actually have a settled policy that they’re going to do this every time – they’re going to do it some of the time, and they’re not going to do it some of the time, and we don’t know the criteria – so now we don’t know what to think about Goldman Sachs and JPMorgan Chase and Citigroup; we have to guess whether the government will come in and bail them out.’ And that’s not a position people wanted to be in, so they began reducing their exposure to all the financial institutions.”