11.4 The Great Deregulation Experiment
3 min read•june 24, 2024
in industries like airlines, railroads, and banking led to increased competition and innovation. However, it also brought challenges like regulatory capture, where industries influence their regulators. These changes reshaped markets and consumer experiences in significant ways.
The 2007-2008 financial crisis highlighted the risks of deregulation in finance. Factors like , complex financial instruments, and lax oversight contributed to a global economic meltdown. This led to new regulations aimed at preventing future crises.
Deregulation and Its Impact
Impact of industry deregulation
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- Deregulation of airlines in 1978 removed government control over fares, routes, and market entry leading to increased competition, lower airfares, growth in the number of airlines (Southwest Airlines) and routes, and the emergence of low-cost carriers
- Railroad deregulation through the Staggers Rail Act of 1980 allowed railroads to set their own rates and routes resulting in improved efficiency and profitability of the rail industry and consolidation of railroads through mergers and acquisitions (Burlington Northern and Santa Fe Railway)
- Banking deregulation in the 1980s and 1990s removed restrictions on interstate banking and branching sparking increased competition and innovation in the banking sector, growth of large, nationwide banks through mergers and acquisitions (Bank of America), and expansion of banking services and products (online banking)
- This also led to , with new products and services being developed
Regulatory capture in price regulation
- Regulatory capture happens when regulatory agencies are influenced or controlled by the industries they are meant to regulate
- Regulated firms may use their resources and influence to shape regulations in their favor
- Captured regulators may set prices or regulations that benefit the regulated industry at the expense of consumers leading to:
- Higher prices for consumers
- Reduced competition and innovation
- Inefficient allocation of resources
- Rent-seeking behavior by regulated firms (lobbying for favorable regulations)
The Financial Crisis of 2007-2008
Causes of 2007-2008 financial crisis
- Housing market bubble fueled by subprime mortgages given to borrowers with poor credit
- of mortgages into complex financial instruments ()
- Unregulated over-the-counter market for instruments like (CDS)
- Excessive risk-taking by financial institutions seeking higher returns
- Lax lending standards and inadequate risk management by banks and mortgage lenders
- Role of unregulated financial assets:
- (CDOs) and credit default swaps (CDS) lacked transparency
- Risks associated with these instruments were not well understood
- Rapid growth of the unregulated "" system (hedge funds, investment banks)
- Consequences of the financial crisis:
- Collapse of major financial institutions (Lehman Brothers, Bear Stearns)
- Severe contraction in credit markets and liquidity
- Sharp decline in housing prices and foreclosures
- Significant losses for investors and retirement accounts
- Global economic recession and high unemployment
- Regulatory responses to the crisis:
- of 2010 increased oversight and regulation of the financial industry
- Creation of the (CFPB) to protect consumers from abusive practices
- Enhanced capital and liquidity requirements for banks to improve their resilience to shocks
Systemic Risk and Regulatory Challenges
- refers to the potential for a breakdown in the financial system that could lead to widespread economic harm
- arises when financial institutions take excessive risks, believing they will be bailed out if things go wrong
- occurs when firms exploit loopholes or differences in regulations to minimize their regulatory burden
Key Terms to Review (23)
Collateralized Debt Obligations: Collateralized Debt Obligations (CDOs) are complex financial instruments that are backed by a pool of debt assets, such as mortgages, loans, or bonds. They are created by securitizing these debt obligations and then selling them as separate, tradable securities to investors.
Consumer Financial Protection Bureau: The Consumer Financial Protection Bureau (CFPB) is an independent federal agency responsible for protecting consumers from unfair, deceptive, or abusive practices in the financial sector. It was created in the aftermath of the 2008 financial crisis to ensure that consumers are provided with clear information about financial products and services, and to hold financial institutions accountable for their actions.
Credit Default Swaps: A credit default swap (CDS) is a type of financial derivative contract that allows one party to transfer the credit risk of a debt instrument to another party. It functions as a form of insurance against the default of the underlying asset, typically a bond or loan.
Deregulation: Deregulation is the process of removing or reducing government rules, regulations, and restrictions on businesses and industries, with the goal of promoting competition and economic growth. It involves the dismantling or relaxation of policies and laws that previously governed certain sectors or activities.
Derivatives: Derivatives are financial instruments whose value is derived from the performance of an underlying asset, index, or other financial instrument. They are used to manage risk, speculate on market movements, or generate income.
Dodd-Frank Wall Street Reform and Consumer Protection Act: The Dodd-Frank Wall Street Reform and Consumer Protection Act was a comprehensive financial reform legislation passed in 2010 in response to the 2008 financial crisis. It aimed to promote financial stability, enhance consumer protection, and prevent future economic crises by increasing regulation and oversight of the financial sector.
Efficient Market Hypothesis: The efficient market hypothesis (EMH) is an investment theory that states that financial markets are 'informationally efficient', meaning that asset prices fully reflect all available information. This suggests that it is impossible to consistently outperform the overall market through expert stock selection or market timing, and that the best investment strategy is to invest in a diversified portfolio.
Federal Reserve: The Federal Reserve, commonly referred to as the Fed, is the central banking system of the United States. It is responsible for conducting monetary policy, supervising banks, maintaining financial system stability, and providing banking services to the government. The Fed's actions and decisions have far-reaching implications for the overall economy, influencing factors such as inflation, employment, and economic growth.
Financial Innovation: Financial innovation refers to the development of new financial instruments, products, and services that aim to improve the efficiency, accessibility, and risk management of the financial system. It encompasses the creation of novel financial tools, technologies, and processes that enhance the way individuals, businesses, and institutions manage their financial activities.
Glass-Steagall Act: The Glass-Steagall Act was a U.S. federal law that established a separation between commercial banking and investment banking. It was enacted in 1933 in response to the Great Depression and aimed to prevent conflicts of interest and excessive risk-taking in the financial sector.
Gramm-Leach-Bliley Act: The Gramm-Leach-Bliley Act (GLBA), also known as the Financial Services Modernization Act of 1999, was a landmark piece of legislation that repealed the Glass-Steagall Act and allowed for the integration of commercial banking, investment banking, and insurance companies under one financial services umbrella.
Great Recession: The Great Recession was a severe economic downturn that occurred in the late 2000s, characterized by a significant decline in economic activity, high unemployment, and financial instability. This event had far-reaching implications across various economic sectors and policies.
Market Liberalization: Market liberalization refers to the process of reducing or eliminating government intervention and control in the economy, allowing market forces to determine the allocation of resources and the pricing of goods and services. This involves the deregulation of industries, the removal of trade barriers, and the privatization of state-owned enterprises.
Monetarism: Monetarism is an economic theory that emphasizes the central role of the money supply in determining economic performance. It posits that fluctuations in the money supply are the primary driver of changes in the broader economy, including inflation, economic growth, and employment levels.
Moral Hazard: Moral hazard refers to the tendency of individuals or entities to take on more risk when they are protected from the consequences of that risk. It arises when an individual or organization does not bear the full cost of their actions and therefore has a reduced incentive to guard against risk.
Mortgage-Backed Securities: Mortgage-backed securities (MBS) are debt obligations that represent claims to the cash flows from pools of mortgage loans, including residential and commercial mortgages. They are a type of asset-backed security that is created by securitizing a group of mortgages into a tradable financial instrument.
Regulatory Arbitrage: Regulatory arbitrage is the practice of taking advantage of differences in regulations or regulatory oversight across different jurisdictions or financial products to circumvent unfavorable rules and gain a competitive advantage. It involves exploiting loopholes or ambiguities in the regulatory system to maximize profits while minimizing compliance costs.
Savings and Loan Crisis: The Savings and Loan Crisis was a major financial crisis in the United States during the 1980s and early 1990s, characterized by the failure of over 1,000 savings and loan associations (S&Ls). This crisis was closely tied to the broader context of the Great Deregulation Experiment, as the relaxation of regulations and oversight in the financial sector contributed to the crisis.
SEC: The Securities and Exchange Commission (SEC) is the primary regulatory body responsible for overseeing and enforcing federal securities laws in the United States. Its primary mission is to protect investors, maintain fair and orderly functioning of securities markets, and facilitate capital formation.
Securitization: Securitization is the process of transforming illiquid assets, such as loans or mortgages, into tradable securities that can be sold to investors. This process allows lenders to remove these assets from their balance sheets, freeing up capital for further lending and investment activities.
Shadow Banking: Shadow banking refers to the network of financial institutions and activities that operate outside of the traditional banking system, often with less regulation and oversight. It encompasses a range of non-bank financial entities that provide credit and engage in bank-like activities, such as lending, maturity transformation, and leverage.
Subprime Mortgages: Subprime mortgages are a type of loan granted to borrowers with poor or limited credit histories, who typically do not qualify for conventional mortgage loans. These mortgages often have higher interest rates and less favorable terms compared to prime mortgages, reflecting the increased risk associated with lending to these borrowers.
Systemic Risk: Systemic risk refers to the risk of collapse of an entire financial system or market, as opposed to the risk associated with any individual entity or component. It is the risk that an event, such as a financial crisis or economic downturn, could trigger a cascading failure of the entire financial system, leading to widespread economic devastation.