Back in early 2017, while the stock market was breaking records, the new administration in the US made promises to significantly roll back the recently implemented regulations under the Dodd-Frank Act. We have seen the move toward deregulation take shape on various fronts. By most accounts, new regulatory appointees have signalled a shift toward a softer approach to financial regulation. On the legislative front, after a failed attempt by the House of Representatives to erase core financial regulations under the DFA, the Senate has voted last week on a bill that would offer regulatory relief to small and mid-sized banks.
Over the last two decades, the US has gone through a regulatory cycle. The financial sector was deregulated during the boom spanning the late-1990s to mid-2000s, and then re-regulated following the 2008 crash (e.g. Goldstein 2009). Currently, it appears that the regulatory pendulum is swinging the other way. In a recent paper, I examine the political economy of financial policy during ten of the most infamous financial booms and busts since the 18th century (Dagher 2018). I rely on a wealth of scholarship on each episode to show that procyclical regulations are a recurring feature since the early days of finance and across countries. Financial booms – and risk-taking during these episodes – were often amplified by political regulatory stimuli, credit subsidies, and an increasing light-touch approach to financial supervision. Financial crises led to a massive regulatory backlash, which sometimes suffocated finance. The regulatory response can be best understood in the context of the political ramifications of such crises.
The large literature on the 2008 Global Crisis tends to focus on identifying the regulatory failures that led to the crash. I argue that it is equally important to understand the roots of these regulatory failures, and that politics is usually at the heart of the story.
A short narrative of three centuries of regulatory cycles
Roll back the clock to 1725, when the South Sea Bubble was riding high in England. It was one of the earliest well documented stock market bubbles. Political elites cheered for the stock market mania – until it crashed. The political backlash was substantial, and many members of parliament were thrown in jail. England inherited from the South Sea Bubble backlash the ‘Bubble Act,’ an oppressive law that placed a tremendous hurdle on companies going public. The Act remained in place for a full century. It was then repealed at the peak of the next big bubble, in 1825. The repeal is well documented as being the result of lobbying and influence peddling. The response to the ensuing crash and banking crisis transformed and modernised financial markets in England.
To those familiar with the financial history of the US this might ring a bell or two. The market euphoria in the late 1920s came at the heels of a period of deregulation, inaction by regulatory agencies, and rising subsidies to the housing sector. President Hoover at the time took a dim view of federal regulations and supervision, and appointed regulators that shared this view. The 1929 crash and the ensuing Great Depression led to a major rethinking of the role of government, resulting in an impressive comeback by the Democrats in Congress. The New Deal reshaped the financial landscape in the US and imposed stricter regulations and supervision. The Glass-Steagall Act of 1933 separated commercial and investment banking in order to protect depositors. The Act remained in effect for much of the remaining 20th century, but was then repealed in 1999 at the height of a stupendous stock market boom. During the 1990s, securities laws were also eased by Congress, but they were then tightened under the Sarbanes-Oxley law a few years later, after the Dot-Com crash – a short-lived regulatory cycle confined to the securities market. But deregulation and a light touch approach in the banking sector continued and intensified in the midst of a tremendous housing boom. The credit boom benefited from government subsidies and sponsorship under both the Clinton and Bush administrations. Two years after its crash in 2008, President Obama signed into law the Dodd-Frank Act, the most significant regulatory overhaul since the New Deal.
These regulatory cycles can be observed across time and countries. In addition to the episodes mentioned above, my paper examines the several notorious financial crises, including the Swedish banking crisis and the Japanese financial crisis in the early 1990s, the Korean financial crisis of the late 1990s, and the Irish and Spanish financial crises of the late 2000s. I rely on a large literature on each isolated episode to gauge the extent to which financial policies were deemed to have provided a stimulus for the boom, for example by decreasing the hurdles against risky lending, either through new laws or through changes in the enforcement of existing laws.
Several stylised facts emerge from the analysis. First, the financial boom stage went hand in hand with a period of significant deregulation. During these periods, governments weakened existing regulations, softened supervision, and often offered credit subsidies that amplified the boom. Deregulation has preceded every episode since the 1825 crisis. The regulatory stimulus to each boom took various shapes – credit subsidies often targeted the housing sector, while the softening of financial supervision has been discussed in the literature during most episodes. While it is hard to quantify such effects, the episodes from which reliable data can be obtained display a decreased level of supervision during the boom followed by a spike after the crisis, in terms of either funding or staffing of financial agencies. Figure 1 presents some examples.
Figure 1 Budgetary and staffing resources for federal regulatory agencies in the US, Japan, and Spain, plotted against the corresponding stock market indices.
Note: See Dagher (2018) for further details.
Second, a marked increase in corruption and symbiotic relations between politicians and financiers is seen during most episodes. Much has been written on this topic on each isolated episode. Amongst the crises in the 20th and 21st centuries, this pattern is particularly pronounced in the case of the Japanese, Korean, Spanish, and Irish crises.
Third, financial crises have had deep political ramifications, as documented in the literature (e.g Mian et al. 2014). With the exception of the 1825 episode, a political turnover happened shortly after each crisis. But, in most episodes, the political repercussions went far beyond that. In Japan, a political crisis ensued, leading to far-reaching political reforms. The formation of new influential political parties or coalitions, sometimes populist-leaning, has also been seen in Japan, South Korea, Spain, and Ireland. The Great Recession led to a period of increased polarisation and political gridlock.
Fourth, crises generated an immense regulatory backlash and significant overhaul of the regulatory framework. In most instances the response happened shortly after the crisis, except in the case of Japan where a major political crisis led to an infamous period of regulatory forbearance, and reforms were delayed until the late 1990s. In some cases, the re-regulatory phase that followed the financial crisis has been described as an excessive knee jerk reaction, particularly in the US following the Great Depression, the Dot-Com crash, and the Great Recession.
While the Swedish episode did witness a regulatory cycle and a political backlash, it does stand out from the other episodes in that there is limited evidence of inefficient government interventions. One therefore wonders whether a strong level of governance can help mitigate some of the unappealing features of regulatory cycles.
These regulatory cycles seem inefficient and puzzling. Understanding their political underpinnings requires theoretical work that is beyond the scope of this column. However, there are takeaway lessons from the empirical observations that could help inform future theoretical research.
First, and foremost, any explanation of these cycles cannot ignore the changes in public sentiment toward finance over the cycle. The euphoria accompanying booms has been well discussed in the literature (Reinhart and Rogoff 2009), and the political backlash of the financial crises indicate a major shift in public opinion about the financial system. This can be illustrated by the results of a US survey that asks households about their confidence in banks and companies (Figure 2). In Dagher (2018) I also present evidence from a cross-country regression analysis showing that a larger taxpayer cost of a banking crisis is a predictor of a stronger regulatory response following the crisis, based on data from Laeven and Valencia (2012) and a survey carried out by the World Bank.
Figure 2 Percent of respondents with a great deal of confidence in banks and major companies
Source: General Social Survey produced by the National Opinion Research Center at the University of Chicago.
However, one might argue that there is more than just voter sentiment at play. Financial regulations witnessed large and rapid turns. In Dagher (2018) I also present consistent evidence of political pressure exerted on regulators, and an important role of influence-peddling and lobbying. A recent paper, Almasi et al. (2018), combines a signalling model of elections with a simple financial regulation model to study how public opinion, financial innovation, and policymakers’ incentives shape financial regulation. While changes in voters’ perceptions of financial innovation alone can generate a pro-cyclical pattern, the paper also shows that this cyclicality can be significantly amplified by politicians’ electoral incentives.
Author’s note: The views expressed in this column are those of the author and do not necessarily represent the views of the IMF, its Executive Board, or IMF management.
Almasi, P, J Dagher, and C Prato (2018), “Regulatory Cycles: A Political Economy Model”, Working Paper.
Dagher, J (2018), “Regulatory Cycles: Revisiting the Political Economy of Financial Crises”, IMF Working Paper, WP 18/8.
Goldstein, M (2009), “Reforming financial regulation, supervision, and oversight: What to do and who should do it”, VoxEU.org, 24 February.
Laeven, L, and F Valencia (2012), "Systemic banking crises database: An update".
Mian, A, A Sufi, and F Trebbi (2014), “Resolving Debt Overhang: Political Constraints in the Aftermath of Financial Crises”, American Economic Journal: Macroeconomics, 6 (2), 1-28.
Reinhart, C M, and K Rogoff (2009), This time Is Different: Eight Centuries of Financial Folly, Princeton University Press.