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Foreword: Deregulation: a Major Cause of the Financial Crisis

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Foreword: Deregulation: a Major Cause of the Financial Crisis 30376-hlp_5-2 Sheet No. 5 Side A 09/07/2011 15:01:13 \\jciprod01\productn\H\HLP\5-2\HLP210.txt unknown Seq: 1 25-AUG-11 10:47 Foreword: Deregulation: A Major Cause of the Financial Crisis Brooksley Born* INTRODUCTION I am delighted to introduce this Harvard Law and Policy Review Sym- posium on Regulation and Institutional Reform. The articles in this issue explore the importance of government regulation of business in protecting the health and welfare of the American people. The Truth About Regulation in America describes the critical need for safety regulations provided by sev- eral federal agencies devoted to protection of consumers, workers, and the environment. The Big Squeeze: The Communications Crisis in America fo- cuses on increasing concentration in the communications industry, the re- sulting reduction in competition, and its implications for the public. Business as Usual? Analyzing the Development of Environmental Standing Doctrine Since 1976 presents an empirical analysis of the application of standing rules in environmental cases, with some encouraging results for environmental advocacy groups. Finally, Federal Funding and the Institu- tional Evolution of Federal Regulation of Biomedical Research describes challenges in federal oversight of medical research in an era where funding and other aspects of the research are changing. My recent service as a member of the Financial Crisis Inquiry Commis- sion (“FCIC”) brought home to me how important it is for us to reexamine the role of business regulation. We are now experiencing the tragic results of thirty years of deregulatory pressures in the financial sector. The FCIC 30376-hlp_5-2 Sheet No. 5 Side A 09/07/2011 15:01:13 quite rightly concluded that failures in financial regulation and supervision along with failures of corporate governance and risk management at major financial firms were prime causes of the financial crisis engulfing this coun- try in 2007 and 2008.1 As the report recently issued by the FCIC documents, decades of der- egulation and failure to regulate newly emerging financial markets, firms, and products led to a financial system that was extremely fragile and vulner- * Brooksley Born was a Commissioner on the Financial Crisis Inquiry Commission from mid-2009 until February 2011. She is a retired partner of Arnold & Porter LLP and served as Chair of the Commodity Futures Trading Commission, the federal independent regulatory agency for futures and options, from 1996 to 1999. In that role she warned about the dangers of unregulated derivatives. 1 FIN. CRISIS INQUIRY COMM’N, FINANCIAL CRISIS INQUIRY REPORT at xviii-xix (2011), available at http://fcic-static.law.stanford.edu/cdn_media/fcic-reports/fcic_final_report_full. pdf [hereinafter FCIC REPORT]. The FCIC was created by section 5 of the Fraud Enforcement and Recovery Act of 2009 and was directed “to examine the causes, domestic and global, of the current financial and economic crisis in the United States.” Pub. L. No. 111-21, § 5(a), 123 Stat. 1617, 1625 (2009). It issued the FCIC Report on January 27, 2011. 30376-hlp_5-2 Sheet No. 5 Side B 09/07/2011 15:01:13 \\jciprod01\productn\H\HLP\5-2\HLP210.txt unknown Seq: 2 25-AUG-11 10:47 232 Harvard Law & Policy Review [Vol. 5 able to a full-blown crisis when the U.S. housing bubble collapsed. Federal Reserve Board (“Fed”) Chairman Ben Bernanke told the FCIC, [P]rospective subprime losses were clearly not large enough on their own to account for the magnitude of the crisis. Rather, the system’s vulnerabilities, together with gaps in the government’s crisis-response toolkit, were the principal explanations of why the crisis was so severe and had such devastating effects on the broader economy.2 The FCIC found that these vulnerabilities in our financial system were the direct result of a growing belief in the self-regulating nature of financial markets and the ability of financial firms to police themselves. Former Fed Chairman Alan Greenspan—a laissez-faire economist—championed these beliefs during his nineteen years in office. With support from large financial services firms, their trade associations, and like-minded economists, he was able to persuade a number of policy makers in several successive presiden- tial administrations, members of Congress, and federal financial regulators to support deregulatory efforts on the false assumption that self-regulation would be sufficient to protect the financial system and our economy against excesses in the market. As he argued in 1997, “[I]t is critically important to recognize that no market is ever truly unregulated. The self-interest of mar- ket participants generates private market regulation. Thus, the real question is not whether a market should be regulated. Rather, the real question is whether government intervention strengthens or weakens private regulation.”3 The FCIC found that the financial sector devoted enormous resources to its effort to convince federal policy makers of the need for deregulation. In the decade leading up to the financial crisis, the sector spent $2.7 billion on federal lobbying efforts, and individuals and political action committees 30376-hlp_5-2 Sheet No. 5 Side B 09/07/2011 15:01:13 (“PACs”) related to the sector made more than $1 billion in federal election campaign contributions.4 Fannie Mae and Freddie Mac, government-spon- sored entities with a public mission to support the mortgage market, exem- plify the political power financial services firms used to resist regulation. From 1999 to 2008, they spent $164 million on lobbying efforts, and their employees and PACs made $15 million in campaign contributions.5 As stated by Armando Falcon, Jr., who headed their federal regulator, “[T]he Fannie and Freddie political machine resisted any meaningful regulation us- ing highly improper tactics.”6 2 FCIC REPORT, supra note 1, at 27; Ben Bernanke, Chairman, Bd. of Governors of the Fed. Reserve Sys., Written Statement before the FCIC 2 (Sept. 2, 2010). 3 FCIC REPORT, supra note 1, at 53–54; Alan Greenspan, Chairman, Bd. of Governors of the Fed. Reserve Sys., Government Regulation and Derivative Contracts, Remarks at the Fi- nancial Markets Conference of the Federal Reserve Bank of Atlanta (Feb. 21, 1997) (transcript available at http://www.federalreserve.gov/boarddocs/speeches/1997/19970221.htm). 4 FCIC REPORT, supra note 1, at 55. 5 Id. at 41–42. 6 Id. at 42; Armando Falcon, Jr., Written Testimony before the FCIC 5 (Apr. 9, 2010). 30376-hlp_5-2 Sheet No. 6 Side A 09/07/2011 15:01:13 \\jciprod01\productn\H\HLP\5-2\HLP210.txt unknown Seq: 3 25-AUG-11 10:47 2011] Foreword: Deregulation: A Major Cause of the Financial Crisis 233 As a result of these pressures, significant regulatory gaps developed in the financial system including the lightly regulated shadow banking system that grew to rival the traditional banking system in size and importance and the enormous market in deregulated over-the-counter derivatives. A number of investment banks grew to be of systemic importance without adequate oversight. Institutional supervision of large bank holding companies, com- mercial banks, and thrifts was gradually weakened, allowing them to engage in riskier activities. Mortgage lending standards deteriorated, and securitiza- tion of mortgage-related assets burgeoned with little regulatory scrutiny. These developments created the conditions that caused the collapse of the housing bubble to turn into a major financial crisis. As Fed Chairman Ben Bernanke told the FCIC, “As a scholar of the Great Depression, I honestly believe that September and October of 2008 was the worst financial crisis in global history, including the Great Depression.”7 As a member of the FCIC, I voted in favor of adopting and issuing its report, which is a comprehensive history of the financial crisis and its causes. The report is based on an extensive investigation, which included nineteen days of public hearings, interviews with more than 700 witnesses and review of millions of pages of documents. I commend the report to the reader. It fully supports the FCIC’s conclusions about the devastating role that inadequate regulation played in causing the financial crisis and the re- sulting economic crisis we are still suffering today. During the late 1990s, as chair of the U.S. Commodity Futures Trading Commission (“CFTC”), I participated in the debate described in Section III below about whether the over-the-counter derivatives market should be reg- ulated. The CFTC was concerned that the rapidly growing and opaque mar- ket posed dangers to market participants and the financial system as a whole and asked whether a regulatory scheme similar to that imposed on futures and options markets would significantly reduce those dangers. Deregulatory 30376-hlp_5-2 Sheet No. 6 Side A 09/07/2011 15:01:13 forces prevailed in the debate, and during the FCIC’s investigation it came as no surprise to me as evidence demonstrated that excesses in the deregulated over-the-counter derivatives market played a major role in the financial crisis. Beyond that, however, the FCIC investigation revealed that financial deregulation was not limited to the derivatives market, but has been perva- sive, extending to mortgage lending, securities regulation, and institutional supervision, among other areas. Described in more detail below are some of the deregulatory actions that the FCIC found contributed significantly to the financial crisis. Without comprehensive financial regulatory reform such as that contained in the Wall Street Reform and Consumer Protection Act (“Dodd-Frank Act”) enacted last year,8 we would remain vulnerable to the dangers of widespread regulatory inadequacy. 7 FCIC REPORT, supra note 1, at 354; Interview by the FCIC with Ben Bernanke, Chair- man, Bd. of Governors of the Fed. Reserve Sys., 24 (Nov. 17, 2009). 8 Pub. L. No.
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