Bank Deregulation and the Credit Crunch

The verdict is in, and the consensus on Wall Street is that the Fed is going to ease rates again on December 11, perhaps as much as .5%. Today Steve Liesman, CNBC analyst, argued with some other commentators who felt the banks should be forced to pay a bigger price for their errors, by noting that "this isn't Walmart going down, this is the banking system for God's sake!" On reflection he is probably right--we can't afford to let the banks suffer too much, because when they suffer, we all suffer.

What bothers me about this situation is the fact that nobody seems to want to recognize that what is happening in the banking industry is a natural outgrowth of banking deregulation which occurred in 1999 (one commentator has-http://www.henryckliu.com/page140.html). The Financial Services Modernization Act of 1999 brought down the firewall between commercial banking and investment banking which was put in place after the depression. Before 1999, banks were very conservative institutions. After 1999, they were suddenly allowed to take on a lot more risk and leverage. The banks' failure to effectively manage the risk of investment in mortgage-based derivatives is at the heart of the current crisis.

Now don't get me wrong--I'm not convinced all aspects of financial modernization are bad--in many ways the modernization of this industry has helped fuel worldwide economic growth over the last ten years.

But it seems like we've created a monster--a banking system which is allowed to compete on a laissez-faire basis in the the capital markets, but unlike other market based entities (i.e. Walmart), when it makes a mistake, the Fed will bail it out.

It doesn't sound much like Capitalism to me--it sounds crazy! If the Fed bails out the banks, then the next CEO of Citibank or Merrill will be advised to take on even more risk--after all, great risk can lead to great rewards, and if the gamble fails to pay off, the American consumer can be expected to pay the price through inflation (note the price of oil) as the dollar loses value due to the Fed action.

What can we do? Is it time for Congress to revisit banking regulations to prevent this kind of event from happening again.