ABSTRACT
Significant reform of the institutional structure of the financial system is “on the agenda.” To understand the possibilities for reform, it is necessary to understand the concrete conditions created by the historical evolution of the financial system.
The system of financial regulation in the United States was constructed in the 1930s. It was based upon two principles: (1) restriction of competition among financial institutions and (2) government protection, including federal insurance of deposits and a federal commitment to prevent financial panics. Its structure was designed for the economic conditions of the times—an environment of low inflation and interest rates, high liquidity, and low debt levels. Because those conditions also characterized the early post-World War II period, the system of financial regulation promoted stability.
But as economic conditions began to change, banks and thrifts (primarily savings and loan associations [S&Ls]) experienced increasing difficulties. Financial innovation and technological change have made possible a partial dismantling of the barriers to competition that previously protected banks and thrifts. Government protection has expanded dramatically in response to these intermediaries’ problems, for example, protection of banks “too big to fail” and the S&L bailout.
Therefore proposals for reform need to take account of the following concrete conditions: (1) the continuing need for government protection in light of financial intermediaries’ present difficulties and the environment of high debt levels, (2) the difficulty of “rolling back the clock” to a regulatory structure no longer compatible with current economic conditions, and thus (3) the need for mechanisms to promote stability in place of restricted competition.
Reform proposals based on free market principles alone eliminate the old regulatory structure but provide no new mechanism to promote stability. They 134run the risk of either financial crises or further taxpayer bailouts of financial institutions. An alternative approach would introduce a framework of public regulation to incorporate public policy goals explicitly into financial institutions’ behavior. The issues then become (1) how to formulate this public regulation so it benefits the broad majority and (2) how to carry it out democratically.
