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Avoid the Next Crisis: Regulate Shadow Banks

The 1800s was a period of considerable instability in the financial sector, with major financial disruptions occurring in 1819, 1837, 1857, 1873, and 1893. This continued into the 1900s with the banking panic of 1907, culminating in the severe banking collapse from 1930 to 1933, and the large number of bank failures was a major factor in the Great Depression.

The response to this collapse in the financial system was the Banking Acts of 1933 and 1935. After these acts were imposed, the performance of the financial sector was markedly different from the tumultuous period prior to the regulation, and we enjoyed a fifty year time period of relative calm within the financial sector without any apparent limitations on our ability to sustain robust economic growth.

But the end of this stable period began with the change in regulatory philosophy ushered in during the 1980s, a change that led to an easing of the restrictions faced by financial firms. In addition, and importantly, the change in philosophy also allowed new types of financial firms and products created through financial innovation to escape the regulatory umbrella that covered the traditional banking sector.

This shadow or non-traditional banking sector grew rapidly, and the vulnerability of the financial system to collapse grew along with the growth in the unregulated sector. Unfortunately, when the mortgage finance bubble popped this vulnerability was realized, and we find ourselves where we are today.

The question is what we should do now to fix the damage that has been done, and to ensure it doesn't happen again. On the latter point, the subject of this discussion, I believe we need to extend the regulatory umbrella broadly and bring the non-traditional banking sector under the same regulatory authority as
the traditional banking sector. Nobel Laureate Robert Lucas explains one reason why this is necessary:

The regulatory problem that needs to be solved is roughly this: The public needs a conveniently provided medium of exchange that is free of default risk or "bank runs." The best way to achieve this would be to have a competitive banking system with government-insured deposits.

But this can only work if the assets held by these banks are tightly regulated. If such an equilibrium could be reached, it would still be possible for an institution outside this regulated system to offer deposits that are only slightly more risky but that also pay a higher return than deposits at the regulated banks. Some consumers and firms will find this attractive and switch their deposits. But if everyone does, the regulations will no longer protect anyone.

He also says:
The regulatory structure designed in the 1930s seemed to solve this problem for 60 years, but something else will be needed for the next 60.
And that "something else" must, for one thing, close the pathways that allow financial firms to bypass regulatory scrutiny, or as many as it can anyway. We will never close every hole or anticipate every possible way that the system might be exploited and made vulnerable. But our best chance of getting as close as possible to this ideal -- our best chance of closing enough of the pathways so that those that remain open are not collectively large enough to endanger the entire financial structure and the broader economy -- is to impose broad based, comprehensive regulation that prevents excessive accumulations of risk and fixes other market failures.

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