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Policy, Regulatory Failures Caused Crisis


Policy, Regulatory Failures Produced Meltdown

UC Riverside political scientist John Cioffi analyzes why world financial markets collapsed in the current issue of Policy Matters.

(June 14, 2010)

John W. Cioffi

John W. Cioffi

RIVERSIDE, Calif. – The meltdown of U.S. and global financial markets that began with the collapse of Lehman Brothers investment bank in September 2008 was not caused by a perfect storm of random market developments or the failure of economic models to account for outlier market conditions, as some economists have argued.

Rather, it was the result of pervasive regulatory failures and failed policies that enriched and empowered a financial sector which, freed of policies designed to prevent another Great Depression, engaged in reckless and predatory behavior, political scientist John W. Cioffi contends in a paper published today in Policy Matters, a quarterly journal published by the University of California, Riverside.

As Congress considers financial reform legislation that may reach President Obama’s desk this summer, Cioffi writes, “The collapse of (the banking) system during the crisis of 2007-2009 … was not really a financial market crash or liquidity crisis, but rather the largest banking run in history that revealed the insolvency of the shadow banking system.” Cioffi is an assistant professor of political science at UC Riverside and an expert on regulation and regulatory politics.

The crisis spread from the unregulated and least regulated areas of the financial system – mortgage-lending practices and standards, investment banks and hedge funds of the shadow banking system, securitized debt instruments, derivatives, credit rating agencies, and leverage ratios, he writes in “The Global Financial Crisis: Conflicts of Interest, Regulatory Failures, and Politics.” Cioffi has spent a decade researching and analyzing the political foundations of financial regulation in the United States and Europe, research that is the basis of his book “Public Law and Private Power,” which Cornell University Press will publish in November.

Cioffi details the role of the mortgage-backed securities (MBS) and collaterized debt obligation (CDO) markets in triggering and worsening the financial crisis of 2007-2009; the impact of deregulation of banking and the securities business; the failure of regulatory agencies to curb predatory or excessively risky mortgage lending; and missed opportunities for substantial structural and regulatory reforms.

Failures of public law and private incentives “fueled the increase of pathological behaviors and systemic risks,” Cioffi explains. “The failure of the regulatory state represented by the financial crisis was the product of the neo-liberal turn of American economic and regulatory policy embraced by both the Republican and Democratic parties. … This idealization of the private sector conceived of markets as largely self-regulating and thus provided a justification for deregulation and limits on regulatory enforcement. Supported by a potent coalition of pro-business interest groups, neoliberalism came to dominate policy making in the Untied States after the 1970s, and in no area was it more influential than financial services.”

There was ample warning of trouble to come, Cioffi contends. Market and regulatory failures had already spawned serious financial and economic crises, including the crash of the junk bond market in the late-1980s, the savings and loan crisis of the late 1980s and early 1990s, the LTCM hedge fund collapse in 1998, the late 1990s stock market bubble and its crash in 2000-2001, and the subsequent Enron-era corporate governance and accounting scandals.

“Political actors not only failed to enact adequate reforms despite the increasing severity of earlier crises, they continued to deregulate the financial sector. Furthermore, regulators failed to adequately enforce many of the rules that were in place,” he says.

Although the threat of a second Great Depression has abated for the moment, Cioffi warms that the political, economic and regulatory consequences and implications of the financial crisis linger.

Cioffi argues for financial reform that effectively regulates derivatives, addresses the “too-big-to-fail” problem of systemically vital financial institutions, and extends financial regulation to the broader shadow banking system. Conflict of interest regulation needs to be substantially strengthened and extended across the financial sector, including the debt ratings agencies, and stronger enforcement mechanisms are needed to ensure that legal reforms are not rendered meaningless in practice, he says.

However, Cioffi criticizes the draft legislation pending in Congress as failing to address the fundamental structural problems plaguing the American financial system. As a congressional conference committee takes up financial regulation reform this week to reconcile the differences between bills passed by the House and Senate, the reforms embodied in these versions may be diluted further during negotiations. Although the financial reform bill passed by the Senate was stronger than many anticipated, this reflected more a low regard for Congress than a high estimation of the likely adequacy of reform to curb the systemic risks and the power of large financial institutions, or to prevent another financial crisis.

Cioffi concludes that the political stakes in the battle over financial reform are enormous. “The corrosive perception of state capture by the financial sector is not only one of the most serious threats to the Democratic Party’s electoral fortunes, it is also a portent of an intensifying legitimacy crisis afflicting American politics across the political spectrum,” he says. “Financial collapse exposed massive regulatory failures and revealed the intellectual, ideological and economic bankruptcy of the neo-liberal variant of finance capitalism. Should efforts to reform the financial system fail, and thus fail to prevent another serious crisis, the next catastrophic bankruptcy may be political.”

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