Deregulation and innovation and the sub prime crisis

Rapid deregulation and financial innovation combined to set the stage for the sub prime crisis. This blog provides a brief hsitorical perspective.
After the economic turmoil of the 1970s, the market economy found passionate champions in Ronald Reagan and Margaret Thatcher. Believing that freer markets would bring economic gains, they took the plunge and abolished various controls. Both Reagan and Thatcher had a lot of fan following. And they commanded respect in many countries. Liberalisation of the financial system soon became a major theme in many developed countries.
In London, the Big Bang of 1986 abolished the distinction between brokers and jobbers and allowed foreign firms, with more capital, into the market. These firms could handle larger transactions, more cheaply. The Big Bang undoubtedly played a big role in the emergence of London as a preeminent global financial centre. Meanwhile, the No.1 financial centre in the world, New York had already introduced a similar reform in 1975, following pressure from institutional investors.
These reforms had major implications for the business models of market participants. The fall in commissions contributed to the long-term decline of broking as a source of revenue. The effect was disguised for a while by a higher volume of transactions. But the broker-dealers (the then popular name for investment bankers) increasingly had to commit their own capital to deals. In turn, this made trading on their own account, or proprietary trading, a potentially attractive source of revenue. No bank made more impressive strides in this area, than Goldman Sachs.
Meanwhile, commercial banks faced intense competition in corporate lending. At the same time, retail banking required expensive branch networks. Naturally, commercial banks wanted to diversify into more lucrative “fee based” businesses. With their strong balance-sheets, they started to compete with investment banks for the underwriting of securities. Investment banks responded by getting bigger. As banks became more diversified, they also became more complex.
As the same time, there were major advances in risk management thanks to innovative financial instruments and sophisticated quantitative techniques. Option contracts have been known since ancient times but the 1970s saw an explosion in their use. The development of the Black Scholes Merton Option Pricing Model, for which Myron Scholes and Robert Merton later won the Nobel Prize, no doubt played an important role. While Black Scholes enabled options trading to take off, other derivatives also became rapidly popular. Currency swaps and interest-rate swaps enabled hedging and speculation in currency and interest rate risk respectively. More recently, credit derivatives have made possible the slicing and dicing of credit risk in ways which would have been unimaginable about 40 years back.
The concept of securitisation rapidly became popular. Securitisation was projected as a mechanism for spreading risk and creating new growth opportunities for banks by freeing up capital. Commercial banks did not have to depend on the slow and costly business of attracting retail deposits to fund their transactions. Of course, securitisation was also misused by some market participants. That is how the sub prime crisis was fuelled.
As deregulation gathered momentum, the global financial system faced crises from time to time. These included the failures of Drexel Burnham Lambert, which dominated the junk-bond market and the collapse of Barings. But these crises were regarded as individual instances of mismanagement or fraud, rather than evidence of any systemic problem. The American savings-and-loan crisis, (mentioned earlier) which was a systemic failure was resolved with the help of a bail-out plan and easy monetary policy, and dismissed as an aberration. Even the Long Term Capital Management crisis of 1998 did not create any serious problems. A Fed sponsored bailout ensured that the markets continued to function normally.
But the recent financial meltdown has resulted in a lot of soul searching about the merits of aggressive deregulation. The melt down has been unprecedented in terms of magnitude and impact. The long drawn out crisis is a reflection of how complex and inter connected the world of finance has become. An array of financial instruments has emerged that make it possible to bundle, unbundle and rebundle risk in various ways. Deregulation, technology and globalization have transformed the world of finance beyond recognition. At the end of 2007, the notional value of all derivative contracts globally was estimated at $600 trillion or 11 times the world GDP. Ten years back, it had been $75 trillion or 2.5 times the world GDP.

Clearly, finance has grown much more rapidly than the underlying, “real” economy. That probably explains why regulation has become so difficult.