History of Financial Regulation in the US

Sources:
https://www.nber.org/papers/w17443
https://www.asz.hu/storage/files/files/public-finance-quarterly-
articles/2012/a_313_331_biedermann.pdf
Debate about how to regulate financial activity began at the Constitutional Convention
in 1787 and continued unabated for two centuries.
o At the Constitutional Convention in 1787, delegates debated how to regulate
financial activity. Some delegates advocated the creation of a national currency
and a national bank. Other delegates opposed those proposals and argued that
the regulation of financial activity should be left to state governments. Bitter
divisions engendered broad comprises.
o Constitution Article 1, Section 8 provides Congress with powers to
Borrow money on the credit of the United States
Coin money, regulate the value thereof, and of foreign coin
Regulate commerce with foreign nations and among the several states

Establish uniform laws on the subject of bankruptcies throughout the
United States.
o In 1791, Congress chartered First Bank of the United states to handle financial
needs of federal govt and the credit/coinage of the nation (charter expired in
1811)
o In 1816, Congress chartered second bank of US, charter expired in 1836
Both these charters expired because politicians disagreed about the
federal governments role in the regulation of the financial system.
Politicians from northern industrial states favored federal government.
Politicians from southern and western states feared financial
conglomerates and favored regulating financial activity through state
legislatures. Their opposition prevented the United State from
establishing a central bank, or a uniform fiat currency, or uniform
nationwide regulations for financial institutions.
o At this point, state govts filled the gaps (enforced contracts, chartered
corporations and regulated their behaviour)
o Chartering a bank was profitable. By middle 1830s, it was easy for financiers to
charter and open new banks. Banks opened in huge numbers, each bank issued
its own currency, which traded at an exchange rate that reflected the banks
reputation and risk of default.
State governments left bank regulation to market forces
Half of all banks failed, most within a few years
This era is called The Era of Wildcat Banking
Civil War
 o Provided opportunity to reform financial systemsouthern politicians who
opposed federal regulation of financial markets withdrew from Congress
o Without Southerners there, Congress passed National Currency Act (1863)
Established national currency printed by US Treasury and issued by
commercial banks
Value of notes that commercial bank could issue was proportional to the
value of the capital the bank deposited with the Treasury
o 1864Congress passed National Banking Act, established a system for issuing
federal charters to commercial banks and authorized the Office of the
Comptroller of Currency to supervise those banks
o Government of 36 states regulated financial activity within their statemost
possessed an agency that regulated activities of commercial banks, loan
corporations, etc.
Responses to financial Panics, 1890-1930
o Between civil war and WWI, financial panics occurred frequently
Major ones in 1873, 1893, and 1907
o After these panics, legislators wanted to reform financial regulation
Eg. 1898 Bankruptcy Actfederal court procedures for liquidation of
corporations unable to pay creditos
1907 panic inspired creation of Federal Reserve System
o Federal Reserve System:
12 district banks, each acting as central bank for a region of the nation
Board of directors in Washington who coordinated (not controlled)
activities of system
However, state govts continue to be principal regulators of financial
activity
Not all banks were members of federal reserve systemfed can
only regulate member banks
Policy Responses to the great depression
o Thousands of banks failed during the economic contraction beginning in 1929
until March 1933
o By 1933, public lost faith in banks in generalpeople not willing to deposit
money, 28 states closed all financial institutions
Prompted president to declare national banking holiday, which shut
down all financial institutions for 7 business days
o In response to disaster, Fed Govt changed structure of financial regulation
o 1933Pass Banking Act of 1933 (Aka Glass-Steagall)
1. Established nation-wide deposit insurancecreated the Federal
Deposit Insurance Corporation (FDIC) for this purpose.
2. Separated commercial from investment bankingrequired
commercial banks to sell their security affiliates and restricted bond
departments. Use of bank credit for speculation is restricted.
3. Imposed stricter regulations on financial institutions
 eg. Prohibited employees at a bank from borrowing from their
own institutions
Increased minimum capital requirements for banks
Prohibited private banking (private bankers = rich individuals who
accept deposits, make loans, etc.)
o 1933: Securities Act
established federal regulation of security issuances
o 1934: Securities Exchange Act
established Securities and Exchange Commission (SEC) to regulate
issuance, purchase, and sale of securities
required all public companies to submit periodic financial statements
Constructing Modern Financial System (1940-1980s)
o Financial markets operated mostly calmly from 1940s through 1980s
o SEC had preference for industry self-regulation whenever possible
Eg. Defer setting accounting standards to the private Financial Accounting
Standards Board (FASB)
o FDIC
Practices influence bank behaviour
ALL banks insured by FDIC must submit Call Report of conditions and
income for the bank each quarter
FDIC maintains this information and makes it publicly available
FDIC handles bank failures
o Other acts passed
Commodity Futures Trading Commission (CFTC)supervised commodity
exchanges
Employment Retirement Income Security Act (ERISA) passed to protect
retirees
Designed major parts of retirement system in place today
Home Mortgage Disclosure Act (HMDA) designed to prevent
communities from not getting enough investment due to geography
Ensure depository institutions are providing adequate services to
all geographic areas
Securities Acts Amendments (1975)
SEC created National Market, National Clearing Systems
Goal: improve competition, liquidity, efficiency, and stability in
securities markets
Modern Financial System Part II (1980 1995)
o What caused these changes?
New prevalence of pro-free market ideology in policy debates
Globalization forced financial institutions in US to compete w/
international competitors in less regulated environments
Inflation was growing at unprecedented levels, destabilizing Great
Depression-era systems
 o Financial institutions lobbied congress to de-regulate them for these reasons,
and congress (in part due to free market ideology) agreed
This led to bankrupt, but fully insured institutions expanding operations
into areas of financial services in which they had little/no experience
o Since the Banking Act of 1933, banks were prevented from being in both
commercial and investment industries
Gramm-Leach-Bliley (GLB) Act sought to allow increased competition by
repealing these rule
o Federal Deposit Insurance Corporation Improvement Act (FDICIA) (1991)
Aimed to implement principles of prompt corrective action (PCA) and
least-cost resolution (LCR) in bank regulation
Aimed to fix issue of perverse incentive for regulators to turn a blind-
eye and later receive a job in the industry that benefitted
Added new concepts like risk-based deposit insurance, higher capital
minimums, etc.
Added the too big to fail policybased on the premise that the failure
of a large institution could have a domino effect, starting bank runs that
could bring down the financial system.
Basically, if a bank is a certain size, the FDIC has to guarantee it,
no matter what (even if risk level, capital amount, etc. are
insufficient)
Fine Tuning the System (2000-Present)
o Sarbanes-Oxley (SOX)
Response to accounting scandals (Enron, Xerox, etc.)
1. Attempted to provide all market participants with access to same
information about companies
2. Made CEO and CFO of all public companies sign the balance sheets
they submit to SEC, making them more accountable (perjury if they lie)
3. Mandated more monitoring by accountants
Also gave SEC task of reviewing FASBs creation of Generally Accepted
Accounting Principles (GAAP)
o Dodd-Frank Wall Street Reform and Consumer Protection Act (aka Dodd-Frank,
2010)
Response to financial crisis, restructured regulatory system
Major parts:
Overhaul of bankruptcy code
Re-regulation of derivatives that had been previously de-
regulated
Regulations disallowing bailouts
Volcker Ruleprohibits banks from operating in both
commercial banking and investment industrieseffectively a
repeal of Gramm-Leach-Blileys deregulation
 Holds NRSRO (Nationally Recognized Statistical Ratings
Organizations) accountable for their ratingsnot being held
accountable and giving everything AAA ratings was a major
cause of financial crisis
The Future
o Will it happen again?
o Well, prior to the Great Depression panics happened periodically, as they do.
However, Great Depression was the biggest of all
o As a response to the great depression, policymakers said never again and
slapped regulations on that stood for 50+ years.
o However, in the 80s and more so the 90s, these Depression-era restrictions were
dismantled but no action taken to solve systemic problems
o This deregulation largely lead to the 2007-2009 Financial Crisis