Journal of Financial Economics

REF 105 The new Américan finance

The paper deals with the disruptions of the payment system during the National Banking Era in the United States (1863-1913). First, the Government policy and the Treasury action regarding the monetary regime, on the one side, the banking legislation and the institutional framework, on the other side, are described. Second, the consequences of the rule of issue of national notes on the seasonal movements of banking reserves and interest rates are examined. Third, the paper analyses proposition for reforming the National Banking System and shows how the banking reforms where insignificant and finally let the Clearing Houses intervene several times in order to solve financial and liquidity crises.

At the origin of this research, is the conviction that securities transactions performed by banks must not be perceived as a more or less recent innovation but as a permanent feature of banks’ activity emphasizing the unity of the financial system. We first put in perspective the theoretical works on the financial intermediation and the role of banks in the mechanisms of financing. We then describe the main stages of the American national banking system; since its creation in 1863, statutory evolutions have affected both the system and banking practices on securities transactions. We thus analyze the securities transactions for own account of the US commercial banks since 1863 through the transformations of their balance sheet assets. We conclude on the durability of the securities activity of banks but also on its high flexibility.

Some bank reforms of the thirties may have been overvalued. The Glass-Steagall Act created new endogenous risks implying possible systemic effects. Deposit insurance failed to address the main cause of banking panics, the prohibition of bank branching preventing diversification of idiosyncratic risks while reinforcing inefficient unit banks. Separation of commercial and investment banking avoided certain conflicts of interest at an opportunity cost associated with rejecting universal banking. Moreover, the regulator was captured by the regulated as it expressed a preference toward an aggressive participant in a duopolistic conflict.

On the opposite, major innovations in bailout process and prudential regulation appeared underestimated. The Reconstruction Finance Corporation of 1932 established the investor of last resort giving the Treasury the authority to recapitalize an insolvent financial institution deemed too big to fail. The banking regulator, the Federal Deposit Insurance Corporation of 1933, was given a special bank-closure rule, different from the usual bankruptcy proceedings, which allowed for orderly resolution of failing banks with a view to protect the economy from systemic risk.

On a world scale, financial deregulation played a major role. In the US in particular, it is probably the banking sector that has undergone the deepest transformations. Between 1980 and 1991, Congress passed five major laws, taking other legal measures as well, all of which aimed at deregulating the banking sector. The process finally culminated few years later in the repeal of the Glass-Steagall Act. This article analyses the impact of deregulation on banking activities in the US from the eighties up to the 2007 crisis.

Relying on various underlying drivers, consolidation has been a fact of life in the wholesale financial services sector, resulting in fundamental changes in the financial architecture and public exposure to systemic risk. Moreover, financial sector reconfiguration has accelerated as a result of the global market turbulence that began in 2007, with governments either forcing or encouraging combinations of stronger and weaker financial firms in an effort to stem the crisis and improve systemic robustness. In the process, financial firms that are “systemic” in nature and had a major role in creating the crisis have come out of it with even larger market shares and greater systemic importance. Given the episodic socialization of risk in the form of widespread use of public guarantees to firms judged too big or too interconnected to be allowed to fail, the role of systemically important financial institutions (SIFIs) is central to the financial architecture and the public interest going forward. This survey paper considers the sources of systemic gains, losses and risks associated with SIFIs in historical context, in the theoretical and empirical literature, and in public policy discussions – i.e., what is gained and what is lost as a result of the available policy options to deal the dominant role of SIFIs in the financial architecture?

US banks entered the 21st century with high rates of return but they were slashed in half, on an average annual basis, by the outbreak of the subprimes crisis in the summer of 2007. Less than four years after the worst of the financial crisis, US banks have swung back into profits more rapidly than expected, especially given the severity of the crisis. Yet the turnaround was largely due to the decline in the cost of risk, which by nature cannot be replicated, while revenues risk being handicapped over the long term by debt reduction in the non-financial sector, a less favorable interest rate configuration and a tighter regulatory framework. Deeply marked by the financial crisis, the new economic, financial and regulatory environment that is taking shape could put a lasting strain on the financial performances of US banks, and at least partially redefine the banking models that co-existed before the crisis.

The rapid growth of the market-based financial system since the mid-1980s changed the nature of financial intermediation. Within the market-based financial system, “shadow banks” have served a critical role. Shadow banks are financial intermediaries that conduct maturity, credit, and liquidity transformation without explicit access to central bank liquidity or public sector credit guarantees. Examples of shadow banks include finance companies, asset-backed commercial paper (ABCP) conduits, structured investment vehicles (SIVs), credit hedge funds, money market mutual funds, securities lenders, limited purpose finance companies (LPFCs), and the government-sponsored enterprises (GSEs). Our paper documents the institutional features of shadow banks, discusses their economic roles, and analyzes their relation to the traditional banking system. Our description and taxonomy of shadow bank entities and shadow bank activities are accompanied by “shadow banking maps” that schematically represent the funding flows of the shadow banking system.

The American private equity industry has been badly hurt by the financial crisis. After a short period of exuberant boom, it collapsed abruptly. In the aftermath, it has to face three major challenges. Firstly, the shrinkage of activity is such that many general partners may have to quit the market; secondly, investors in private equity funds are taking advantage of this situation to enforce a better governance and to cut the rent of the GP and thirdly, the entrance of the industry in the regulated area will force it to act in a more transparent way. For all, these reasons, the shape of the American private equity will certainly deeply change and evolve towards a more standardized operating mode.

The purpose of this article is to demonstrate a certain internal incoherence within the professional fund management industry, and in particular within the American pension funds. Following a discussion of the structure of the industry of pension fund management, and the special role of public pension funds particularly with respect to corporate governance and sustainability issues, a peculiar form of self-deception is demonstrated in the latter: their actions are often not in accordance with stated policies in this area. The author identifies two self-contradictory tendencies which dominate the current debate regarding corporate governance and the responsibility of investors, including the pension funds, for the current crisis. One, short-termism, is integral to the nature of savings and of the professional management of retirement monies for others. Whatever amelioration of this tendency is possible would have to come from outside the industry itself. The other, a prevalence of conflicts of interest particularly focused upon issues of investor involvement in the governance and sustainability of the business models of corporations, is a by-product of the current structure of the industry, and could be ameliorated by internal reforms initiated within the industry itself.

By treating derivatives and financial repurchase agreements much more favorably than it treats other financial vehicles, American bankruptcy law subsidizes these arrangements relative to other financing channels. By subsidizing them, the rules weaken market discipline during ordinary financial times in ways that can leave financial markets weaker than they would be otherwise, thereby exacerbating financial failure during an economic downturn or financial crisis emanating from other difficulties, such as an unexpectedly weakened housing and mortgage market in 2007 and 2008. Moreover and perhaps unnoticed, because the superpriorities in the Bankruptcy Code are available only for short-term financing arrangements, they thereby favor short-term financing arrangements over more stable longer term arrangements. While proponents of superpriority justify the superpriorities as reducing contagion, there’s good reason to think that they in fact do not reduce contagion meaningfully, did not reduce it in the recent financial crisis, but instead contribute to runs and weaken market discipline. A basic application of the Modigliani-Miller framework suggests that the risks policymakers might hope the favored treatment would eliminate are principally shifted from inside the derivatives and repurchase agreement markets to creditors who are outside that market. The most important outside creditor is the United States, as de jure or de facto guarantor of too-big-to-fail financial institutions.

The article argues that a major omission in the Dodd-Frank financial reform act focuses on the problem of to interconnected to fail banks and non-bank (shadow) banks. While Dodd-Frank promises “no more” bailouts of too big to fail banks (TBTF) and non-bank banks, the paradox of a lacking a major focus on too interconnected to fail institutions (TITF) is actually to: increase systemic risk under some conditions; and create a “back door” set of complex and contorted processes to “bailout” financial institutions in spite of political promises not to. This is accomplished by removing 'bailout’ authority from the Federal Reserve and creating an Orderly Liquidation Authority modelled on the Federal Deposit Insurance Corporation which along with the Department of the Treasury can in fact “bailout” financial institutions under certain conditions. Yet this new authority may fail given its focus on TBTF rather than (as well) TITF structures.

The financial crisis has made central banks use functions that had been largely ignored for decades. At the beginning of the 20^th century, central banking was about price stability and open-market activity. Since 2008, the functions of financial stability and of liquidity provider to illiquid financial institutions have been rediscovered. From now on, central banks will have to operate broader roles: regards on macroeconomic policy, implementation of macro-prudential policy and regulation of financial institutions. With these broader responsibilities, the environment in which central banks operate will also change becoming more political.

The US regulatory system has multiple regulators on the federal and state level, many with overlapping jurisdiction. The result has been both overregulation and underregulation – in some cases, the same entity may be subject to different (and perhaps inconsistent) regulation for the same activity, while in other cases certain activities may remain unregulated in the midst of a complex regulatory patchwork. Regulatory reform in the United States provided a unique opportunity for reform of this archaic and byzantine regulatory structure. Yet, remarkably, the drafters of Dodd-Frank Act – an 849-page bill that includes 400 rulemaking requirements, implicates 25 regulators and creates 2 new ones – perpetuated many of these flaws. This Article focuses on one of the clearest examples of complication in the U.S. regulatory structure exacerbated by the Dodd-Frank Act – the division of the regulation of securities, futures and (now) swaps between the Securities and Exchange Commission and the Commodity Futures Trading Commission.

The financial crisis that took hold in 2008 had many causes, but consumer financial products originated in the United States were at its heart. This article discusses the U.S. regulatory framework that existed before the crisis, with a particular emphasis on the decentralized approach to regulating consumer financial products and the attendant lack of supervisory attention to these products. We then discuss the products that emerged during this period of lax oversight, including the subprime mortgages that eventually threatened the global financial system. In the third section we discuss the broad legislative response to the crisis, a key component of which was a new federal agency: the Consumer Financial Protection Bureau. We conclude with the agency’s near-term priorities, including better supervision of nonbank providers of consumer financial products, simpler financial disclosures, and stronger standards for originating and servicing mortgages – and note that the agency’s success depends to some extent on managing the political controversy that surrounds its very creation and its new director.

While the creation of the credit rating industry traces back to the beginning of the twentieth century, conflicts of interest have emerged particularly since the 1970s, and they escalated in the run-up to the subprime mortgage crisis. In the 1970s, the leading credit rating agencies shifted from an investor-pays to an issuer-pays business model, i.e. issuers that were willing to be rated started to hire the agencies. This shift has been best explained by the quasi-regulatory role given to the leading agencies by regulators in the United States and later worldwide. Consequently, the leading credit rating agencies Moody’s, Standard & Poor’s and Fitch have become increasingly profitable. However, numerous rating scandals during the recent financial crisis highlighted the fact that credit ratings have in fact little informational value as compared to the significant revenues they generate. This paradoxal situation gives rise to concern about the lack of regulatory oversight in the credit rating industry and the need of monitoring conflicts of interest. In the United States, the Dodd-Frank Act of 2010 partly addresses these concerns in its credit rating agency reform.

In this article, Paul Volcker, one of the principle architects behind the regulatory response and financial reform legislation in the United States, outlines the remaining reforms necessary to complete the structural changes to the US financial system. Specifically, he directs governments and central banks to move to adopt international accounting standards, increase competition among credit rating agencies, and finalize policies to end “too big to fail.” The article stresses that the reform effort is incomplete and structural change is necessary.