Question

Discuss the viability (workability) of deregulating financial accounting and using market forces to control the quality of F/S reporting—Please use the perspectives of: PAT, Normative Accounting, and Stakeholder/Legitimacy.

Answer 1

Financial deregulation in recent years has vastly increased the ability of the financial markets to allocate international capital efficiently. It has also sparked explosive growth in financial transactions and resulted in a restructured, more competitive, and less costly financial services industry. But the deregulation has proceeded so rapidly that the volume of purely financial transactions now greatly exceeds that of transactions driven by international trade in goods and services. This new pattern has led to growing economic uncertainty and instability. Markets now run around the clock and respond to change so rapidly that there is a growing danger of chain reactions that could precipitate global market failure. Regulators in the major trading nations need to address the possibility of a full-scale breakdown of the financial system.

In May 2018, by 258 in favor and 159 against, the US Congress adopted the Economic Growth, Regulatory Relief, and Consumer Protection Act. This bill represents the most significant change in the Dodd-Frank Act which was adopted after the 2008 financial crisis to protect the economy against future crises. Summarizing first the different waves of financial regulation and deregulation in the US history, this article will analyze this latest bill and its implications.

History of financial regulation/deregulation

The earliest regulation to the financial sector can be traced back to the 1907 Bank run. After a failed takeover bid, Knickerbocker Trust Co., the largest US bank at that time, lost the trust of its customers and was subject to a bank run which quickly spread to the whole banking sector.

The resulting liquidity crisis led to the closure of several banks. In response, Congress created the Monetary Commission in 1913, and adopted a set of rules designed to manage money supply and demand, as well as to dampen boom-bust cycles and the risk of escalation.

The 1920s were marked by a series of deregulations promoted by policymakers, allowing a credit bubble to grow. The resulting Great Depression of 1929 led to the first stringent and serious regulation of the financial sector: the Glass Steagall act. The core of Glass Steagall was the separation of commercial and investment banking, designed to prevent banks from risking customers’ deposits in financial gambling. Decades after its adoption, Glass Steagall was slowly eroded by a series of bills, culminating in the Gramm-Leach-Bliley Act which completely repealed it. In doing so, this bill removed barriers imposed by Glass-Steagall in the market among banking companies, securities companies and insurance activities. Since then, through the absence of serious rules to constrain financial actors in their activities, the way was paved for another major financial crisis.

In 2008, the subprime crisis hit the US and spread quickly to the whole world. In response, the Dodd-Frank Act was adopted in 2011. This act again set up stringent rules and established a number of new government agencies designed to oversee the financial system.However, years after the 2008 financial crisis, critics once again bemoaned Dodd-Frank as excessively stringent and debilitating for growth.After several years of discussion among lawmakers, the Economic Growth, Regulatory Relief, and Consumer Protection Act was adopted in May 2018.

Rolling back Dodd-Frank

The most controversial change introduced by the Economic Growth, Regulatory Relief, and Consumer Protection Act concerns mandatory annual “stress tests.” Under Dodd-Frank, all banks with more than 50 billion in assets are subject to a stress test, however, the new bill raises the threshold to 250 billion, thereby reducing the number of banks subject to the rule from 5,670 to 12. The collapse of even three banks at the limit of that threshold could induce a Lehman Brothers-like turmoil. Moreover, according to empirical studies, financial markets tend to be highly correlated, especially in time of crisis. Reducing the number of banks subject to the stress test tremendously increases the systemic risk of the financial sector.

Other provisions in the bill make it easier for big banks to buy bonds from state and local governments, which in turn lowers the leverage ratio for large “custody” banks such as State Street Corp. and Bank of New York Mellon Corp. Lenders with less than $10 billion in assets would be exempt from Dodd-Frank mortgage-underwriting standards.

The Dodd-Frank reform was far from a perfect legislation. This law gives too much power to regulators, by leaving numerous decisions at their discretion and a myriad of rules to write, exacerbating the problem of Human Resources they were already facing before the bill. Dodd-Frank also leaves the bailout process at the discretion of the government, not really tackling the “too big to fail institutions” issue. The bill also constrains corporate shareholders, who were not involved in the 2008 financial crisis. Moreover, it does not include the reform of Fannie Mae and Freddie Mac, the Government-Sponsored Enterprises (GSE), main originators of the famous subprime, and epicenter of the 2008 financial crisis.

Instead of tackling the limitations of Dodd Frank, the Economic Growth, Regulatory Relief, and Consumer Protection Act loosens the protections and buffers imposed to guard against financial crises. The main reasons for the changes are that Dodd-Frank was too stringent, debilitating for growth, and harmful to consumers. However, the current booming US economy certainly does not need further stimulus. Even if some signals about the next economic recession, like the current flattening of the US treasury bond yield curve, are debatable, it is unequivocal that the US economy is well above its potential. Therefore, it is time to strengthen buffers and protections designed to face the next economic downturn, not abolish them. Moreover, the changes occurred in the context of record profits posted by Wall Street, raising questions around the necessity of the new bill.

Moving forward

The Economic Growth, Regulatory Relief, and Consumer Protection Act will certainly have a positive impact on growth by loosening credit conditions. However, this bill induces more vulnerability in the financial system. A couple of years ago, altering Glass-Steagall would have stirred stronger opposition than today because the disastrous effect of the financial crisis was still fresh in the public’s collective memory.