Running head: DEREGULATION AND ITS CATASTROPHIC CONSEQUENCES
LESSON LEARNT FROM THE FINANCIAL CRISIS 2007 - 2008:
DEREGULATION AND ITS CATASTROPHIC CONSEQUENCES
FOREIGN TRADE UNIVERSITY HO CHI MINH CITY CAMPUS
Name: Chu Trí Đức
Class: K56CLC2
Student ID: 1701035109
DEREGULATION AND ITS CATASTROPHIC CONSEQUENCES
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Hitherto, it has been over a decade since the financial world endured one of the most serious
crises ever: the financial crisis originated in the United States in 2007 that lasted for two years and
left an inevitable downturn in the financial system worldwide. The biggest question is: What led
to this catastrophe? Renowned economists at that time argued over the question by blaming the
crisis on the following factors: deregulation in the late 1990s, securitization that created “toxic”
marketable securities and magnified the “housing bubble” in the early 2000s, the growth of
subprime mortgages and banking policies that created interest-only loans that became affordable
to subprime borrowers. To some extents, it is widely acknowledged by most economists and wellknown professors that financial deregulation from the late 1990s was the primary cause of the
financial crisis of 2007 - 2008. This essay aims to analyze deregulation on several aspects: its
definition and origin as well as its profound effects on the crisis mentioned above, therefore
propose some actions we should take in order to prevent similar occurrences.
According to Merriam - Webster Dictionary, “deregulation” refers to “the act or process
of removing restrictions and regulations, typically in the economic sphere. It is the repeal of
governmental regulation of the economy”. The financial crisis was claimed to have been
fundamentally caused by deregulation in the financial industry. Why so? Deregulation in the late
1990s conducted by the U.S Government created an ideal environment in which mortgage lending
expanded and speculation in other financial markets were elevated, even though riskiness was
steadily increasing. Banks then demanded more mortgages to support the profitable sale of
derivatives - a new and sophisticated type of instrument that derives its value/price from the
underlying assets (Wikipedia). Additionally, due to policies ratified by Federal Reserve, banks
made interest-only loans that became affordable to subprime borrowers. The outcome was, first,
the failure of mortgage firms, banks and a major insurance company like Lehman Brothers,
American International Group (AIG), etc. and then followed by the collapse of the market for
short-term loans. This initially led to a liquidity crisis and then to defaults, followed by a debt
deflation; eventually the whole economy sunk into a deep recession.
Back to the primitive days of financial regulations and deregulation, following the Great
Depression in the 1930s, a series of financial regulations were introduced in the United States.
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These regulations were designed to ensure the stability of the financial sector and enhance its role
in supporting two other fields: investment and production. For instance, the Glass-Steagall Act of
1933 prohibited commercial banks from being involved with investment banks. Creating the
separation between commercial banks and investment banks keeps the riskier transactions of
investment banks from disrupting the deposits at commercial banks and therefore provides
monetary stability. In parallel with that, deregulation began in the 1960s because there was a new
wave of bankers who had not experienced the Great Depression and wanted more innovation and
competition - especially from foreign banks. Two central trends were observed in this period: the
corporations’ search for ways to increase profitability and the rise of finance in a gradually
deregulated system.
The globalization of production devised an adjustment in the financial needs of the nonfinancial corporations by the 1970s and this has been an attribute to the deregulatory drive. As
trade exceeded its geographically national borders and expanded to other countries, the
predominant business and economic theories began to claim that regulations and restrictions were
obstacles to development and profitability. Thus, the prosperity of industrial and productive firms
created an influential push to eliminate the regulatory restrictions to spread to new markets.
Increasing power of financial institutions over time was another significant factor in the push
towards further deregulation. The first wave of financial deregulation included the Depository
Institutions Deregulation and Monetary Control Act of 1980 and Garn-St. Germain Act of 1982.
As a result, interest rate controls were abolished in 1980. The second wave began with the U.S.
Financial Modernization Act of 1999 that allowed increased diversification of financial activities
that can be undertaken by financial institutions. The 1933 Glass-Steagall Act imposing a separation
between commercial and investment banks was repealed in 1999 by the Gramm-Leach-Bliley Act,
also known as the Financial Services Modernization Act. The Commodity Futures Modernization
Act of 2000 left credit default swaps (CDS) and equity default swaps (EDS) unregulated.
There is a saying that still remains true up to the present days: “Nothing ever comes without
a consequence”. Indeed, the Depository Institutions Deregulatory and Monetary Control Act of
1980 removed interest-rate restrictions and allowed banks to compete with money market mutual
funds. This freedom was equivalent to an increase in interest-rate risk. Moreover, the Gramm-
DEREGULATION AND ITS CATASTROPHIC CONSEQUENCES
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Leach-Bliley Act of 1999 permitted banks to use deposits to invest in derivatives, thereby
increasing credit risk, moral hazard of banks and likelihood of default. Traditionally, banks made
mortgages and held them. Nowadays, banks and non-bank mortgage lenders made loans, but then
sold the loans to others. Investment banks pooled plentiful mortgage loans into “collateralized debt
obligations” (CDOs) and then sold them with a promise of a steady stream of revenue from interest
payments, whose operations were unregulated. Despite the fact that the involved investors attained
sophistication, no one took account of how shoddy the loans were or the certainty that huge
numbers would go bad if the housing bubble popped. Another aftermath of deregulation is the
loosened responsibility of credit rating agencies (like Standard and Poor’s, and Moody’s) to assess
the CDOs and give investors guidance on how risky they were. They totally failed because they
wanted to maintain good relationships with the investment banks issuing the CDOs.
After the Gramm-Leach-Bliley Act, both Congress and regulators were argued to have
supported deregulation by ignoring numerous warnings about the risks of derivatives, particularly
credit default swaps (CDS), and choosing not to impose needed restrictions. Warren Buffett used
to consider derivatives as “weapons of mass financial destruction,” and warned that the focus on
derivatives risk in a few dealers posed “serious systemic problems.” when being interviewed in
2003. However, he was not the only one that called for additional derivatives regulation. During
her chairmanship of the Commodity Futures Trading Commission (CFTC), Brooksley Born
published a paper outlining how the CFTC should approach the regulation of derivatives, but her
suggestions were aggressively criticized by members of the Clinton administration. The lack of
regulations in trading derivatives eventually led to the collapse and bailout of AIG - one of the
biggest insurance companies in the world - by compensating the proportional amount of money in
accordance with the credit default swaps that AIG had issued earlier.
Learning from the failure, what are our steps to prevent the next financial crisis from
happening? Resolving the issue by eliminating the main causes is a must, and in this case,
tightening financial regulation is mandatory. Governmental authorities in general and financial
regulators in particular should supervise and take actions in time against the anomaly in operations
of the financial system properly, specifically the trade of newly introduced instruments like
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derivatives. Appropriate sanctions against violation in the banking system should be taken
seriously to avoid repetitive frauds.
In conclusion, the financial crisis of 2007 - 2008 has left several lessons for us to bear in
mind. One of them was deregulation - the main cause of the financial catastrophe over ten years
ago. Knowing what it truly is, how it affects the whole financial system worldwide and consider
proper acts against repetition is of utmost importance in order for sustainable economic growth,
more efficient international trade and living standards amelioration.
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DEREGULATION AND ITS CATASTROPHIC CONSEQUENCES
REFERENCES
1. Documentary “Inside Job", directed by Charles Ferguson, narrated by Matt Damon (2010).
2. Article “Causes of the 2008 Global Financial Crisis" by Kimberly Amadeo (2009):
https://www.thebalance.com/what-caused-2008-global-financial-crisis-3306176
3. Article “Did Deregulation cause the Financial Crisis?" by Mark A. Calabria (2009):
https://www.cato.org/policy-report/julyaugust-2009/did-deregulation-cause-financialcrisis
4. Working paper “Financial Deregulation and the 2007-08 US Financial Crisis” by Özgür
Orhangazi (2014): http://fessud.eu/wp-content/uploads/2013/04/Financial-deregulationand-the-2007-08-US-financial-crisis-Working-Paper-49.pdf
5. Working paper “The 2008 Financial Crisis: How Deregulation Led to the Crisis” by
Katherine
Bentley
(2015):
https://publications.lakeforest.edu/cgi/viewcontent.cgi?article=1054&context=seniorthese
s
6. Article “Deregulation and the Financial Crisis?" by Robert Weissman (2011):
https://www.huffingtonpost.com/robert-weissman/deregulation-and-thefina_b_82639.html