Financial Regulation and the Current Crisis: A Guide for Antitrust

• Pages: 65-117

65

CHAPTER V

FINANCIAL REGULATION AND THE CURRENT

CRISIS: A GUIDE FOR ANTITRUST

Lawrence J. White



A. Introduction

The U.S. financial crisis of 2007–2008 has been a searing

experience. The popping of a housing bubble exposed the subprime

lending debacle, which in turn created a wider financial crisis, which has

had international ramifications. The weakened financial sector has

contributed to a U.S. recession that currently is the worst since the early

1980s and that may become the worst since the Gr eat Depression of the

1930s.

One theme in discussions of the crisis has been the roles and

regulation of very large financial institutions: large commercial banks

(e.g., Citigroup, Bank of America, JPMorgan Chase, Wells Fargo); large

investment banks (e.g., Bear Stearns, Lehman Brothers, Merrill Lynch,

Morgan Stanley, Goldman Sachs); large insurance conglomerates (e.g.,

American International Group (AIG)); a nd large ―government sponsored

enterprises‖ (GSEs) that are devoted to residential mortgage finance

(e.g., Fannie Mae and Freddie Mac). Many of these institutions are

described as ―too big to fail‖ (TBTF). Discussions of financial size a nd

excessive bigness seem to invoke antitrust issues.

This paper will offer an overview of the financial sector, financial

regulation, the subprime debacle, and the wider financial crisis that

followed.1 An antitrust—and thus a competition—perspective will be

 Stern School of Business, New York University.

1. A comprehensive discussion of these topics is beyond t he capabilities of

this paper. In many places, however, this paper will draw on other

writings of the author that have addressed these topics at greater depth:

e.g., Lawrence J. White, The Partial Deregulation of Banks and Other

Depository Institutions, in REGULATORY REFORM: WHAT ACTUALLY

HAPPENED 169 (Leonard W. Weiss & Michael W. Klass eds., 1986);

LAWRENCE J. WHITE, THE S&L DEBACLE: PUBLIC POLICY LESSONS FOR

66 Competition as Public Policy

maintained throughout. This perspective will reveal that there has been a

longstanding tension between the operation of financial regulation and

the promotion of competition. Beginning in the late 1960s, that tension

progressively lessened in many areas of financial regulation, as important

anticompetitive elements of financial regulation were eliminated

(although there was one important area—the regulation of large credit

rating agencies—where new regulation fostered less competition, with

consequences that can be linked to the subprime lending debacle). The

financial sector has considerably fewer regulatory impediments to

competition today than was true 40 years ago, although regulatory

impediments still remain in too many places. This perspective will also

reveal that, although TBTF is a size issue, it is not an antitrust issue since

competition issues are not at stake; and modern antitrust is about

competition, not about size.

This paper will proceed as follows: Section B will set the stage by

providing an overview of the important features of finance and of

financial regulation in the United States Section C will add a discussion

BANK AND THRIFT REGULATION (1991); Lawrence J. White, The Credit

Rating Industry: An Industrial Organization Analysis, in RATINGS, RATING

AGENCIES, AND THE GLOBAL FINANCIAL SYSTEM 41 (Richard M. Levich,

Carmen Reinhart & Giovanni Majnoni eds., 2002) [hereinafter White, The

Credit Rating Industry]; Lawrence J. White, Focusing on Fannie and

Freddie: The Dilemmas of Reforming Housing Finance, 23 J. OF FINANCIAL

SERVICES RESEARCH 43 (2003) [hereinafter White, Focusing on Fannie

and Freddie]; Lawrence J. White, Fannie & Freddie: Part of the Solution,

or Part of the Problem?, 10 MILKEN INSTITUTE REVIEW 15 (2008)

[hereinafter White, Fannie and Freddie]; Lawrence J. White, F inancial

Regulation: An Agenda for Reform, 11 MILKEN INSTITUTE REVIEW 15

(2009) [hereinafter White, Financial Regulation]; Lawrence J. White, The

Community Reinvestment Act: Good Goals, Flawed Concept, in REVISITING

THE CRA: PERSPECTIVES ON THE FUTURE OF THE COMMUNITY

REINVESTMENT ACT 185 (Prabal Chakrabati, David Erickson, Ren S.

Essene, Ian Galloway, & John Olson eds., 2009) [hereinafter White, The

Community Reinvestment Act]; Lawrence J. White, The Role of Capital and

Leverage in the Financial Markets Debacle of 2007–2008, 37 MERCATUS

ON POLICY (2009) [hereinafter White, The Role of Capital and Leverage];

Lawrence J. White, The Credit Rating Agencies and the Subprime Debacle,

21 CRITICAL REVIEW 389 (2009) [hereinafter White, Subprime Debacle];

Lawrence J. White, Wal-Mart and Banks: Should the Twain Meet? A

Principles-Based Approach to the Issues of t he Separation of Banking

and Commerce, 27 CONTEMPORARY ECONOMIC POLICY 440 (2009)

[hereinafter White, Wal-Mart and Banks].

Financia l Regulation and the Current Cr isis: A Guide for Antitrust 67

of U.S. policy toward housing finance, since housing finance has figured

so prominently in the financial crisis. Section D will offer a selective

history of financial regulation and some of the anticompetitive features

of financial regulation that have arisen at various times, which will

highlight the history of tensions between financial regulation and

antitrust. Section E reviews the subprime lending debacle and the wider

financial crisis that followed and uses that backdrop to discuss the

concept of financial institutions that are considered to be TBTF. Section

F concludes with a set of procompetitive policy recommendations for the

financial regulation area.

B. Finance and Financial Regulation

1. Understanding Finance

a. Finance Is Special

Finance is special in at least three ways. First, finance is ubiquitous.

Almost all enterprises need finance in order to obtain the resources for

investments and to bridge the gap between the time when inputs are paid

and the time when outputs are sold. Almost all governments need

finance, again to obtain the resources for investments and to bridge the

gap between the time when expenditures are made and the time when tax

revenues are received. Almost all individuals need finance, so as to

accommodate large investments and purchases and to bridge smaller

expenditure/income gaps. In addition, finance underlies the operation of

the monetary/payments system of any modern economy.

Second, finance unavoidably involves a time dimension: a loan or

investment is made at an initial point in time;2 repayment is expected to

occur at some future point in time.3 This time dimension means that

lenders always face some uncertainty as to whether the borrower will

actually repay the loan. T his uncertainty reflects the lender‘s

informational disadvantage (―asymmetric information‖) vis-à-vis the

2. For ease of exposition, the following discussion will be in terms of

―loans‖ that involve a ―lender‖ and a ―borrower;‖ but the same principles

apply to issues of equity investment rather than lending.

3. There is a similar time element to insurance: a commitment (to insure

against an event) is made at an initial point in time (with the insured party

making a ―premium‖ payment); and then subsequently, if the

insured-against event occurs, the insurance payment is made.