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The banking crisis of the new millennium - why it was inevitable

By Carolyn Currie - posted Friday, 31 July 2009

Why has regulatory failure occurred in 2007-9 and spread to a Global Financial Crisis (GFC)? Causes lie not only in laissez faire capitalism, but also in accounting rules such as mark-to-market which promoted the idea that huge profits could be recognised before realised by churning non liquid assets. Contributing to this quagmire was regulatory confusion between State and Federal legislation, lobbying against controls on residential lending, and flaws in the literature on regulatory failure which took no account of the present stage of development of an advanced economy. This translated into the lack of recognition that advanced economies had not adjusted their regulatory models as their economic and social infrastructure underwent some profound changes.

However, none of the commentators today are recognising the regulatory confusion in the USA. Instead we are greeted in the media everyday with common excuses for the GFC. We admit a lack of prudential supervision and blame laissez faire capitalism. However, we never admit to the major flaws in the regulatory structure as well as the political philosophy of the largest world economy that has almost destroyed a decade of progress.

The fact that not only in the US have state governments been left to administer the originators of mortgages and credit default swaps, but the federal government has never complied fully with the Financial Action Task Force money laundering provisions. By not complying, they have created the ability to abort such legislation using cross-border transactions and complex financial instruments. In addition not only was the implementation of Basel II lobbied against by US financial interests since 1999, and never instituted in the US financial system which could have highlighted the over lending to the residential mortgage market, but since 2003 SEC recommendations to control the hedge fund industry were never instituted.


A further flaw in the US market is the fact that their real estate industry is not subject to market forces and that the tax system can encourage over borrowing. For instance in Australia the buyer pays no premium to a broker to find a property. All fees are negotiable and rarely go above 2 per cent, not the 6 per cent that is paid in the US.

In Australia real estate agents can offer properties nationally and are subject to Federal legislation. Overseas buyers can buy subject to certain requirements - for instance properties below A$400,000 are protected, and overseas investors in the unit/apartment market cannot buy second hand real estate. Moreover, the exemption from capital gains tax, but the non expensing of interest on home loans against income, encourages owners to never walk away from their homes. Australian banks must prove default and cannot advertise a home merely on what is owed. They must auction and seek a fair market price from an arm’s length buyer.

There are a huge range of types of regulatory models that can exist as detailed by the author in numerous publications (see Each should be adapted to each individual country’s stage of economic and social development. The taxonomy the author developed shows that the US moved from a regulatory model with a strong enforcement mode, with strong sanctions and an intense auditing method, with highly restrictive activity measures, to one that ranked the weakest on all measures.

The lessons that should have been learnt from the past recent financial crises such as 1991, 1997, 2003, were the necessity for a staged approach to deregulation of protective measures, accompanied by, an integrated, enhanced and even approach to the development of prudential supervision and the establishment of an early warning system.

The evolution of financial services sectors in advanced and emerging nations has been marked by a change in the regulatory model from one dependent on protective measures to one more reliant on prudential supervision. What was necessary was to adjust such models for the following factors:

  • The growth of financial conglomerates which demanded co-ordination among different regulatory bodies and levels of government and also meant that regulation, whether prudential or protective, must concentrate on ALL financial institutions. The failure of the US government to adjust its model after repealing the Glass-Steagall and McFadden Acts, meant that highly leveraged investment banks and insurance companies could bring major banks to the point of extinction (Source: Wall Street Journal, September 23, 2008).
  • Unregulated non bank financial institutions (NBFIs) by offering a regulatory black hole have now been proven to provide a home to the new transnational criminal. Witness the Ponzi schemes now uncovered. Mortgage lenders, hedge funds and unregulated finance companies have spread financial risk and promoted contagion.

Investment banks were allowed unprecedented levels of borrowings - Bear Stearns was levered at 31:1, Lehman Brothers 34:1, Fannie Mae/Freddie Mac at 45:1, Merrill Lynch at 46:1, Goldman Sachs at 26:1, Morgan Stanley at 20:1. None of these investment banks complied with Basel II capital adequacy requirements and were geared far more than the normal on-book average of 22:1. This is why many of these investment banks disappeared and the question still remains - why were they allowed to operate in such an unregulated manner given their proven possibility to trigger systemic crises as proven over and over again during the 80s with the Savings and Loans fiasco, and in the 90s with the Long Term Credit Fund.

In conclusion, the most blatant cause of the GFC was the merging of insurance, funds management and banking activities in the US, justified on the grounds of liberalisation. Hence regulatory failure can occur in not just the traditional banking industry but in insurance, by virtue of either cross linking guarantees or the effect on confidence. This together with the regulatory confusion, created by too many regulatory bodies and state versus federal controls, resulted in regulators failing to recognise the problems of insurance companies selling credit default swaps being supervised by state bodies - who were also allowed to supervise without appropriate federal oversight the sale of mortgage backed securities (MBS), not only across state borders but across countries.

So what actions have been taken to date to relieve the crisis? Apart from stimulus packages and direct aid to banks, including open market operations to ensure member banks’ liquidity, central banks have reduced interest rates charged to member banks for short-term loans, re-examined again the credit rating process - this was done after 1998. There has been much talk on further regulatory controls on lending practices, possible reforms to bankruptcy protection, and the use of tax policies to promote affordable housing. Credit counselling and education for borrowers together with the licensing mortgage lenders have been discussed together with future amendments to disclosure rules and promotion of investor education and awareness.

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About the Author

Dr Carolyn Currie is the Managing Director of Public Private Sector Partnerships Pty Ltd.

Other articles by this Author

All articles by Carolyn Currie

Creative Commons LicenseThis work is licensed under a Creative Commons License.

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