It is a fundamental claim of my book Corporate Governance after the Financial Crisis that financial bubbles almost invariably lead to bad law. As I summarize the argument in the introduction to the text:
The basic thesis of this work is that the federal government—especially Congress—normally pays little attention to corporate governance. Only in response to major economic crises does corporate governance become a matter of national political concern. This recurrent pattern inherently tends to result in flawed legislation. This is so because, in the first instance, federal corporate governance regulation tends to be enacted in a post-crisis climate of intense political pressure, which discourages taking the time necessary to conduct careful analysis of costs and benefits. Second, federal corporate governance regulation tends to be driven by populist anti-corporate emotions. Finally, the content of federal corporate governance regulation is often derived from prepackaged proposals advocated by policy entrepreneurs skeptical of corporations and markets. Their agenda therefore is often at odds with the interests of Main Street corporations and their retail investors.
Worse yet, as I demonstrate in the concluding chapter of Corporate Governance after the Financial Crisis, such laws almost never get repealed:
… the uniformity imposed by federal law precludes experimentation with differing modes of regulation. As such, there will be no opportunity for new and better regulatory ideas to be developed—no “laboratory” of federalism. Likewise, the persistent refusal to accommodate private ordering eliminates solutions from emerging from competition in the market. Instead, the federalization of corporate governance has resulted in rules that were wrong from the outset or may quickly become obsolete, but are effectively carved into stone with little prospect for change.
In sum, the federal role in corporate governance appears to be a case of what Robert Higgs identified as the ratchet effect. Higgs demonstrated that wars and other major crises typically trigger a dramatic growth in the size of government, accompanied by higher taxes, greater regulation, and loss of civil liberties. Once the crisis ends, government may shrink somewhat in size and power, but rarely back to pre-crisis levels. Just as a ratchet wrench works only in one direction, the size and scope of government tends to move in only one direction—upwards—because the interest groups that favored the changes now have an incentive to preserve the new status quo, as do the bureaucrats who gained new powers and prestige. Hence, each crisis has the effect of ratcheting up the long-term size and scope of government.
Financial scandals rarely have a potent a regulatory effect as bubbles. If a scandal gets big enough, however, it too can lead to bad laws and twist the ratchet yet higher.
I'm worried that the brewing LIBOR scandal will prove big enough to generate bubble law-like bad law.
There's no doubt that employees of major banks (possibly in cahoots with their regulators) engaged in some serious misconduct. As The Economist explains:
The attempts to rig LIBOR (the London inter-bank offered rate), a benchmark interest rate, not only betray a culture of casual dishonesty; they set the stage for lawsuits and more regulation right the way round the globe. This could well be global finance’s “tobacco moment”. ...
The evidence that has emerged from the Barclays investigation reveals two types of bad behaviour. The first was designed to manipulate LIBOR to bolster traders’ profits. Barclays traders pushed their own money-market desks to doctor submissions for LIBOR (and for EURIBOR, a euro-based interest rate put together in Brussels). They were also colluding with counterparts at other banks, making and receiving requests to pass on to their respective submitters. ...
The second type of LIBOR-rigging, which started in 2007 with the onset of the credit crunch, could also lead to litigation, but is ethically more complicated, because there was a “public good” of sorts involved. During the crisis, a high LIBOR submission was widely seen as a sign of financial weakness. Barclays lowered its submissions so that it could drop back into the pack of panel banks; it has released evidence that can be interpreted as an implicit nod from the Bank of England (and Whitehall mandarins) to do so. The central bank denies this, but at the time governments were rightly desperate to bolster confidence in banks and keep credit flowing. The suspicion is that at least some banks were submitting low LIBOR estimates with tacit permission from their regulators.
Even though I suspect most commentators could not tell you what LIBOR stands for, let alone what it is, how it is set, or what it's used for, calls are already echoing around the 24-hours news cycle for massive new regulation. The BBC reports that Bank of England chief Mervyn King, to cite but one scary example, "a total separation between" retail and investment banking. In other words, he wants a UK version of the USA's old Glass-Steagall Act. Indeed, The Financial Times reports that calls for just such a new law are sounding widely in the UK:
The revelation that swaps traders at Barclays manipulated Libor lending rates has induced convulsions in Westminster and the media. ... Lombard suggested a couple of weeks ago that rate-rigging would reinvigorate calls for a Glass-Steagall style break-up of universal banks. So it has proved. Barclays is rightly seen as emblematic of the capture of a solid old bank by amoral risk-takers. Swap traders exploited their access to Treasury staff within the model of a universal bank to manipulate its Libor submissions.
The 1999 repeal of Glass-Steagall was one of the rare occasions when the ratchet slipped in favor of deregulation. Repeal was an essential response to the inefficiencies inherent in the artificial separation of commercial and investment banking, which by the 1990s had resulted in the former facing declining business opportunities, intense competition, and falling profits. The complex nuances of deciding where the line between commercial and investment banking lay resulted in massive rent seeking and even cases of corruption.
All this despite, the lack of evidence that the pre-Glass-Steagall structure of the banking industry was responsible for the financial crisis of 1929 and thereafter. To the contrary, as Jonathan Macey observed in 2000 (25 JCORPL 691):
… there is a wealth of historical and empirical evidence showing that bank involvement in the securities business makes financial institutions and the economy safer. In particular, a careful study by Eugene White found that securities activities of commercial banks prior to Glass-Steagall did not impair bank stability. Banks in the securities industry were not riskier (as measured by earnings variance) and did not have lower capital than banks without any securities operations.
More importantly, banks involved in the securities business were less likely to fail than banks that were not involved in the securities business. Five thousand banks failed in the 1920s, but virtually none of these were the city banks that had securities affiliates. Moreover, in the bank failures at the height of the Great Depression (between 1930 and 1933), although more than twenty-five percent of all national banks failed, less than ten percent of the national banks with large securities operations closed.
Even so, pro-big government/anti-bank regulators and activists have been trying to bring it back ever since. But Glass-Steagall was such an awful idea that even Chris Dodd and Barney Frank gave it a miss in Dodd-Frank. Unfortunately, the LIBOR scandal could be the final impetus the pro-regulatory types need.
Just as there is no evidence that allowing commercial and investment banking to co-exist within the same firm was causally linked to the bank failures of the 1930s, there is no evidence--zero, nada, zilch--that it contributed to the LIBOR scandal.
The LIBOR scandal was caused by roque employees and complicit regulators (the latter being a fact that ought to give even liberal fans of big government pause). It is a form of price-fixing. As such, no one has yet identified any misconduct that is not already illegal under existing laws.
The answer thus is not to bring back Glass-Steagall.
The answer is to enforce the laws that are already on the books.
And, while we're at it, to ask USA and UK regulators how they--once again (see, e.g., Bernie Madoff)-- managed to miss a huge criminal enterprise taking place right under their noses.
Update: Over at OTB (thanks for the link), one of James Joyner's commentators opined:
Citing a study made in 2000 suggests that it may need to be updated based upon the events of the last few years. A study showing that the “securities activities of commercial banks … did not impair bank stability” in the 2008 crash may be more useful.
Fair enough. How about:
"After reviewing the Glass-Steagall Act of 1933 and related subsequent developments, this paper discusses the enactment of GLBA and demonstrates that the GLBA and little or nothing to do with the crisis and thus that a re-enactment of the Glass-Steagall barriers or enactment of the Volcker Rule would not prevent future such barriers. The paper argues that the GLBA’s erection of a new barrier to a non-financial firm’s ownership of a depository institution was misguided. Thus, in an important sense, the GLBA did not go far enough in breaking down barriers." -- White, Lawrence J., The Gramm-Leach-Bliley Act of 1999: A Bridge Too Far? Or Not Far Enough? (2010). Suffolk University Law Review, 2010. Available at SSRN: http://ssrn.com/abstract=1836668