Post-crisis regulatory changes

As you can undoubtedly tell from your reading thus far, the global financial crisis revealed the weaknesses in the financial system and the need for better regulation. The fact that large institutions like Lehman Brothers and AIG could cause the whole financial system to collapse was a serious weakness in the system. The financial world is highly intertwined and that is a necessary evil. In fact, this is even the case in today’s “DeFi” world. But one bad egg shouldn’t lead to the whole financial recipe being immediately scrambled.

The Fed and government strongly felt that more oversight of the system as a whole was necessary.

After many months of debate, the Dodd-Frank Wall Street Reform and Consumer Protection Act was passed in 2010 under the Obama Administration, which placed many new stringent regulations on the banking system. Moreover, several changes were made to how the Fed operates.

The Dodd-Frank Act

The Dodd-Frank act was a massive piece of financial reform that was 2,300 pages long and took several years to fully implement. It targeted key financial institutions that were believed to have caused the financial crisis, including banks, mortgage lenders, and credit-rating agencies.

The act made regulators responsible for tracking and responding to possible risks to the financial system as a whole.

Below are some of the regulatory reforms enacted:

• A “Financial Stability Oversight Council” (FSOC) was created to help regulators coordinate their efforts.
  • The FSOC allowed the Fed to supervise nonbanking institutions and the stock exchange.
• Financial institutions had tougher supervision and regulation, such as:
  • Higher capital requirements
  • The Volcker rule, which restricted the ways banks can invest. Specifically, they were no longer allowed to trade on their own account. Banks were also not allowed to be involved with risky hedge funds or private equity firms.
  • Regular “stress tests” were conducted to ensure banks could survive in a crisis.
• The act tried to tackle the problem of “too big to fail”:
  • New “orderly liquidation authority” allowed the FDIC to close failing financial firms so that the firms could fail safely, without causing the entire system to collapse. To do this, an “Orderly Liquidation Fund” was created that provided liquidation and restructurings when companies needed to be propped up (instead of paying for the bailouts with tax dollars).
  • The council was allowed to break up banks considered too large and could also force them to increase their reserve requirements.
• The act required more transparency and standardization of derivatives transactions.
• The act created a new agency (the Consumer Financial Protection Bureau) whose job was to prevent predatory mortgage lending and make it easier for consumers to understand the terms of a mortgage before agreeing to them.
• The act established the SEC Office of Credit Ratings, which was in charge of making sure that rating agencies provided reliable credit ratings.
• The act strengthened and expanded the existing whistleblower program.

You can read more about the Dodd-Frank Act here.

Although there were a number of vital reforms made, you’ve undoubtedly noticed that they mostly focused on the banking industry, leaving the shadow banking sector (which we learned about in a previous post) largely intact. So to this day, the shadow economy remains largely unregulated. That, of course, is problematic, because we have no transparency into what is happening in the shadow banking economy. This is one of the biggest benefits of crypto — nothing that happens in crypto can remains in the shadows because it is all open-source and transparent.

Communication about monetary policy

The level of communication that the Fed has with the public about monetary policy was determined to be lacking, and this lack was judged to be one of the factors behind various financial crises. The Fed is now expected to communicate more clearly about when it expects to adjust the federal funds rate. This will allow investors to better understand policy goals and anticipate future policy actions.

For example, the chairman of the Fed began holding news conferences in 2011. In fact, the Federal Reserve now even has a YouTube channel where updates are posted periodically.

The Fed has also recently begun to provide more information about its goals and policy approach (for example, defining price stability as inflation of 2% in the medium-term).

Conclusion

Wow! You made it this far through the history of banking. Congratulations. You now have a rock- solid understanding of how the central banking system in the US started, and how it evolved over time through various booms and busts. Moreover, you learned about how effective (or ineffective) the Federal Reserve was in keeping the financial system afloat if/when there was a bust.

Financial crises will always be with us. However, the goal remains to minimize the intensity of these crises and avoid major damage to the economy. Since we cannot predict or eliminate shocks to the economy, we must build a system that can resist these shocks without collapsing.

I want you to start thinking about whether the new financial system we are building with Bitcoin and other cryptocurrencies is more (or less) resilient than the system we have now, with the Federal Reserve and other central banks around the world serving as the central coordinators of monetary policy.

Before we move on to learning about the cypherpunks, we have one final lesson where we will look at a series of charts that paint a shocking picture of our financial system after Nixon moved the United States off the gold standard in 1971. Stay tuned.