Peltzman Says Regulation Aided Failure

by Greg Slisz '10

April 7, 2010

In the aftermath of a financial crisis that left bank failures and stunned investors in its wake, people around the country have tried to explain what exactly caused the downturn. Dr. Samuel Peltzman addressed what he perceived to be one of the main causes of the crisis in his Rogge Memorial Lunchtime Talk titled “Regulation and the Financial Crisis.” In the talk, Peltzman analyzed how increased regulation has actually led to more risky behavior from the banks. 

Watch Peltzman's evening talk on Wabash YouTube page or at bottom of this page.

Peltzman, an economics professor at the University of Chicago and editor of the Journal of Law and Economics, began the lecture by explaining the two main types of regulation which the government imposes on the banks. While the first types of restrictions, those on the services offered by banks, have mainly been removed over the years, the second kind, regulations on financial safety, have steadily increased, Peltzman said. 
Peltzman detailed the reasoning why this second type of regulation, which includes requirements for a bank’s capital ratio as well as its portfolio risk, were actually not even necessary until after the invention of Federal Deposit Insurance in 1933. Until this time, Peltzman said, free market competition should have, in theory, caused institutions with higher levels of risk to also yield higher interest rates for their depositors. 
However, with the advent of Federal Deposit Insurance, Peltzman explained, depositors no longer cared what kind of assets or capital ratio their bank possessed due to the fact that their assets were now insured against loss. 
Likewise, banks themselves had little incentive not to take risks. In an example he dubbed “Bank ‘A’ Goes to Las Vegas,” Peltzman showed the way in which a bank’s stockholders are essentially given incentive to “gamble” on risky investments that yield an average positive return due to a high leverage ratio as well as the fact that the US government now protects them from losing their deposits. 
Evidence of this risky behavior, Peltzman illustrated, could be witnessed in the years after the advent of deposit insurance, as leverage ratios fell from 18 to 8 percent. After the first big bank bailout, which occurred during the savings and loan crisis in the mid 1980s, the government responded again by creating FDICIA, a law that forced banks to hold higher capital to asset ratios but said nothing about risk. The problems, Peltzman said, persisted, as banks responded to this by investing in a high volume of risky assets, including the debt of developing countries. 
Once again, the government reacted with more regulations and created a risk-weighted capital ratio requirement. This, Peltzman said, has helped lead us to the current financial crisis. Banks, faced with these regulations, either tried to convince the government that the assets, which included risky subprime mortgages, were safe, or they moved the assets off their balance sheet altogether and sold the assets to an investment bank or hedge fund. However, the banks failed to take into account that the risks of all these risky mortgages could have been correlated, and as housing prices declined, banks failed across the board. 
Because many of these banks were deemed “too big to fail” due to their large quantity of assets held, the federal government felt that it had no choice but to bail them out in order to prevent a collapse of the financial system. Peltzman said that this concept, combined with the fact that the government now extends guarantees to even uninsured deposits, means that moral hazard will continue, likely leading to more financial crises in the future.  
Peltzman, in contrast, proposed two alternative solutions, one in which risk was prohibited, and another in which banks, even those that were “too big to fail,” could do what they wanted, but also pay the consequences. Ultimately, Peltzman concluded that the second of these two options would have to be the long-run solution for the US if it wished to avoid future financial crises. 
The Rogge Memorial Lecture and Lunchtime Talk are dedicated to the memory of Benjamin Rogge, a former dean and economics professor of the college.

