Although they can put in place any laws and regulations that they see fit, politicians are not in the driver’s seat in their relation with banks. Bankers know more about banking than politicians. Moreover, politicians want the bankers’ cooperation to make the investments the politicians favor — or campaign contributions. When bankers warn that capital requirements will hurt bank lending and reduce economic growth, they are rarely challenged by politicians, not only because politicians do not see through the banks’ claims but also because they do not want to upset their symbiosis with bankers.
Bankers and politicians have a two-way dependence. In this situation, politicians can forget their responsibilities, and the political system fails to protect the economy from banking risk. Even after the financial crisis, as one politician admitted, the banks “own the place.”
The three decades leading to the financial crisis of 2007–2009 were marked by enormous growth in the financial sectors of the United States and Europe. Banks and financial firms convinced politicians and regulators that tight regulations are not needed because markets work well enough. Bankers gained prestige and wealth and their political influence increased. An anti-regulation ideology helped as well.
Prior to the financial crisis, regulators failed to set proper rules and supervisors failed to enforce the rules in place so as to prevent the reckless behavior of bankers. In the United States, for example, Alan Greenspan (chairman of the Federal Reserve), Arthur Levitt (chairman of the Securities and Exchange Commission [SEC]) and Robert Rubin (treasury secretary) prevented an initiative in 1998–2000 that would have imposed more transparency on derivatives markets. Such transparency was sorely missing in the run-up to the financial crisis. A 2004 ruling of the SEC allowed US investment banks to determine their regulatory capital on the basis of their own risk assessments, and this enabled Lehman Brothers and other investment banks to become highly indebted and vulnerable. The United Kingdom also instituted so-called light-touch regulation in order to expand its role as a major financial center.
An important factor underlying the financial crisis of 2007–2009 has been the failure of regulators and supervisors in the United States and in Europe to set and enforce proper rules to prevent the reckless behavior of bankers. Supervisors in the United States and Europe allowed banks to circumvent capital requirements by creating various entities that did not appear on the banks’ balance sheets. Investors were willing to lend to these entities because the sponsoring banks were providing guarantees. The supervisors did not object to banks’ keeping these exposures off their balance sheets, nor did they try to limit the banks’ obligations from the guarantees. The obligations ended up greatly weakening the sponsoring banks and bankrupting some of them when the crisis broke in the summer of 2007.
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