One of the best titles ever devised for a book about Washington was Lawrence F. O’Brien’s No Final Victories. Washington is really like that. Some policy goals lie dormant for years and—like ancient spores found in an archaeological dig—spring to life when a climate change makes them viable once again. So it is that the mid-March bailout of Bear Stearns summoned from the fertile Washington soil the ardent folks who are always eager to regulate something—anything—in the economy. A securities firm was bailed out by the Federal Reserve? Well, what we need now is a whole new regulatory structure with which the Fed can regulate securities firms and the financial markets generally. 

It should be no surprise, then, that before the Bear Stearns bailout story was a full day old, a Washington Post editorial “Regulation to the Rescue” captured Washington’s eagerness for action. Similar stories and editorials followed: “Regulation of Investment Banks Set for Scrutiny” (Financial Times), “Political Pendulum Swings Toward Stricter Regulation” (The Wall Street Journal), and “Toward New Rules for Wall Street” (The New York Times). All these stories and editorials liberally quoted from the usual sources in Congress and elsewhere, touting the need for a firm regulatory hand to prevent future problems. This once again confirms Wallison’s precept: that regulation is the only human undertaking that gains respect and support the more it fails. 

The mid-March bailout of Bear Stearns summoned the ardent folks who are always eager to regulate something— anything—in the economy.

Before getting too deeply into the policy questions associated with regulating securities firms, it is important to recount the defeats that the proponents of regulation have suffered over the last 30 years or so. Despite prior warnings in every case that it would lead to higher consumer prices, lower safety standards, and instability in the regulated industry, deregulation has been an unqualified success everywhere that it has been adopted. Airline deregulation has made air travel safer and accessible to families; elimination of fixed securities brokerage fees has reduced the cost of trading and made the stock markets flourish; deregulation of long-distance telephone rates has made the Internet possible and radically lowered the cost of long-distance voice and data services; and trucking deregulation has brought down the cost of food and goods and fostered the growth of online commerce. These are only a few of the areas where deregulation has occurred, but in these examples and every other case the scenarios of destruction forecast by regulation’s advocates have been proved hollow. 

In addition, time and again regulation has failed to produce the stability its supporters claim to want, especially in financial services. The failure of bank regulation is so recent that having to remind people about this history is remarkable in itself. Less than 20 years after the Federal Reserve System was established to create stability in the banking sector, which had suffered repeated panics and collapses under regulation during the preceding 100 years, the Depression claimed thousands of banks. The tighter regulatory structure introduced during the New Deal only produced stability as long as it maintained control over interest rates. When that regime had to be scrapped under the inflationary pressures of the late 1970s and early 1980s, the resulting collapse of the savings and loan (S&L) industry cost taxpayers $150 billion. The fact that 1,600 commercial banks also failed in this period showed that faulty or incompetent S&L regulation alone was not the cause. 

Regulation and widespread failure, it turns out, are kissing cousins. Especially when it is coupled with government backing of some kind, regulation creates moral hazard, so that creditors and other counterparties, lulled by government oversight and the possibility of an eventual government bailout, exert less market discipline than they otherwise would, should, or could. In addition, regulation enforces uniformity, which means that a failed business model for one regulated entity signals failure for many more. Diversity, as both economists and biologists have shown, is the ultimate bulwark against wholesale failure. Accordingly, while it is not remarkable that so many S&Ls and banks failed during the S&L crisis, it is remarkable that so many otherwise intelligent people in Washington still believe that better and tighter regulation is a path to greater stability. What is even stranger is that while the political class is busy blaming the regulators for not preventing the current breakdown in the financial markets, the very same people are demanding more regulation as a way of preventing another problem in the future. 

Bear Stearns wasn’t bailed out because it was too large to be allowed to fail, but because the market psychology at the moment of its failure was something close to panic.

The alternative to regulation is more market discipline, which has shown itself to be more effective at producing stability than regulation. During 2007, after months of punishing turmoil in the financial markets, the hedge fund industry—which many had thought would be a source of financial distress because of its lack of transparency and government oversight—has remained remarkably stable. The industry consists of thousands of funds, managing almost $2 trillion in assets, but during all of 2007 only 49 funds, representing $18.6 billion in assets, closed their doors—all without major disruption of that year’s turbulent markets. This was even a smaller number of closures than occurred in 2006, when the financial markets were functioning smoothly; in that year, 83 funds, managing $35 billion in assets, closed down. According to The Wall Street Journal, through March 2008 there have been only a few hedge fund closures, representing $3.9 billion in assets. The risk-taking of hedge funds is controlled by market discipline, not government supervision, and the stability of the industry is further protected by the diversity of the strategies hedge funds employ. The discipline is applied by their lenders and counterparties, principally the prime brokers who serve as the main source of financing and stand to suffer the greatest losses if a hedge fund fails. 

Those brokers are themselves controlled by market discipline, exerted by their customers, creditors, and counterparties, all of whom are diligent to assure that their risks are commensurate with anticipated rewards. In this way, the securities industry has been kept stable from the Depression of the 1930s until the extraordinary events that began with the subprime meltdown in late 2007. This is not to say that no securities firms failed during this period—failures always occur in competitive markets—but only that the failures of securities firms, because of the tight reins imposed by market discipline, never significantly disrupted the economy. To be sure, the Securities and Exchange Commission (SEC) regulates securities firms, but this regulatory regime is considerably less onerous than that applicable to banks. The focus of the capital rules for securities firms is on liquidity rather than solvency. The idea is to make sure that customers, who are the owners of the securities and cash in their accounts, can regain possession of these assets whenever they want. This is a different regulatory focus than bank regulation, because bank depositors don’t own their deposits, but have only a creditor’s claim on the bank; the objective of bank regulators, accordingly, is to assure that the bank is operated in a safe and sound manner so the claims of depositors can always be met. For that reason, bank regulators have greater authority to control bank activities in order to assure (by their lights) that the bank is operated in a safe and sound manner. In brief, then, regulation of banks is supposed to control risk-taking, while the regulation of securities firms is not. 

The rescue of Bear Stearns now raises the question whether the regulation of securities firms should be closer to that of banks—in effect whether market discipline should be supplanted by the safety and soundness regulation previously applicable only to banks. Large securities firms, it is argued, are now so big and so interconnected with the rest of the financial markets that their collapse, like the collapse of a large bank, will create unacceptable negative systemic effects—that they are, in the vernacular so loved in Washington, “too big to fail.” Thus, like banks, they need a backstop in the form of Fed lending, to ensure that they have the necessary liquidity to meet their financial obligations. If this were true, regulation would indeed be necessary, simply because overt and regularized Fed support for large securities firms would diminish market discipline and make excessive risk-taking and the resulting failures more common. Under these circumstances, the Fed would have to protect itself against excessive risk by regulating the risk-taking of the firms that are likely to come to it for liquidity support. On the same theory, regulation will also be necessary for hedge funds, private equity funds, and other large financial institutions that act as counterparties for one another in the vast and interconnected financial markets. 

It is wrong to believe that the collapse of a securities firm—no matter what its size—will or could have systemic effects.

But the premise is wrong. Bear Stearns was not bailed out because it was too large and interconnected to be allowed to fail, but because the market psychology at the moment of its failure was something close to panic; the Treasury and the Fed were compelled to act because the market had been unhinged by fear. Indeed, as SEC Chairman Christopher Cox noted in testimony to the Senate Banking Committee, the SEC did not consider that Bear Stearns would become illiquid, because it had billions of dollars of good securities that it could pledge to obtain the necessary cash. But on March 14, no one in the market would trade with Bear—no one would lend it any money even against the collateral of fully marketable securities—and the firm lost $10 billion in liquidity in that one day as panicked lenders and counterparties withdrew their support. This reaction is virtually unprecedented, and must be chalked up to the madness of crowds. But it would be foolish in the extreme to treat this one extraordinary event as the basis for a new regulatory regime that will make the largest investment banks wards of the federal government. Fed Chairman Ben Bernanke commented afterward that “under more robust [market] conditions, we might have come to a different decision about Bear Stearns”—in other words, if the market had been functioning normally, Bear Stearns could have collapsed without the need for Fed intercession.

Leaving aside the dire conditions that threatened the market on March 14, it is wrong to believe that the collapse of a securities firm—no matter what its size—will or could have systemic effects. The reason for this is another difference between commercial banks and investment banks that few who advocate tighter regulation of securities firms seem to recognize. Commercial banks do not generally collateralize their borrowings; they borrow on the basis of their balance sheets. If they fail, their depositors and other creditors must stand in line for payment following the liquidation of their assets. In addition, the business of banking requires that banks hold deposits from other banks, and depository institutions are always in the process of clearing payments and deposits on one another. The failure of a large bank can deprive many other banks of the funds they need to meet their own payment obligations, causing the losses and economic dislocations to cascade down through the banking industry. That is why large banks are sometimes said to be too big to fail. 

Securities firms, however, are entirely different. They do not borrow on the basis of their balance sheets. Instead, their borrowing is generally collateralized by the securities they hold. If they fail, their counterparties can sell the collateral to make themselves whole. A case in point is the collapse and bankruptcy of Drexel Burnham in 1990. At that time, Drexel was one of the most powerful firms on Wall Street, with 5,300 employees (compared with Bear’s 14,000 employees 18 years later), and it dominated the junk-bond market with about 50 percent of all junk-bond transactions. Drexel asked the Fed for support but was refused. Its subsequent collapse created minor contemporary disruption but had no long-term effect on market conditions and certainly had no systemic consequences. Thus, there is no policy or practical basis for arguing that securities firms—no matter what their size—cannot be allowed to fail; in the absence of a market meltdown such as occurred on that fateful Friday in mid-March, the way securities firms operate prevents their failure from creating systemic consequences. 

There is little doubt that the securities industry will survive the current turbulence and return to solid growth—unless, of course, Washington steps in to help with ‘stabilization.’

Under these circumstances, giving the large securities firms routine access to the Fed’s discount window is unnecessary. Not only would it introduce moral hazard into a field where it has generally been absent, and provide a policy foundation for regulating other financial market players such as hedge funds and private equity groups, but it would also create an anti-competitive tiering in the securities business; the largest firms—profiting from the appearance of government backing—would have a competitive advantage over smaller ones that have no discount window access. It is important to recall that all banks—not just the largest—have access to the Fed’s discount window because banking, by its nature, involves holding illiquid assets with highly liquid liabilities. This is not the case with securities firms, which, by their nature, hold liquid assets that are readily turned into cash. The proposal to give the largest securities firms access to the discount window rests on a different and wholly unproven theory—that their interconnectedness with the rest of the financial world makes their failure a danger to market stability. 

Perhaps most important, government regulatory control would change the character and quality of the U.S. securities industry. One of the reasons that these firms dominate the world’s financial markets is that they have not been subject to the tight regulation of capital and activities that has characterized the business of commercial banking. Bank regulation has forced banking activities into approved channels, reduced diversity, and suppressed innovation, while the less intrusive oversight of securities firms has allowed for the aggressiveness, flexibility, and innovation that have led to world leadership. 

What, then, is the right course for the future? The answer depends on how one looks at the financial markets. If, as many in Washington seem to think, the markets are now so interconnected that the major players must be backed by the government, then the steadying hand of regulation will always seem necessary. But a more balanced view of financial history tells a different story. There, lightly regulated securities firms have shown themselves adept at adjusting to change, while the heavily regulated depository institutions, as shown by the S&L and bank defaults in the late 1980s and early 1990s, have not. Changes in the financial market in the 1970s and early 1980s—principally a highly inflationary period in the national economy—made the continuation of the regulatory model for banks and S&Ls untenable. But the institutions and their regulators continued on the same path until both S&Ls and large numbers of commercial banks suffered a financial collapse. Today, in the midst of the subprime meltdown and a credit crunch, the banks are reluctant to lend to one another because of uncertainty about each other’s financial soundness, and the banks’ write-downs are still rising. If the tight regulation of banks had done what it was supposed to do, the banking industry would be financially more stable today than the hedge fund industry. The fact that it is not says a great deal about the efficacy of regulation itself. 

Meanwhile, the securities industry, without serious disruptions, survived the deregulation of brokerage commissions, the rise of discount brokerages, the great inflation of the 1970s, several recessions, the end of Glass-Steagall protections, the near-default of Long Term Capital Management, the rise of hedge funds, the collapse of the dot-coms, the decline of the open-outcry securities exchanges and the rise of electronic trading, the globalization of the securities market, and enormous changes in communications technology. In the process, the industry took huge segments of the financial services business away from the banks, including consumer deposits through money-market mutual funds, bridge financing for mergers and acquisitions, corporate finance through efficient fixed income underwriting, short-term financing through commercial paper, inventory financing through asset-backed securities, municipal financing through auction-rate securities, and financial guarantees through credit default swaps. Based on this record, there is little doubt that the securities industry will survive the current turbulence and return to solid growth—unless, of course, Washington steps in to help with “stabilization.” 

In other words, here is the policy choice: on the basis of one extraordinary and unprecedented period in the financial markets we could subject our securities industry to the kind of bank-like capital and activity regulation that will increase moral hazard and reduce its ability to respond to change; or we can recognize that change is a continuing process and leave our securities industry free—as it has been for 70 years—to find its own path to profitability. 

Peter J. Wallison is the Arthur F. Burns Fellow in Financial Policy Studies at the American Enterprise Institute.

Composite of images by Stefan Zaklin/ EPA / Corbis and Darryl Estrine/ Getty Images.