Banks effectively borrow from depositors and re- lend their funds out to others. A simple version of this relationship illuminates the risks involved. Your deposit in a savings account is effectively a loan to the bank in which you’ve deposited those funds. You probably get very low interest payments, but on the plus side, you can withdraw the funds at any time. The bank doesn’t know exactly when you’ll decide to do so— but it can estimate when that might happen. Let’s say you are earning 3 percent in interest. If it is certain you won’t withdraw the funds, and the bank can lend those funds out to some-one else at a 6 percent rate for some-one year, and the bank is certain that person will repay, it’s guaranteed a risk- free return of 3 percent per year. As the old saying goes, banking can be a 3- 6- 3 business: bor-row at 3 percent, lend at 6 percent, hit the golf course at 3:00 p.m.
But certainty is more easily modeled than achieved. If a criti-cal mass of depositors demands their money back immediately, a bank that lends unwisely could be overwhelmed. That happened at
thousands of banks in the early 1930s, both refl ecting and accelerat-ing America’s worst economic crisis. Unregulated banks are inher-ently unstable.
After the Great Depression, regulators decreed a fi rewall be-tween depository institutions (which were supposed to invest very cautiously) and more freewheeling investment banks. A Federal De-posit Insurance Corporation (FDIC) was established to protect or-dinary bank account holders.10 Investment banks’ customers weren’t as protected, but could at least take comfort in the structure of the institution: the own ers (partners) had their own capital on the line in case the bank failed. The leading fi nancial institutions were smaller, too, and their balance sheets were easier for regulators to monitor and understand.
The post- Depression banking system was much more stable than what came before, but it ended up a victim of its own success. Hav-ing deregulated airlines, truckHav-ing, and other industries, a powerful laissez- faire movement questioned why banks still needed admin-istrative training wheels. Investment banks also started “going public”— as corporations, not partnerships. This or gan i za tion al change allowed management to shield its own fortunes from what-ever losses the bank might incur.11 Becoming a publicly traded com-pany made some aspects of their books more open. However, it also created pressure to maintain the outward appearance of constant, steady growth.12
Given the business cycle and the natural instability of demand and supply, constant growth is an elusive target. Finance fi rms promised inventive ways to “smooth away” the risks from, say, interest rate hikes or volatile energy prices. Futures trading expanded as the less regulated world of “swaps” of risk. The 1990s witnessed the rapid growth of investment contracts called derivatives.13 For example, the insurance company AIG established a Financial Products (FP) divi-sion to offer fi rms “interest rate protection”: in exchange for a fee, AIGFP would pay in case rates rose or fell by a certain amount. Some of these “swaps” of risk lasted thirty years or more. The head of AIGFP kept these risks so hidden, and the CEO of the parent com-pany grew so concerned about them, that AIG eventually hired a “co-vert operation of auditors, derivatives experts and other professionals
to infi ltrate” its own secretive unit.14 A consulting fi rm estimated AIG lost $90 million on the bets.15 (AIG went on to lose vastly more on risky bets in 2008, intensifying the fi nancial crisis.)
While the contracts were marketed as a way to hedge risks, they could also create enormous losses. For example, in 1994, Orange County, California, became the largest municipality in U.S. history to go bankrupt after its trea sur er lost $1.7 billion of its $7.4 billion investment portfolio in derivative bets.16 (And the problem endures:
cities to this day are spending enormous sums on bad derivative bets.) Former trader Frank Partnoy’s book F.I.A.S.C.O. portrayed bankers who laughed about “ripping the face off” unsuspecting cli-ents. Repeated crises provoked liberal Demo crats in the House of Representatives to investigate these “products” in the early 1990s, but their legislative proposals were quickly blocked.17
The chair of the U.S. Commodity Futures Trading Commission (CFTC), Brooksley Born, renewed the call for more regulatory scrutiny of such transactions in 1997. She warned Congress that their rapid growth could menace “our economy without any federal agency knowing about it.”18 Born fl oated a “concept release,” an agency document announcing the need for study of a given market practice.
Note that Born had not proposed any specifi c regulation at the time—
she was merely prodding agencies to learn more about this new and growing aspect of Wall Street trading. Then- assistant Trea sury secretary Lawrence Summers quickly put the kibosh on her. He claimed, “I have thirteen bankers in my offi ce, and they say if you go forward with this, you will cause the worst fi nancial crisis since World War II.”19 Born backed down.
Many factors contributed to the deregulation of fi nance. Power and ideology matter: banks invested massively in lobbying, and the Reagan era primed politicians to see government as less a protector of markets than a pesky problem. Insiders shuttled between Washing-ton and Wall Street. As information technology improved, lobbyists could tell a seductive story: regulators were no longer necessary. So-phisticated investors could vet their purchases.20 Computer models could identify and mitigate risk. But the replacement of regulation by automation turned out to be as fanciful as fl ying cars or space colonization.