The regulation of the United States financial system: An analysis of alternative theoretical approaches

This is an analysis of the controversy over the necessity of regulation for a robust and stable financial system. Economists associated with the Shadow Financial Regulatory Committee have proposed a program of extensive deregulation. The core thinking behind this program is that it will maximize the exposure of financial intermediaries (FIs) to the risks, rigors, and discipline generated by free markets. It is argued that exposure to these forces will induce FIs to be more cautious in weighing which portfolio risks are acceptable, thereby avoiding inappropriately risky holdings out of self-interest. The result is resilient FIs and a robust and stable financial system without the customary regulatory constraints.; An examination of the deregulation arguments shows that they are based on a set of twelve assumptions derived from conventional marginalist economics melded with Friedman's monetarism. These arguments lose power and credibility when those assumptions are questioned. This difficulty is addressed by proposing an alternative set of twelve assumptions which more fully reflect reality. For FIs, these assumptions are derived from Alfred Chandler's study of firms as well as institutional models of firm behavior, while noting the impact of short-termism. For financial markets, the assumptions are derived from works using an approach developed by Hyman Minsky. This approach builds on Keynes' theoretical foundation.; Under this alternative set of assumptions, an analysis of FIs likely behavior indicates outcomes which render a program of financial deregulation destabilizing, not stabilizing as claimed. The central reason for this difference is that, under the alternative assumptions, FIs respond to the increased competition of deregulation by pursuing high rates of growth. The simplest path to such growth is the acquisition of a riskier portfolio. The inducement of this sort of growth weakens FIs, reducing to dangerous levels their ability to absorb reversals. The result is a fragile and unstable financial system.; Instead, the alternative assumptions suggest a regulatory structure where voice-led relationships dominate and all FIs operate under the same soundness principles. A structure doing this is proposed. It is concluded that the alternative program has greater merit than the deregulatory one because its theoretical assumptions provide a better understanding of reality.