When a presidential election falls in the middle of a financial crisis, it is not surprising that we are besieged with misinformation. Much of it is finger-pointing about responsibility for the absence of effective regulation that would have stopped or moderated the crisis. This article aims to provide some perspective on this issue.

Political responsibility for inadequate regulation: There are two sectors where more extensive regulation might have made a difference. These are the investment banks and the government-sponsored enterprises (GSEs) of Fannie Mae and Freddie Mac. Both sectors were major players in the events leading up to the crisis.

In 2004 the U.S. Securities and Exchange Commission (SEC) adopted a rule that pretty much allowed the investment banks to regulate themselves. While a number of other factors were involved in this decision, the commission’s belief at that time was that self-regulation would be more effective than SEC regulation. This policy was consistent with the free market ideology of the Republican administration.

In 2003, efforts to bring the GSEs under tighter regulatory control were defeated in Congress. This was primarily the work of Democrats, who feared that tighter regulation would crimp the ability of the GSEs to meet affordable housing goals.

I call it a tie. I also hasten to add that had both financial sectors been subject to regulation, an only slightly less severe crisis would have occurred anyway, for reasons explained below.

Deregulation, meaning the scrapping of existing regulations, was not a factor in the crisis. The only significant financial deregulation legislated in the last three decades applied to commercial banks. Restrictions on where they could branch and on their involvement in investment banking were both removed. Most economists, including me, believe that these actions made the banks stronger than they would have been otherwise.

But doesn’t that simply mean that regulators, who are not motivated by profit, should err on the side of caution? To a degree, yes, if that were not the case, regulation would be utterly pointless. But capital requirements that are higher than needed to meet potential future shocks not only reduce profits, they also impose social costs, to which regulators are sensitive. Larger capital requirements reduce loan volume and raise interest rates, a fact well understood by the congressmen who resisted tightening regulatory controls on the GSEs.

Better regulatory tools are needed. We should take a hard look at applying the system used to regulate mortgage insurance companies to mortgage lenders. Under this system, lenders would be required to allocate a portion of every dollar they receive in interest above some base rate to a reserve account that would not be touchable for 10 years except in an emergency. The higher the interest rate, the larger the payment to the reserve account.

Can we prevent it from happening again? Yes, the next crisis will almost certainly be different.

The writer is professor of finance emeritus at the Wharton School of the University of Pennsylvania. Comments and questions can be left at www.mtgprofessor.com.

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What’s your opinion? Leave your comments below or send a letter to the editor. To contact the writer, click the byline at the top of the story.

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