Condemned to Incrementalism? Institutional Investors and Post-2009 Financial Sector Reforms in the United States

Abstract

The 2007-09 financial crisis did not prompt the far-reaching changes to financial sector regulation called for by many politicians, regulators and policy analysts. Instead of transformative reforms that would have restructured the financial sector, the regulatory changes adopted by national governments and international standard-setting bodies produced only incremental change that strengthened existing regulations and added new regulations but did not fundamentally alter industry practices. The lack of transformative change has been linked to the policy preferences of policymakers, who continued to see large, complex financial institutions as central to the economy. This limited the range of regulatory reforms policymakers were willing to consider and provided opportunities for the financial sector to influence policy proposals. This explanation does not, however, tell us why policymakers continued to see the prevailing industry structure as beneficial in the face of strong evidence to the contrary and intense public anger at large banks. Looking at the U.S. experience between 2008 and 2010, I argue that policymakers held on to their preference to largely maintain the status quo because it was necessary to stabilize the financial sector. Banks rely heavily on institutional investors to fund their activities. Transformative policy proposals that would have threatened the dominant position of largest banks would create uncertainty about the future value of bank securities, which would discourage institutional investors from holding them at a time when their support is needed. This feedback link between policies and markets—where proposed regulations affect current market conditions—led President Obama to appoint a policy centrist to Treasury secretary, who was well regarded by Wall Street for his experience dealing with financial crises and his pragmatic approach to regulatory reform. A desire to restore investor confidence in the banking sector also tempered the types of regulatory reforms the Obama administration and Congressional committee leaders were willing to put forward while the health of the banking sector was in doubt. Proposals to regulate banks that were less friendly to institutional investors were considered only after the financial sector had stabilized.