Growth in post war United States, aperiod known as “the golden age of capitalism,” brought never-before-seenprosperity and growth to the American people. In 1978 the average worker made$48,302 (adjusted to 2010 dollars) and his CEO made $393,682 (Reich, 2013). However,the golden age began to wane in the late 1970’s and wealth inequality has beenincreasing drastically since. In 2010 a similar worker averaged $33,751 and theCEO averaged $1,101,089 (Reich, 2013). For the worker that is a 30% decrease inwages, for the CEO that is a 180% increase. There are many theories explainingthe increase in inequality such as; technological change, loss of collectivebargaining, minimum wage, and even corruption. Inequality in the United Stateshas grown exponentially and in the wake of the recession of 2008, caused in nosmall part by deregulation and securitization, we must ask ourselves how freethe free market should be.
Should banks be unregulated by the government andleft fully in the hands of the free market? The purpose of this paper is toexamine the idea that bank deregulation is a cause of inequality and answer thecentral question, does deregulation of banks and financial institutions create,add to, or have any effect on inequality? In what follows several pointsrelating bank deregulation, financialization, and inequality will be discussed.There are two basic drivers of inequity, mechanisms that increase wealth forthe wealthy and those that stagnate or diminish wealth of the poor. This paperwill examine how bank deregulation fuels both mechanisms.
The paper will bebroken into four sections with each section containing a brief summary. Thefinal section will be the conclusion to bring the sections to a centralanalysis to answer the question, does deregulation create inequality? Deregulationat the state levelThe first major steps towardsderegulation happened at the state level. Prior to the 1970’s states had lawsrestricting the interstate and intrastate expansion of branches and bankingactivity. Many states had limitations on branch expansion within the state. Thebank could have several branches but operated with separate licenses andcapital.
Some states would only allow a bank to have a single branch in theentire state. Over time, pressured by changes in banking technology, theserestrictions were loosened in an effort to improve bank performance. Those mostaffected by state deregulation were in rural areas. Previously with banks beinglimited in branching, and in some cases only allowed one branch, rural areasrarely had a bank of their own.
The less wealthy rural areas had limited accessto loans, loans they could use as an investment in education, or for businessventures, loans that would, over time, have the possibility of increasing theirincome. Another issue prior to deregulation was local bank monopolies. Thelarge local institutions, devoid of any competition, were better able to sethigher interest rates, unfavorable terms and be more selective of loanapprovals.
Deregulation at the state level resolved both of these problems.Rural areas were given access to loans they could in turn invest in education,increasing their income, and increased competition limited the power of localmonopolies (Beck, Levine, and Levkov, 2010).Empirical evidence by Beck, Levine,and Levkov (2010) shows that deregulation also increased the wage of lowskilled workers. They conclude that demand for unskilled workers (those with 12years or less of education) increased in deregulated states along with thehours worked by unskilled workers, relative to skilled workers. They also showthat due to the increase in demand for unskilled workers, unemploymentdecreased. Their findings suggest that bank deregulation created competitionamongst banks which in turn stimulated growth, raising the demand for unskilledworkers.
Interstate and intrastatederegulation decreases inequality by increasing the income of those with lowerincomes, as they were the most affected by regulated banking. In summary,deregulation at the state level did not contribute to inequality but in facthelped to decrease inequality. However, during the same time period, inequalityat a national level was increasing. The biggest take away is that deregulationincreased competition and the increase in competition in turn benefited thepoor by increasing their income and therefore reduced inequality. From this wecan conclude that bank competition decreases inequality at the state level.
It is important to mention that Beck, Levine,and Levkov (2010) also found that the decrease in inequality only lasts a shorttime, leveling off after approximately 8 years. They conclude “deregulation has a level effect on inequality, but doesnot have a trend effect.” We must now move our attention to bank deregulationat the national level to determine its effects, if any, on inequality. Deregulationat the national levelThe stock market crash in 1929 andthe resulting depression forced government regulators to question the need forbank regulation.
The first regulatory bill to come after the crash was theGlass-Steagall Act of 1933. The act clarified a separation between investmentand commercial banking. At the time, when a person deposited money into theirbank account, the bank would use those funds to make investments, and thereturns from those investments were profits for the banks. Banks made riskierand riskier investments, and when the stock market crashed those investmentsfailed. There was a run on the banks, and when the limited cash on hand thebanks had was exhausted, the average citizen suddenly had lost most, if notall, of their money. The motivation behind the bill was to prevent banks frommaking risky investments with depository funds by separating depository andinvestment banks, therefore taking the risk away from every day banking andprotecting savings in times of crisis.
Glass-Stegall had also setrestrictions on interest rates for depository accounts. However, in the late1970’s high inflation started to eat away at gains from depository accounts, soinvestors needed something better. Investment banks created money market mutualfunds (MMMF) where they would combine money from different investors to buycommercial stocks. MMMF were notregulated and became increasingly popular with investors. As the economyevolved the Glass-Steagall Act was slowly phased out, starting with theDepository Institutions Deregulation and Monetary Act (DIDMCA).
The act aimed to allow banks to compete withMMMFs by phasing out interest rate ceilings. Several other small acts duringthe 1980’s and 90’s ultimately lead to the death blow of the Glass-Stegall Act,the Gramm-Leach-Bliley Act. The Financial Modernization Act (FMA), as it wasalso known, removed all restrictions on combining investment and depository banks.The FMA and its numerous deregulatory predecessors created two major drivers ofinequality, the creation of what Carow and Kane (2002) call “megabanks” andsecuritization.A megabank is the combination oftwo (sometimes more) financial institutions, typically combining a depositorybank with an investment bank, and in some situations, an insurance company. Oneparticular case of a megabank creation that sets an example of the power theseinstitutions have is the creation of Citigroup, Inc.
In 1998 Citicorp andTravelers Insurance Group announced that they were going to merge, a mergerthat was, at the time, illegal. Prior to the announcement top executives fromboth firms had spoken to government officials including the president, BillClinton. The companies went ahead with the merger, although it was stillillegal, and formed Citigroup, Inc.
The newly formed mega-bank was given a yearextension giving the government time to repeal Glass-Steagall and allowing thecreation of the largest financial services company in the world (Mars, 2010). Thisis a prime example of the power megabanks have. On the state level deregulationdrove competition and ended local monopolies; the paradox is that on thenational level deregulation drove the creation of monopolies.
As it wasintended (national level) deregulation drove competition. However, thatcompetition lead to mergers, and mergers created megabanks, and megabanksmonopolized the financial industry. As banks become larger and combinedistinct types of financial institutions (insurance, depository banking, investments)they become harder to regulate. Each aspect of the company is subject todifferent regulatory agencies. Depository banks are governed by the FDIC,investment banks are governed by the SEC, and insurance is typically governedat the state level. The mergers leave the government struggling to effectivelymonitor these new institutions. The complex nature and speed of transactions ofsecuritized assets (discussed below) meant that firms themselves were notcertain who owned what at a given time (Mars, 2010). This made it even moredifficult for regulators, so they started to take a hands-off approach andentrusted the firms to self-regulate.
Eventually, in 2004, the SEC changed itsrequirements making reporting information to the SEC voluntary. Sherman (2009)states; “The system of voluntary regulation relied on the internal computermodels of these firms, essentially outsourcing the job of monitoring risks tothe firms themselves.” Prior to the 1970’s a home buyerwould get a 30-year mortgage at their local bank and that bank would hold ontothat loan for the entire term. For the banks, this meant that they had to becareful who they lent to, so they had high standards for home buyers and it wasrare that someone would default on their mortgage. However, as banks began toderegulate, depository institutions began to sell their mortgages to investmentbanks in order to free up capital.
The investment banks would then poolthousands of mortgages together (sometimes also including student loans, autoloans, and credit-cards) to create Collateralized Debt Obligations (CDOs). Thebanks would then sell CDOs to investors and when homeowners paid their mortgageevery month the payments went to the investors. CDOs were then broken into tranches(French for “slice”) based on the quality or safety of the underlying loans. Seniortranches being the safest with lower interest returns and juniors being riskierbut with a higher return. This was a good and safe system fora long time.
Because of high underwriting standards the loans were being repaidand everyone was making money. This made CDOs popular with investors and soonthey ran out of mortgages to pool together. The CDOs then started being filledwith subprime loans.A subprime loan is a high interestrate loan offered to people who do not qualify for a traditional loan.
Theywould use teaser rates or interest only balloon loans to entice borrowers tobuy a home with unfavorable terms. Subprime lenders only offer these types ofloans and received large profits from them. The mortgage industry then became anumbers game: as the subprime lenders would create loans they would be sold toanother institution within a week (Baradaran, 2015), so the more mortgages theycreated, the more they could sell and the more profit they would make. Lendersbegan to push subprime loans on low income borrowers as well as those who couldqualify for a conventional mortgage.
Brooks and Simon (2007) reported that asof 2006, 61% of subprime borrowers’ credit scores were high enough for them toqualify for a conventional mortgage. In the 90’s subprime loans were added to CDOswith better performing mortgages usually with about 5% of the loans in the poolbeing subprime (Mars, 2010). So even if all of the subprime loans failed, theCDO would not. However, as the CDO market became even more popular subprimeloans began to take up more and more of a percentage of CDOs. In some cases,the loans that were not used in one CDO (due to risk) were packaged togetherwith other unused subprime loans to create a new CDO. The CDO, now made up ofmostly subprime loans, was given a safe rating because it was seen as diversified.So, a CDO made up of mostly subprime loans was rated as highly as CDOs withonly 5% subprime loans.
Carow and Kane (2002) point out that this type ofactivity did not create economic value, but redistributed wealth. While theCDOs did not create value for the American economy, wages in the financialindustry, created by bonuses and fees, have risen drastically (Philippon andReshef, 2012).With the government placing thetask of regulation in the hands of the banks themselves, the issues withsecuritization went on unnoticed and unquestioned. The problem withsecuritization is that it puts the risk ultimately on the American tax payer.In the old system if a mortgage failed the bank who had the loan would beliable for the lost funds. With securitization, when the loan was sold by theoriginating bank the risk fell to the institution that had bought it. When thatloan was added to a pool of loans to make a CDO, the risk was then passed tothe investor. When one loan in a CDO fails it is just taken out and replaced byanother.
However, as was examined in 2008 just after the teaser rate expiredfor subprime loans, so many of the mortgages failed that they could not simplybe replaced, and the CDOs failed. When the CDOs failed it was akin to a modernday run on the banks except investors didn’t have to race to the bank to getwhat they could because their money was already gone. In the wake of the crisisretirement investments lost approximately $2.4 Trillion, “Of the 18 millionworkers aged between 55 and 64 in 2012, 4.3 million will be poor ornear poor by the time they’re 65” (Ghilarducci, 2015). To reexamine the creation ofCitigroup, Inc. points out another crucial factor in relating bank deregulationto inequality, political power of the financial industry. As mentioned above,Citigroup had such an influence on the government that they were able to openlybreak the law.
Not only were they able to break the law, but the governmentchanged the laws at the discretion of the banks. Banks, and any othercorporation or industry, gains power through lobbying and political donations.Between 1998 and 2008, the financial industry spent over $5 billion on lobbyingand campaign contributions (Mars, 2010). Campaign contributions help officialsget elected, and once elected companies pressure officials to vote forregulations that favor that company. Lobbying puts similar pressures on electedofficials hoping to sway their vote.
The power banks get from thesecontributions is most evident in a study by Blau, Brough, and Thomas (2013)where they examine how Troubled Asset Relief Program (TARP) funds weredistributed. TARP, also known as “the bail out”was the government’s response to the financial crisis of 2008. The idea was tobuy the failed CDOs from the banks and the banks would use that money to reinvestin the economy stimulating growth, lifting the country out of recession.
TARPfunds were given out over several payouts starting in October of 2008. Theirfindings suggest that 62% of firms that lobbied in the 5 years prior to TARPreceived funds in the first two payouts and 95% of firms that lobbied receivedfunds in the first nine payouts. Firms that lobbied received TARP support21.34% sooner and for evert dollar spent on lobbying firms received between$485.77 and $585.65.
Reich (2013) examines what he calls”the virtuous cycle” when money is invested into the economy via private sectorgrowth it creates a prosperous economy. Each aspect of the cycle fueling thenext, economy expands, wages increase, higher tax revenue for the government,the government invest more, productivity grows, the economy expands. He alsoexamines an opposing trend he calls “the vicious cycle” where money is takenout of the flow of the economy. The economy contracts, wages stagnate,consumption decreases, tax revenue decreases, production decreases,unemployment rises. He concluded that the deregulated financial system createshigh wages at the top that are not reinvested in the economy. He points out acommon misconception of what is often called “trickle-down economics” (PresidentRonald Raegan’s economic policy). The idea of trickle-down is that by givingtax breaks and other incentives to the wealthy, the wealthy will reinvest thatmoney into the economy creating growth for the economy as a whole.
Reich (2013)shows that the wealthy do spend more in dollar value than the poor and middleclass, however, as a percentage of income, the wealthy spend far less. Thismeans that the wealthy are holding onto a large portion of their money and notinvesting it into the economy. Carow and Kane (2002) explain that bankderegulation “redistributed rather than created value.” To conclude this section, bank deregulationcreates megabanks that take wealth out of the economy and redistribute thatwealth amongst themselves. This is done through CDOs and other financialproducts that redistribute wealth rather than create value for the economy.This is also evident in Philippon and Reshef (2012) where they providequantitative evidence that wages in finance have grown rapidly, compared toother non-farming industries, since the 1980’s. Deregulation lead to riskyinvestments and subprime lending that most financial experts and economist attributeto causing the 2008 financial crisis. The wealth gained by the megabanksallowed them to lobby creating a relationship with government officials.
Bankstook advantage of that relationship and as explained by Blau, Brough, andThomas (2013), 95% firms that lobbied would receive TARP funds in the first 9payouts. Instead of reinvesting those funds into the economy, the banks paidthemselves large bonuses (Baradaran, 2015). The wealth of individuals in thefinancial industry was relatively unaffected by the crisis they had caused(Mars, 2010). At the same time $2.4 trillion in retirement savings was lost inthe wake of the crisis (Ghilarducci, 2015).
In the introduction it was mentionedthere are two ways for inequality to happen, the wealthy become wealthier, orthe poor stagnate or become poorer. In the case of national level bankderegulation, both situations are evident. Theunbanked Thomas Jefferson believed that ifthe banks were able to gain too much power they would aid only the wealthy, atthe expense of the rest of the American people. As a rural farmer himself heworried that a central bank would concentrate wealth in cities and leave littleto rural farming areas. He once said “I believe that banking institutions aremore dangerous to our liberties than standing armies” (Baradaran, 2015). Statelevel deregulation was effective in decreasing inequality because it gavepeople in rural areas access to banking. Deregulation at the national level hadthe opposite effect.
Deregulation drove competition, banks merged, and thenumber of bank branches decreased. As banks began to merge the profitability ofoffering services to the poor diminished. Bank users were now seen as a sourceof profit and the poor were simply unprofitable. Baradaran (2015) explains”between 1984 and 2014, the amount of bank charters fell by over 60%.” Just asThomas Jefferson had predicted, driven to increase profits, banks left ruralareas in favor of wealthier cities. The gains for the poor that were made withstate level deregulation were reversed with national level deregulation. As thestate level deregulated the poor gained access to banking activities in turnincreasing income. National level deregulation reduced the number of banks decreasingbanking access to the poor.
It reduced access by reduced branches but more soby the refusal of banks to open accounts for the poor. Banks do not outrightrefuse the poor, they use minimum balances to keep the poor out. The averageminimum balance requirement for a checking account is $400, and with half ofAmericans unable to come up with $400 with out selling something or borrowing,minimum account balances effectively keep the poor out (Baradaran, 2015).
Leftwith out a bank account, in order to cash their paycheck, they must pay a fee,or to write a check (usually a money order) for their rent, they must pay afee. Baradaran (2015) explains “the average unbanked family with and annualincome of around $25,000 spends about $2,400 per year on financial transactions.”National level deregulation makes it expensive to be poor. This is not just aproblem in rural areas. Banks did move from rural areas into the cities, but somecommunity banks and credit unions stayed behind giving the rural poor some,although limited, access to banking.
With offering banking to the poor beingunprofitable and the smaller institutions that serviced the poor being pushedout, inner city poor were left with no banking options at all. As mentionedabove, when the poor are denied access to banks, they have to pay for it,driving down the percentage of income being spent on consumption. And asdescribed by Reich (2013) when consumption decreases, production decreases, wagesstagnate or decrease, unemployment rises. To conclude this section; nationallevel bank deregulation reduced poorer peoples access to banks, decreasing the amountof money they can spend on consumption and ultimately decreasing real income. ConclusionState level deregulation promoted competition,and decreased local monopolies giving the poor access to banking activities. Withaccess to banks the poor were able to take out small loans that in timeincreased their income.
Bank deregulation at the state level had a decreasing effecton the poor. However, the affects lasted only a short time, approximately 8 years.With national level bank deregulation, we can observe that the same factor,competition, had the opposite effect. At this point the relationship betweennational level bank deregulation and inequality is abstract. From the researchcollected, no empirical relationship has been evaluated. However, data doessuggest that deregulation creates high incomes for CEOs and board members ofmegabanks along with high wages in the financial sector in general. Researchalso shows that in the wake of the 2008 financial crisis, firms that hadlobbied in the past five years and had political connections received thelion’s share of TARP (Troubled Asset Relief Program) funds. This tells us thatthose at the very top of the managerial chain are less affected by crisis.
Ithas also been reported that instead of using the TARP funds to invest back inthe economy the large financial firms used those funds to pay themselves largebonuses, increasing incomes at the top. The lack of value creation andinvestment in the economy of the financial sector created stagnant real incomefor the poor and middle class. The deregulation of banks has led to competitioncreating large banking institutions that are unwilling to offer banking servicesto the poor. This makes it difficult for those in poverty to gain wealth orassets keeping them in poverty. This leads to the theoretical conclusion thatalthough bank deregulation itself may not cause inequality, it creates mechanismsthat allow earnings for the wealthy to grow exponentially when the income ofthe poor and middle class remain stagnant.