Abstract of the Day: Wilmarth “Transformation of the US Financial Services Industry…”

It’s not often that I read an abstract that makes me sit up and really pay attention. In 2002, Arthur Wilmarth (professor of law at GWU) published a tremendously long article (262 pages) in the Univeristy of Illinois Law Review titled “The Transformation of the US Financial Services Industry, 1975-2000: Competition, Consolidation, and Increased Risks”. Here’s the abstract:

The structure of the U.S. financial services industry has fundamentally changed during the past quarter century. Rapid improvements in information technology and the creation of innovative financial instruments have produced a dramatic increase in competition and spurred deregulation, thereby eroding traditional barriers that separated banks from securities firms and life insurance companies. In response to these trends, major banks, securities broker-dealers and life insurers have aggressively expanded by merging with their direct competitors and by acquiring firms in other financial sectors. The Gramm-Leach-Bliley Act of 1999 has encouraged this consolidation trend by authorizing the creation of financial holding companies that engage in a full range of banking, securities and insurance activities. The Act’s proponents claim that the new financial supermarkets will produce favorable economies of scale and scope, offer convenient one-stop shopping to customers, and achieve a safer diversification of risks.

This article contends that the motivations for and probable outcomes of financial conglomeration are very different. Managers of large, diversified financial firms have sought growth in order to build personal empires, to increase market power and to secure membership in the exclusive club of too big to fail (TBTF) institutions. By virtue of their TBTF status, major financial holding companies are largely insulated from market discipline and regulatory oversight, and they have perverse incentives to take excessive risks at the expense of the federal safety net for financial institutions. Based on past experience, the new financial megafirms are likely to encounter diseconomies of scale and scope, shrinking profit margins, increased customer dissatisfaction, and greater vulnerability to sudden disruptions in the financial markets. In addition, current policies create a near-certainty that federal regulators will prop up these gigantic financial firms during economic crises.

In light of the challenges posed by financial holding companies, federal regulators have tried to strengthen capital regulation and increase market discipline. However, these incremental regulatory initiatives cannot control the potential risks of financial conglomerates, because they do not solve the problems of supervisory forbearance and moral hazard created by the TBTF doctrine. This article calls for more far-reaching reforms to our financial regulatory system in order to compel financial conglomerates to internalize the costs of their risk-taking.

Hm. Too big too fail, increased risk to disruptions, near certainty of bailout… In 2002, Wilmarth seems to have nailed how the current crisis would feel and sound. I’m looking forward to reading the rest of the article, and seeing just how good his predictions are.

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1 Comment

  1. Russ

     /  April 13, 2010

    Interesting…he notes that already by “1990-97, trading assets held by the nine U.S. banks with the greatest involvement in securities activities accounted for more than a fifth of their total banking assets” (p. 374).