AN ACCIDENT WAITING TO HAPPEN

Abstract

Banks provide a valuable but inherently unstable combination of deposit‐taking and lending functions that were successfully held together for several decades after the New Deal by tough banking rules. The weakening of the rules after the 1970s promoted the displacement of traditional relationship‐based banking with securitized, arms‐length alternatives that encouraged banks to undertake activities about which bankers lacked deep relationship‐based knowledge of the risks. Ironically, this risky behavior, encouraged by loosened regulation, was reinforced by progressively tightened securities regulation, which promoted stock‐market liquidity but also deprived large banks (and other publicly traded companies) of oversight by investors with “insiders’” knowledge. Both the underregulation of banking and the overregulation of securities were underpinned by economic theories that favored blind diversification in liquid, anonymous markets, and that ignored the value of relationship‐based knowledge and case‐by‐case due diligence.

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