On October 19, 1987, the stock market crashed, with
the Dow falling by 22.6%. I remember the day well; I was a speaker at a
conference on new, proposed government security market regulations in New York
at which senior SEC officials also spoke. At each break, the news about how
much the market had fallen got progressively worse. Most of the conference
attendees remained, since they were for the most part accountants and
compliance officials at Wall Street firms, but the SEC officials started
disappearing. When I returned to
Treasury the next day, my colleagues joked that I must have given one hell of a
speech the previous day.
Diana Henriques has written a book about this stock
market crash, which has been eclipsed by more significant, subsequent events.
She argues that we failed to learn the lessons from the crash and that the
regulatory laxity that led up to it was not corrected. The book has earned some
praise, and it is obvious that a great deal of research went into it. While
reading it, I was reminded of events I had not thought about for quite some
time.
Nevertheless, the book is frustrating to read. The
author, perhaps not wanting all her research to go to waste, discusses a lot of
financial events and disputes without drawing a clear link to the ostensible
subject of the book, the 1987 stock market crash.
An example of this is the aforementioned government
securities market regulation, a subject I was very involved with as a Treasury
official both while the Government Securities Act (“GSA”) of 1986 was being
written and considered by Congress and during the writing of regulations (I
wrote the capital rules mandated by the legislation). It is hard to see what
the problems in the government securities repo market, which led to the enactment
of the GSA and which the book discusses, had to do with the stock market crash.
Also, annoyingly she criticizes the GSA as a weak measure. In fact, it has been
a success by bringing regulation to firms which had not been previously
regulated and likely causing other firms which did not for whatever reason want
to face regulatory scrutiny to close up shop. The author is also wrong in
saying that “the whole statute would expire in five years unless Congress
renewed it.” What expired was Treasury’s rulemaking authority, not the
legislation nor the regulations that had been previously issued. Because of the
Salomon Brothers Treasury auction bidding scandal, Treasury’s authority did
lapse. However, Treasury’s response to the Salomon Brothers episode, including
promptly alerting the SEC when we had discovered what had happened, was
appropriate. In the end, the Treasury’s authority was renewed and the GSA was
strengthened in certain areas.
It would be a real stretch, though, to argue that all
this has anything to do with the stock market crash. The author seems to think
that this is evidence of regulatory laxity, which it isn’t, and that regulatory
laxity led to the crash.
The book also discusses over-the-counter (“OTC”) derivatives.
Whether or not the Commodity Exchange Act (“CEA,” the statute the CFTC
administers) applied to OTC derivatives was hotly debated among the futures
exchanges, investment and commercial banking firms, the Treasury Department,
the banking regulators, the SEC, the CFTC, and Congressional committees. The law
was unclear, and the legal debate was motivated by both policy positions and
turf interests. What the author misses is that certain OTC derivatives, those
that were arguably futures, would not have been subject to CFTC regulation if
the CEA applied but would be illegal contracts without the CFTC having any
ability to change that. The universe of potentially illegal contracts was
narrowed with amendments to the CEA as time went on. But, again, what does any
of this have to do with the stock market crash?
Henriques is more on point when she discusses stock
index futures. Clearly, portfolio insurance using stock index futures played a
significant role in the stock market crash. Stock index futures were and are
subject to regulation by the CFTC; while the stock market itself is of course
subject to SEC regulation. I have long thought it would be preferable for the
two agencies to be merged, but I am not at all certain that a merged agency
would have prevented the crash. What triggered the panic on October 19 is
unclear. One can argue that the stock market had been overvalued prior to that
date in 1987 and a needed correction was in order (if not such a quick one). It
is hard to see how regulators would address an overheated market, and it is
even harder to see regulators, whatever agencies are involved, taking
regulatory actions to make a market fall.
Given all the financial market issues the book
discusses, the lack of any discussion of the eventual legislative proposal of the
Treasury Department in the George H.W. Bush Administration is mystifying. The
Treasury advocated that stock index futures regulation be transferred from the
CFTC to the SEC. Quite a bit of effort was made to push this proposal in
Congress, and the SEC was naturally on board. It failed, because the policy
arguments against it were strong as were the opponents to this proposal. The
problem with the policy is that all exchange-traded futures contracts, no
matter the underlying “commodity,” share basic similarities, are traded on the
same exchanges, and are cleared and netted by the same clearinghouses. Having
different regulations issued by a different agency would have unnecessarily complicated
regulatory compliance and burdens. The futures exchanges were naturally
opposed. It would have made more sense to propose merging the two agencies, but
that was (and still is) politically impossible. Henriques could have usefully
discussed this issue in depth.
Finally, there is a reason that the stock market crash
of 1987 has receded from memory. The feared collapse of the economy did not
happen. While it is true that it took some time for the market top in 1987 to
be reached again, the stock market did recover. In short, while the crash
highlighted market vulnerabilities and regulatory shortcomings, the book makes
too much of this event. Yes, it was scary, but its significance pales to what
later happened in 2008.
As for regulation, while I do not agree with some of
her criticisms of regulation and wish she had studied the facts more closely, I
agree that the regulatory structure could be improved. A major failure of
Dodd-Frank was the lack of rationalizing the regulatory structure to make it
more effective. There are too many banking regulators, and the somewhat
arbitrary division of responsibilities between the SEC and the CFTC does not
make much sense.
The author could have usefully discussed various
proposals to address the regulatory structure and also could have addressed
what I have observed in more than one agency to be a serious problem –
regulatory capture. There is no easy solution to regulatory capture, but I
submit that it is more of a problem when there are competing regulators who
focus on one type of financial institution.
The book is well-written, and the stories told are
interesting. However, for those with some knowledge of what the book discusses,
it is in the end disappointing both for its hasty judgements on some issues and
for the lack of a coherent and convincing argument about what the market crash
signifies and what its implications for policy are going forward.
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