“We tend to think of innovation as something that follows or is affected by regulation. This is an interesting case because it flips the relationship around and says what can innovation do to regulation?”

 

Despite regulators’ best efforts to govern their activity, firms continually find new loopholes to circumvent financial rules. According to Assistant Professor Russell Funk, this happens because regulators are not equipped to handle financial innovations that don’t fit the existing framework.

Funk first learned of this phenomenon when, along with collaborator Daniel Hirschman (University of Michigan), he began investigating the cause of the 2008 financial crisis. Ultimately, they discovered looser regulations were not to blame. Furthermore, their research suggested companies had developed new means to sidestep the rule, long before it was repealed.

“At the time, many people were speculating on the causes of the crisis but there was little systematic research that offered credible insights, which was frustrating,” says Funk.

Many identified the catalyst of the crisis as the 1999 repeal of the Glass-Steagall Act, a law dating back to the Great Depression that placed a barrier between commercial and investment banking in the United States. Funk decided to start here. He traced the evolution of the law by reviewing bank financial records, congressional reports, banking trade publications, and newspaper archives. 

Funk found that the repeal had little to do with the crisis, as Glass-Steagall was largely ineffective by that time anyway. In the early 1980s, commercial banks found they could participate in interest rate and foreign exchange swaps, putting them in competition with investment banks, all while staying within the limits of Glass-Steagall. These swaps became the most widespread of modern financial innovations.

Funk says the big lesson from his research is that the findings affirm the need to continually evaluate standing regulations to see if they are still serving their intended purpose.

“Regulations need to be updated as the world evolves and organizations engage in new practices,” Funk says. “If they are not, as we found in the case of Glass-Steagall, they can have effects that are potentially the opposite of what their framers may have intended, while also giving some groups unfair advantages.”

Watch Funk describe his findings

 “Derivatives and Deregulation: Financial Innovation and the Demise of Glass-Steagall” Funk, R., Hirschman, D., Administrative Science Quarterly (2014)