Funk & Hirschman (2014). Derivatives and Deregulation: Financial Innovation and the Demise of Glass–Steagall

Russell J. Funk – University of Minnessota
Daniel Hirschman – University of Michigan

Cassandra Aceves – University of Michigan
Pete Aceves – University of Chicago

Article link:

Question 1. One of the interesting contributions of your paper is the counterintuitive finding that innovations can shape regulation, instead of the opposite notion (regulations shape innovations) that is well-studied in prior research. In your discussion section you mention that “innovation may… be understood as a previously unrecognized form of corporate political action.” One could think of political activity as driven by certain goals on the part of actors, requiring a purposive stance. Thus, the conceptualization of the process you describe seems to imply a significant amount of agency on the part of industry actors. To what degree do you think firms might consciously pursue innovations in order to further political aims as opposed to having these regulatory outcomes be the unintended side-effects of innovations?

This is a great question, one that we’ve wrestled with a number of times over the course of the project. We suspect that the degree to which these sorts of politically consequential innovations are intentionally developed by organizations with the aim of disrupting regulations varies a lot across cases, probably according to the nature and extent of regulation, the resources firms have available, and the character of innovation within the industry. Unfortunately, getting historical evidence on intentions, especially for many different innovations, is extremely difficult.

In the absence of data, we can make some speculations. Most of what we found on the origins of swaps suggests that their regulatory attractiveness became clear after their invention. For example, it was not until the 1980s that managers at J.P. Morgan realized there were no provisions against derivatives in Glass-Steagall and moved their London derivatives group to the U.S. Swaps were also a huge opportunity for commercial banks—which were facing stiff competition from nonfinancial firms and foreign banks—even in the absence of any regulatory advantages. Nevertheless, the category-spanning nature of swaps gave banks powerful rhetorical arguments that they could muster when trying to avoid oversight. This made swaps even more attractive, thereby increasing their influence and contributing to the erosion of regulatory frameworks. To the extent that banks may have pursued swaps with the goal of undermining regulations, they appear to have been doing so as an emergent strategy.

Of course, swaps were running up against a long-established, widely accepted institution in American banking and for that reason the process of deregulation was gradual and unfolded over many years. One could imagine different cases that are more modest in scope where an organization devises an innovation with a more clear intent of challenging some set of rules.

We tend to think that what’s especially important—particularly given the difficulty of finding good data on intentions, and the often long and messy road between coming up with an idea and finding an application—is how organizations use innovations to undermine regulations, conditional on realizing there are regulatory implications, whether those realizations come before the invention stage, or after a product has been developed.

Question 2. Your analysis also highlighted the role of ambiguity. The innovations of swaps were ambiguous in terms of their existing category membership—were they futures, securities, or loans. This ambiguity allowed a lag in active regulation, since regulators could not easily classify the innovation of swaps and therefore had to either ignore their existence or create new ways to regulate them. You point out that this allowed for the potential of policy drift and the relaxation of regulation. Accordingly, you demonstrate that ambiguity (not being easily classified into existing categories) could in some cases be beneficial for economic actors. However, it seems as if this case relied on the unwillingness of regulators to aggressively regulate these new innovations (attributed to new economic values and the fear that these swaps would then be performed overseas and the US would lose this growing set of transactions). Could you envision a separate scenario where ambiguity did not trigger policy drift and a lack of enforcement, but rather triggered “over-regulation” (regulating the single new innovation according to all three categories)?

Another great question! Logically, the ambiguity of regulatory categories could swing both ways. Zealous regulators – something hard to imagine in the present United States! – could cite the ambiguity of regulations in order to increase the scope of their activities. And from one perspective, this is exactly what Brooksley Born tried to do as head of the CFTC in the late 1990s: take an ambiguous authority to regulate futures and extend that authority to new forms of derivatives. The major banks, and the other major regulators, saw this as “over-regulation” while Born simply saw it as appropriately enforcing the rules as written. That’s the tricky part about ambiguity – it means that assessing “over” vs. “under” regulation in somewhat in the eyes of the beholder. If we were to study the expansion of regulatory authority in the 1930s to 1970s, for example, we might expect to see a lot more cases of regulators pushing at the boundaries of their authority to regulate, rather than deregulate.

Question 3. This is a fascinating historical study—a method that we do not see as much in organizational studies. Can you shed some light on the genesis of this paper idea and your choice of method?

Thanks! We started on this paper way back in early 2010. It was initially two term papers (one written by each author) for Sandy Levitsky’s Sociology of Law seminar at the University of Michigan. At the time, the financial crisis was still all over the news. People were starting to look more closely at its causes, but we were frustrated that there wasn’t yet much systematic research. We found arguments about the repeal of Glass-Steagall to be especially interesting, particularly because the law is discussed pretty extensively in many classic works of economic sociology. So we knew we were interested in the financial crisis and the role of Glass-Steagall. Our decision to use historical methods was largely defined by our question. Once we began digging into the details of the case, we found so much interesting material on the history of Glass-Steagall that we decided to focus on the period leading up to the repeal, and jettisoned our focus on the financial crisis—that’s for another paper!

Question 4. This paper is a result of student collaboration (you both began working on this paper and finalized this paper as graduate students). What tips might you provide for students who are looking to form these types of collaborations during graduate school?

RJF: I think it’s really helpful to collaborate with someone you enjoy working with and who has a similar work ethic. Dan and I were good friends before starting on this project, which was great because it made our collaboration fun and also kept us positive through the many ups and downs of the peer review process. I think it’s also very useful to have a good division of labor, for example, around methods and theory, or analysis and writing, or something else, especially if it can be done in such a way to play to each authors’ strengths or to align with work each collaborator needs to do for other projects. Anything you can do to make the collaboration more efficient is good. We also found that meeting on a regular basis was a nice way to keep accountable, and I think it was a big advantage that we were in the same department at the same university.

DH: As a sociologist of science and technology, I want to add a plug here for the importance of finding the right kinds of collaboration tools. We used a hodgepodge of tools for different aspects of collaboration, including a shared Dropbox (for storing data, secondary sources, and drafts), Google Docs (for simultaneously editing shorter sections of text), Skype (for remote meetings), and ShareLaTeX (a Google Docs-like tool for editing and compiling TeX documents). The process can bog down if collaborators aren’t on the same page – sometimes literally! – and so it’s important to revisit the technological side of collaboration to make things are working smoothly. As Russ and I transitioned from working in the same department to working remotely, the technological routines we developed helped us keep up the momentum.

Question 5. What should we have asked you, but didn’t? Please ask yourself a good question and provide an answer.

DH: Let’s each ask each other a question! Russ, what do you think was the most interesting paper you came across in the process of working on this project?

RJF: I’d have to say it’s the original (1999) paper on legal endogeneity by Lauren Edelman, Christopher Uggen, and Howard Erlanger in the American Journal of Sociology. We ended up using a different, less institutional approach to analyze our case, but their theory and findings about the often subtle and unexpected ways that organizations shape the laws that govern their behavior are fascinating and were a big motivation for us along the way!

RJF: What’s your favorite quirky factoid about U.S. banking and finance you learned over the course of our research?

DH: When we set out to study the politics of financial regulation in the United States, I would never have guessed that a pivotal moment would involve the UK House of Lords! In 1991, the House of Lords upheld a lower-court ruling that certain swaps transactions were invalid. They ruled that British local governments had no right to enter into swaps transactions, since these transactions were basically a form of gambling. Because the local governments were not legally allowed to make such contracts, the contracts were held to be invalid – costing the big international banks a fair bit of money, and bailing out the London borough of Hammersmith and Fulham. This story demonstrated the uncertain nature of swaps and added a small comparative (or really, international) dimension to our analysis, but it was also just fun to read about.

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