An Ill-Advised Second Post (of the Day) on FinReg

I shouldn’t do this. I really should not do this. But I’m going to post again today on FinReg. (Hey, it’s Friday and I’ve got a few minutes and a few thoughts. Plus, what’s a blog for…).

I don’t think Krugman was necessarily saying don’t break up big banks. I think he was more clearly saying that breaking up the big banks is insufficient. That is, even if it is necessary, regulation is also required. Well, even if this is not exactly what he meant it isn’t a crazy position. And Michael Konczal agrees.

For those who really do want to do reform, Krugman divides them into (a) those who want to break up the banks and call it a day, and (b) those who want to bring resolution authority and expand the scope of regulation into the shadow banking sector….

For me, it’s not an either/or but a both/and question. I think we should do both (a) and (b), impose a hard size cap of $400 billion to $500 billion and then expand regulation over all the broken-up shadow banks.

So, by all means, let’s do both. Or can someone tell me why we should really badly prefer large financial institutions over small ones. (Krugman? Anyone?)

Arnold Kling can’t tell me either. He also argues for breaking up the banks in a National Review article. Kling summarizes his argument in a post saying that it is a subtle one.

The advantages of breaking up the largest banks would be subtle. One is that an individual bank would be less likely to see itself as too big to fail. A second possible advantage is that there would be more diversity of thinking within the financial system. One of the more disturbing aspects of the housing finance boom/bust was the sheer groupthink involved. As I have shown in my published writing on the financial crisis, the key financial industry executives and regulators all “knew” the same things, which turned out not to be true. Maybe if there had been forty major financial institutions instead of ten, they would not have all shared the same outlook. It is possible (by no means certain) that some independent thinking might have found its way into the financial community, and perhaps even the regulators would have been open to diverse points of view.

The key here really is correlated failure. Kling is banking a lot on variation in strategy that he hopes will emerge if there are more opportunities for it. There’s nothing wrong with that. But I wouldn’t bet the farm on something that is articulated with words like “maybe” and “it is possible.” So, again, I’m finding myself open to the idea that breaking up the banks might be of some help, but I can’t see a convincing argument that it is sufficient. In fact, in his National Review article Kling wrote

To the extent that they share exposure to the same risk factors, a system with many small banks could be just as vulnerable as a system with a few large ones. The fundamental sources of financial risk — including leverage, interest-rate risk, exchange-rate risk, and speculative bubbles — have a way of insinuating themselves regardless of the banking industry’s structure and in spite of the best intentions of regulators.

This sounds like a set up for a both/and (break-up and regulate) position. I didn’t see the pro-regulate part in Kling’s article. He prefers “a completely hands-off policy when it comes to financial markets.” But with so little confidence that busting the big banks will help, how does one justify not arguing for more regulation as well?

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