Financial Regulation In a Few Paragraphs

I was just lamenting yesterday to co-blogger/colleague Steve that I don’t get financial regulation reform as deeply or thoroughly as health reform. Part of the reason is that, though I’ve been reading about FinReg all along, I’ve been reading a lot more about health reform. That, combined with the fact that I study health care, made health reform much easier for me to grok. I could identify all the important elements and track how they were approached in the various pieces of legislation that moved through Congress.

Not so with FinReg. I just can’t follow it at the same level. Then, in swoops Krugman today to make it all simple. Moreover he nails exactly the point that I’ve had on my mind ever since the whole “too big to fail” notion started kicking about. Basically, I don’t buy it, and neither does he.

Breaking up big banks wouldn’t really solve our problems, because it’s perfectly possible to have a financial crisis that mainly takes the form of a run on smaller institutions. In fact, that’s precisely what happened in the 1930s, when most of the banks that collapsed were relatively small — small enough that the Federal Reserve believed that it was O.K. to let them fail. As it turned out, the Fed was dead wrong: the wave of small-bank failures was a catastrophe for the wider economy.

The same would be true today. Breaking up big financial institutions wouldn’t prevent future crises, nor would it eliminate the need for bailouts when those crises happen. The next bailout wouldn’t be concentrated on a few big companies — but it would be a bailout all the same. I don’t have any love for financial giants, but I just don’t believe that breaking them up solves the key problem.

The story of major financial crises (as I understand them) is one of correlated failures. If all (or most) of the banks are doing the same thing and experiencing the same economic forces, institution size isn’t the biggest issue. Therefore, the solution, Krugman says, is to reform what banks are permitted to do and how they do it, not how big they are.

I’ll let you read his whole column to get the details (it’s short). He promises another to complete his Financial Reform 101 series. It’s a good way to start to get up to speed. If you’re yearning for more, I suggest the items on Ezra Klein’s recent FinReg Think Tank list. I read Mike Konczal’s Financial Reform 101 which Klein recommends. It hits all the issues and major pieces of legislation in a few pages.

(No I’m not going to blog as heavily on FinReg as I did on health reform. Go find another blogger for that. It shouldn’t be hard. I just linked to two in this post. Here’s another hint.)

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