• 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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    • Thanks, Austin, though like you, I don’t have time to follow financial reform at that level of detail. The real question (that I see Bank of America facing, though not necessarily confronting) with bigness is the two headed monster of efficiency and innovation. As I learned very well at the beginning of my health career, banking and health care are remarkably similar in the efficiency problems they face (I’ll leave this as an exercise to the reader 😉

      But innovation is probably the bigger conundrum in seeking the balance. We do want banks to do some innovation, but not to drive the bus off the cliff. Again, interestingly, health reform faces precisely the same problem. This is, I think, more obvious to everyone.

      So really, the problems in reform affect the whole economy and are very similar, that’s what I rely on in thinking about it, though like you I don’t have the time to follow the details.

    • Greater regulation generally leads to greater arbitrage. That was the case with the shadow banks, they simply avoided regulation.

      Since they gained a huge competitive advantage, they gained greatly in size and political power.

      What happens to this regulatory system when it cannot keep up with financial innovations, becomes negligent when times are good, and bows to the interests of very large banks?

      • @Brad P. – That all sounds sensible. But it doesn’t really address the issue of correlated failures. In such a situation it doesn’t matter as much how big the institutions are. They’re all going down. That’s what PK is saying. Makes sense to me. OTOH, what you’re saying is if the banks are small we’re less likely to get into a risky situation in which failures are correlated in the first place. Maybe so. I’m not an expert.

    • Read Simon Johnson for a better idea on why too big is harmful. Among other things, there is no way we will ever let banks that large fail as we do not know how to resolve them and the potential fallout is too risky. Ideally, we address both TBTF and interconnectedness.

      OT, but the guys at Volokh seem to think there is a good chance that the mandate may be declared unconstitutional. There may be more resistance here than I thought. It is unclear how the bill would hang together without the mandate as it is so central.

      http://volokh.com/2010/04/01/the-myth-of-an-expert-consensus-on-the-constitutionality-of-the-health-care-mandate-revisited/

      Steve

      • @steve – I’m not going to argue with SJ on TBTF. But PK at least has a point that TBTF regulations are insufficient. I doubt SJ would disagree. Moreover, TBTF regs may be a harder sell than other regs (speculation). If so, giving it up but retaining good, strong regs on what banks do may be a good enough start. Don’t expect to get everything from a political process.

        As for mandates. There are other ways to compel people. Ezra Klein has noted some. I can think of many: allow a pre-existing exclusion period (as in MA), use open enrollment periods, add a penalty for late enrollment (as in M’care Pt. D), and sundry others. I’m not worried. This is all politics anyway. (We’re talking an essentially Republican bill that some call Romneycare after all. That it was passed by Dems is the self-fulfilling cause for resistance.)

    • i read the other day about 5 top hedge fund managers and how they mad over a billion dollars each, that’s right a billion dollars in 2009.

      How did they do this?

      easy they bought into the banks and auto manufactures, know that at the lowest levels in March 2009 that the Government would not let them fail. So as the Govt. bailed out these companies so investors jumped on the coat tails and made a fortune.

      i have a huge problem with govt. bail out and especially people who make money off my tax dollars…