Archive for the ‘FinReg’ Category

How Much Does ‘Too Big to Fail’ Matter?

Monday, April 26th, 2010

One thing that’s throwing me off a bit in the debate over how much effort to put towards breaking up large banks is this notion of focusing on the idea of being “too big to fail.” That is, an institution getting so large that its failure will send intolerable ripples through the rest of the industry/economy, making it imperative that the public not allow such a failure. This is, obviously, the motivating factor behind the bailout of the financial industry and, to a lesser extent, General Motors.  But it seems to me that the concept of resolution authority mostly eliminates that need. The problem with allowing even a relatively small firm like Lehman Brothers to fail is the overall impact it has on the entire industry, essentially creating a panic. Given those sorts of circumstances, some sort of public authority needs to make sure a failure doesn’t happen. But if the FDIC has the authority to seize failed shadow banks and unwind them orderly and slowly, that theoretically takes care of the problems associated with panics and failures. This, of course, is why we don’t have panics related to deposit banks anymore; there’s a process in place for managing these kinds of failures that’s well understood by the industry, and people can anticipate what it means for their firms. Plus, receivership eliminates the problem of failed banks flooding the market with assets, devaluing similar assets on everyone else’s balance sheets. In this sort of structure, no one is too big to fail, because receivership is there as a sort of safety net to slowly manage the collapse of the bank. There are other problems associated with large banks to be sure, so I think the excess attention paid to failures is probably distorting more than it’s clarifying.

A Market Case For Financial Regulation

Monday, March 29th, 2010

To go along with the superb point that there’s a difference between “pro-market” lobbying and pro-business lobbying, today’s Krugman column provides a pretty good starting point for the debate over financial regulatory reform as we begin to move on from healthcare. The column is premised around a historical reading of financial regulatory norms:

Some background: we used to have a workable system for avoiding financial crises, resting on a combination of government guarantees and regulation. On one side, bank deposits were insured, preventing a recurrence of the immense bank runs that were a central cause of the Great Depression. On the other side, banks were tightly regulated, so that they didn’t take advantage of government guarantees by running excessive risks.

From 1980 or so onward, however, that system gradually broke down, partly because of bank deregulation, but mainly because of the rise of “shadow banking”: institutions and practices — like financing long-term investments with overnight borrowing — that recreated the risks of old-fashioned banking but weren’t covered either by guarantees or by regulation. The result, by 2007, was a financial system as vulnerable to severe crisis as the system of 1930. And the crisis came.

I would say that this is the biggest problem for “free-market” criticisms of financial regulations. To put it very bluntly, the banking system as we know it simply wouldn’t exist without the backing of federal deposit insurance, without which banks would be too unstable to grow as large as our major banks or have anywhere near the longevity they do now. The trade-off for this, however, is certain regulations designed to limit th public’s risk in insuring bank deposits, and banks are basically willing to take this deal. But there’s no FDIC for investment banking, nor am I sure anyone is really proposing anything like it, beyond the implicit guarantee that the government won’t let large investment banks fail. But the thing to keep in mind as Republicans start screaming that new regulations are socialism or will kill the financial industry is that the government already provides the structural backbone of American banking, and that without it the industry could never exist on the scale it does.