Financial reform for beginners

Let’s face it: Financial reform is a hard issue to follow. Reasonable people can and do disagree about exactly what we should do to avert another banking crisis.

One side — exemplified by Paul Volcker, the redoubtable former Federal Reserve chairman — sees limiting the size and scope of the biggest banks as the core issue in reform. The other side — a group that includes me — disagrees, and argues that the important thing is to regulate what banks do, not how big they get.

It’s easy to see where concerns about banks that are “too big to fail” come from. In the face of financial crisis, the United States government provided cash and guarantees to financial institutions whose failure, it feared, might bring down the whole system.This rescue was necessary, but it put American taxpayers on the hook for potentially large losses. And it also established a dangerous precedent: Big financial institutions, we now know, will be bailed out in times of crisis. And this, it’s argued, will encourage even riskier behaviour in the future, since executives at big banks will know that it’s heads they win, tails taxpayers lose.

The solution, say people like Volcker, is to break big financial institutions into units that aren’t too big to fail, making future bailouts unnecessary and restoring market discipline.

It’s a convincing-sounding argument, but I’m one of those people who doesn’t buy it.

Here’s how I see it. 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 OK 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

So what’s the alternative to breaking up big financial institutions? The answer, I’d argue, is to update and extend old-fashioned bank regulation.

What ended the era of United States stability was the rise of “shadow banking”: institutions that carried out banking functions but operated without a safety net and with minimal regulation. In particular, many businesses began parking their cash, not in bank deposits, but in “repo” — overnight loans to the likes of Lehman Brothers. Unfortunately, repo wasn’t protected and regulated like old-fashioned banking, so it was vulnerable to a pre-1930s-type crisis of confidence. And that, in a nutshell, is what went wrong in 2007-2008.

What is needed now are two things: (a) regulators need the authority to seize failing shadow banks, the way the Federal Deposit Insurance Corporation already has the authority to seize failing conventional banks, and (b) there have to be prudential limits on shadow banks, above all limits on their leverage.