What happened to the global economy and what we can do about it
with 34 comments
By Simon Johnson, co-author of 13 Bankers
In our continuing financial debate, one of the central myths – put about by big banks and also not seriously disputed by the administration - is that reigning in "too big to fail" banks is in some sense an “anti-market” approach.
Speaking on CNBC at the end last week, Gene Fama "“ probably one of the most pro-market economists left standing "“ pointed out that this view is nonsense. (The clip is here, and also on Greg Mankiw's blog; TBTF is the focus from about the 5:50 minute mark.)
Having banks that are Too Big To Fail, according to Fama, is "perverting activities and incentives" in financial markets – giving big financial firms,
"a license to increase risk; where the taxpayers will bear the downside and firms will bear the upside."
Fama is not backing down from any of his previous strong pro-market views "“ as explained by David Cassidy in the New Yorker recently (the full article on the Chicago school is also good, but requires a subscription) - and we can argue about his views on the functioning of financial markets or capitalism more broadly. When everyone is opportunistic and the "rules of the game" themselves are up for grabs "“ for example through lobbying based on existing and expected future super-profits (e.g., from being allowed to exercise any form of monopoly) "“ then bizarre and bad things can happen.
But, in any case, Fama is completely correct that,
"[Too Big To Fail] is not capitalism. Capitalism says "“ you perform poorly, you fail."
He is also correct that "complicated regulation may be a nice idea in principle but in practice it never works". Regulators get captured by the people they are supposed to be regulating (as now illustrated in the oil and gas industry); this is "not unusual; it happens all the time".
Fama has obviously considered just letting big banks fail ("I would have been for that all along"), but he recognizes that this cannot work in our political realities "“ governments will step in and make bail for banks when there is serious trouble. And, as Senator Ted Kaufman pointed out in his exchange with Senator Mitch McConnell, allowing the collapse of huge banks is a recipe for turning crisis into catastrophe.
Fama argues "the only solution is to raise capital requirements of these firms dramatically," maybe up to 40-50 percent, which is an idea we have also advanced. It's an interesting question whether this by itself would take the failure of mega-banks completely off the table "“ that would probably depend on the extent to which they were allowed to game the system, for example with risk taken through derivative positions against which they hold too little capital.
Still, Fama is thinking along exactly the right lines "“ and this is further confirmation that the consensus on big banks is shifting.
If implemented properly, capital requirements of the kind he proposes would essentially force the largest six or so banks today to become much smaller. Given that capital requirements are set by regulators, who claim to be pro-market, they should take careful note of Fama's views – and look for ways to implement a tough version of this approach.
Written by Simon Johnson
June 2, 2010 at 6:07 am
Posted in Commentary
That’s “reining in” not “reigning in.” Has to do with controlling a horse — or bull and bear . .
mondo pinion
June 2, 2010 at 6:48 am
Are you implying that we should “tow the line” when it comes to homonyms
Sufferin' Succotash
June 2, 2010 at 8:25 am
spell check ain’t got no scents
mondo pinion
June 2, 2010 at 9:18 am
A capital requirement that adjusts upward with size and risk is essentially a tax – but one administered by regulators. If high enough to be effective it would make the big institutions uncompetitive and lead to their break up. But they will resist this mightily and there is no evidence the Fed would effectively enforce this requirement. Witness the Fed’s abrogagtion of the 10% deposit rule and failure to regulate fraudulent mortgage lending. Fama himself admits that regulators will get captured. If this is so, why does he advocate what is essentially a regulatory solution? So in the end such a “tax” is not a real solution. If you want to break them up, you must simply break them up, relying on the “market” to do so won’t work.
Denver
June 2, 2010 at 8:27 am
Higher capital requirements are not ‘essentially a tax’. A higher capital requirement is not at all a tax. Taxes are revenues collected by the government as a percentage of economic activity in order to create/maintain the hospitable economic environment in which the activity can happen. A rule which says you can only pretend to have 2-3 times as much money as you actually do instead of 10 or 15 or 30 times as much is not in any way a tax.
I’m not advocating higher capital requirements as THE solution, but we should at least be fair and accurate with the subjects we debate. There are facets of the idea that demand attention, like the reduction in liquidity that would result from reduced leverage. However, a lot of the liquidity in the system is not contributing to productive or useful activity – and the question becomes: how do you get rid of the speculation and gambling instead of the investment and lending?
Robizio
June 2, 2010 at 8:55 am
Breaking up the five largest institutions should be the first place to go because it is the simplest solution. There is no way that the Justice Department would have allowed the consolidating mergers to go through in the first place unless there was a crisis. JP Morgan, B of A and Wells Fargo became the beneficiaries of the political reality that the government could not take over Wachovia, Bear Stearns, Washington Mutual, Merrill Lynch et al directly.
Where I disagree is that JP Morgan with a 30% capital requirement would not be uncompetitive, it would just have much lower shareholder returns and trade at much lower multiples of earnings – more like a regulated utility with ROE caps. This would make future acquisitions for stock out of the question but they are too big already so that doesn’t matter.
quakerfink
June 2, 2010 at 9:05 am
Fama says that “complicated” regulation won’t work. The question is whether calculation of capital requirements will be complicated or not. The statement “assets over $100 billion require retention of 50% capital backstop” sounds simple (at least, to frequent readers of this blog), but in reality it may not be if banks can disguise assets through creative accounting.
engineer27
June 2, 2010 at 11:40 am
No amount of regulatory reform "“ whether consumer protection, limits on leverage, or abolishing certain derivatives and forcing others to trade on exchanges "“ will fix the current banking problem or prevent future problems.
As long as five banks make 85% the market there will continue to be market dysfunctionalities and distortions, and serious fraud and abuse.
The solution is simple:
1. BREAK UP THE BIG BANKS. They're too big to fail. They're too big too indicting. They're too big to regulate effectively. They wield far too much power in the market and in Washington.
2. BRING BACK GLASS-STEAGALL. There's absolutely no reason big commercial banks, which carry explicit and implicit government (i.e., taxpayers) guarantees and borrow from the Fed at rates not available to others, should be speculating in any market.
These two steps will fix 95% of the problem.
There is no pro-market or economic case to preserving the current commercial/ investment bank oligopoly. It stifles competition, innovation and growth, and it concentrates wealth, power and risk "“ and ultimately distort free markets beyond recognition to the unfair advantage of a few.
Dan Stewart
June 2, 2010 at 8:37 am
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