Arnold Kling  

Regulatory Dilemmas

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I wrote this for the Mercatus Center.

The case for accentuating regulatory differences. We want to provide consumers with bank deposits that are insured. To protect taxpayers, we want to prevent insured banks from taking significant risks. Therefore, banks should be very closely regulated. On the other hand, we do not want to suppress risk-taking in general. Therefore, we should allow non-bank institutions much wider discretion to take risks, with the understanding that their liabilities are not insured or otherwise protected by taxpayers. In conclusion, we need to differentiate sharply between banks that are closely regulated and non-banks where the risks are borne entirely by private investors.

The case for reducing regulatory differences. We have seen that in a crunch the government cannot allow important financial institutions to fail. The federal government stepped in to guarantee money market funds and provide funds to AIG.. We have also seen that when institutions face differences in regulatory regimes, transactions take place that are motivated solely by regulatory arbitrage, to the detriment of the entire system. Moreover, it may not be possible to set up a system that insulates the regulated banking sector from spillover risks that are created by the unregulated sector. Therefore, we need to bring as many financial institutions as possible under a coherent regulatory regime.

Most of the paper concerns the not-constructive role that Basel capital regulations played in recent years. However, the issue of whether or not to try to have sharply different regulatory regimes for government-guaranteed institutions is a thorny one. I would dearly like to say, "As long as you're not a bank, you are free to fail any way you like. On the other hand, if you are in charge of a bank, we'll put you in jail if you run out of capital." But that is probably too simplistic.

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COMMENTS (6 to date)
Unit writes:

Do you think repealing Glass-Steagall was a mistake?

Arnold Kling writes:

Unit: Glass-Steagall was mostly aimed at fighting concentrated power in finance, as opposed to trying to deal with safety and soundness. It was repealed largely by technological change and financial innovation.

The issue is not separating banks and non-banks into separate markets. It is separating insured and uninsured institutions into different regulatory regimes.

Unit writes:

Thanks Arnold. This is subtle, I'm going to have to read your paper to understand this better.

Thomas DeMeo writes:

"The issue is not separating banks and non-banks into separate markets. It is separating insured and uninsured institutions into different regulatory regimes."


I don't see how you can possibly hope to accomplish one without the other.

Ultimately, the instability originated in housing values. Any solution that allows highly leveraged money from anywhere in the financial sector to flood the housing sector will destabilize the other parts, no matter how well behaved they are.

shayne writes:

Thank you, Arnold - very informative paper. I have often read your references to Basel I and II, but did not understand the basic influence they had on the current phenomena.

Two Points:

1.) I was surprised that your paper didn't emphasize your thesis of 'Easy to Fix' as opposed to 'Hard to Break'. I know you've stressed the 'Easy to Fix' approach in the past, and I heartily concur.

2.) Somewhat to 'Unit's' question, and your response[s], I still lean toward the conceptual separation of commercial and investment type financial institutions as was included in the original Glass-Steagal legislation. And I suspect that such separation provision would be highly effective in realizing your 'Easy to Fix' thesis, by virtue of containing/limiting the extent of future market mis-pricings. I know you and others have argued that the repeal of that provision of Glass-Steagal is/was not a factor, and I'm beginning to understand your perspective on that issue (above response to 'Unit'), but I'm still not convinced.

Let me explain my perspective. The financial system, like any other market system, would be best designed to offer a range of (investment) products that provide investors with as wide a variety of investment choices (risky to riskless) as possible. From an investor's perspective - individual and/or institutional - it is the range of financial products and their risk/return characteristics that are important. The laudable goal of a financial system should be to maximize capital flows (globally) and also provide a range of products - risky to riskless - that preserves robust, informed, investor choices.

Zoom forward to today. As you've explained (and others have recognized) risk assessment was deeply flawed in the events leading up to and contributing to the current situation. The market then was left with investment instruments, alleged to be low/no risk and priced accordingly, but in fact with high/severe (unpriced) risk. But the negative impact to financial markets was not limited just to those investment products. Instead, the flaw was 'allowed' to taint all financial products, all investment portfolios and the global financial system and economy at large - at least partially by virtue of 'allowing' what would/should be considered 'investment bank' practices/innovations to affect the viability of otherwise relatively 'safe' commercial banks and their assets. Further, as you also noted, it is unclear (and unlikely) that any new regulatory regime would be capable of fully warranting the 'safety' of future financial innovations, or the full financial system.

My point (and I suspect 'Unit's' point) being that, had that bank-type separation provision of the orignal Glass-Steagal act been left intact, it would not have precluded the events/contributions/flaws of the recent past, but it may well have contained/limited the damage. I understand that may not have been the original intent of the Glass-Steagal separation, but it does seem to be a valuable artifact of it, or would be, currently and in the future. Am I missing something?

"We want to provide consumers with bank deposits that are insured. To protect taxpayers, we want to prevent insured banks from taking significant risks. Therefore, banks should be very closely regulated."

¿Who is that “we”? ¿How do you know what “we” want? ¿What if insuring bank deposits turned out to be expensive and in itself risky (moral hazard)? I do not want to provide consumers with bank deposits that are insured: I want depositors to look after the safety of their own deposits, and in this way control the banks. Taxpayers and the state need not be involved in insuring or regulating banks. Functional and legitimate regulation comes from below, from competitive and evolving contractual arrangements between interested parties, not from far away and detached bureaucrats.

And of course the state should be separated from money production and management.

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