Tuesday, January 19, 2010

True or False?

. Tuesday, January 19, 2010

1. "Private regulation generally has proved far better at constraining excessive risk-taking than has government regulation.”

2. "If a small-enough-to-fail bank takes too many risks and fails, the systemic consequences are manageable. If a TBTF bank takes too many risks and fails, it can drag down the entire economy."

Both come from here. The first is Alan Greenspan in 2005, but he has since recanted. The second is Felix Salmon, arguing that we should chop down too-big-to-fail banks until they are small enough to fail.

#1 is interesting to me, because Salmon seems to think that it is an obviously false statement; even its originator disagrees with it now. But I'm not necessarily convinced. First of all, what does Salmon mean by "government regulation"? Well, according to this post he means the Federal Reserve. Is it true that the Federal Reserve has proved better than market discipline at constraining excessive risk-taking by banks? I believe that's an open question. That doesn't mean that markets are perfect; but surely regulators aren't either. Is it obviously the case that regulators are less flawed than markets? Neither performed well in this crisis.

When you have systemic collapses, it's because you have systemic failures in risk-pricing. That means both markets and regulators get it wrong. But look statement #1 again: I think there is a strong case to be made that in general markets do a better job of disciplining banks than governments do, even if I accept that markets did worse in this particular case.

Now, about #2. Is it really the case that small banks can't cause systemic collapses? Well I guess you can do what Salmon does and make the answer tautological. If a bank collapses and sets off a broader collapse, then it was ipso facto TBTF. But Salmon is talking about chopping up TBTF banks until they are a manageable size. But how big is too big? Bank Herstatt wasn't very large, but it caused quite a bit of damage. The Great Depression was not caused/exacerbated by the collapse of one or two TBTF institutions, but rather by the spread of panic throughout the entire system. Smaller community banks failed first, touching off a panic that led to bank runs that caused other banks to fail. It's simply not true that we're protected from a systemic banking crisis if we limit the size of financial institutions.

Suppose we all do as as Salmon and others are asking, and move our money from large TBTF banks to smaller community banks. What happens the next time a panic enters financial markets? If we can isolate a handful of very large institutions, we can stabilize the system by stabilizing those few institutions. But if market power is much more diffuse, then containing the contagion is much more difficult: counterparty obligations can still have cascading effects, but it's more difficult to see how, when, where, and why. You may end up having to bailout or nationalize the entire banking system rather than just a handful of institutions.

In other words, perhaps TBTF is actually the best scenario. It allows us to focus recovery efforts where they can do the most good.

UPDATE: I should say that I'm not actually persuaded that any of this is actually right. Just thinking out loud.


True or False?
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