Wednesday, August 15, 2012

Crisis and Regulation, part three: Conclusion via Cochrane

A while back I did a two-parter on the financial crisis that I never finished with a conclusion (typical). The second post proved massively popular due to a graphic of the "securitization chain" that google decided was mine instead of the site I grabbed it from (awesome). 

In any event, I meant to end the series by saying that the solution to preventing another financial crisis would be to not only end "Too Big to Fail" as Bernanke says, but to re-structure the banking sector so that it is comprised of lots of small and medium sized banks, the failure of any one of which would not be consequential to the whole sector. In this way, the financial sector would be like any competitive industry we fetishize in our micoeconomic models, where market forces diseminate best practices, prices are at socially-maximizing equilibrium, and systemic risk is minimal to non-existent. 

And in a counter-intuitive fashion, I concluded that more government regulation of the sector could prove counter-productive to his end. Instead of going over the specifics of this, I found this handy quote for John Cochrane in the WSJ circa Dec. 2011 that sums it up better than I can: 

"The depressing scenario is that the six big banks will use this massive regulation as an anti-competitive fortress. We will have the same six big banks 30 years from now, spurred to even greater size with ontinuing subsidies, cheap Fed-provided financing, the government guarantee, and occasional bailouts. And a financial system as innovative as the phone company, circa 1965. The only hope I see is that nimble, new small-enough-to-fail competitors will spring up and rebuild the financial system. But this is faint hope in the face of the vast discretionary powers in last year's Dodd-Frank financial legislation and the Fed's rules, which allow the government to step in whenever they decide that a financial risk is "systemically important." What is not "systemically important?" How I can I build a new financial company that demonstrably causes no "systemic" danger—and is therefore not subject to the Fed's onslaught of regulation, discretionary supervision and "remediation"? How can I assure my creditors that they will receive the legal protections of bankruptcy court, and not be dragged into some arbitrary and politicized "resolution"?

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