How Should Banking Be Regulated?

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With the economy appearing to begin to stabilize, more attention is being given to possible measures for preventing a recurrence of an economic crash as calamitous as this one has been and continues to be. Advocacy of specific measures seems to me premature, however. This is not only because proposals for overhauling the regulation of banking adds additional uncertainty to the economic environment. It is also because the reform of banking regulation is an immensely complex undertaking that should be attempted only after careful deliberation. There is no urgency about strengthening bank regulation at present or in the immediate future. Memories are short, but there isn't going to be another housing or credit bubble in the immediate future even if no regulatory changes are made.

Congress seems about to pass a law that would create an investigatory commission, modeled on the 9/11 commission, to explore the causes of the current depressioin. The 9/11 commission issued, in the summer of 2004, an exhaustive narrative and analysis of the events leading up to the terrorist attacks of September 11, 2001, and of the failure of our intelligence agencies to discover the terrorists' plot in advance of its execution. Almost as an afterthought the commission made a number of ill-conceived recommendations for reform of the intelligence system, many of which were adopted with, I have argued in several books, meager results. One hopes the commission to investigate the causes of the current depression will devote more attention to formulating intelligent, constructive recommendations for reform than the 9/11 commission did. (It would be nice if we could occasionally learn from our mistakes.) But the completion of the commission's report will doubtless take a long time, so one can hope that the rush to reform banking regulation will be halted until the report is published and its recommendations digested.

Many reforms are being discussed, and in this entry I will offer my reactions to just a few of them. The first is to have two tiers of banking regulation, one for the vast majority of banks, the other for the handful (about 20) banks that among them account for about two-thirds of the revenues of the U.S. banking industry. The latter group, often described as banks "too big to fail" (more precisely, too big to be allowed to fail, that is, to go broke), would, in the suggested reform that I am discussing, be carefully regulated by a "systemic regulator" charged with responsibility for preventing the banks from taking risks that, if the risks materialized, could precipitate a general economic crash and require massive federal bailouts, as in the current crisis. A radical alternative that is unlikely to receive serious consideration is to break up the banks or shear away the parts of their business that do not fit the traditional understanding of commercial banking.

The concern with the big banks is understandable, but the idea of subjecting them to a "systemic regulator" doesn't make a lot of sense. To begin with, size per se is not a good indication of the macroeconomic significance of a financial institution. Lehman Brothers, which the government allowed to collapse last September, was not very large. But it occupied a strategic position in several important financial markets, such as commercial paper, letters of credit, and credit default swaps, with the result that its collapse, against the background of the severe weakening of the banking industry as a whole by the collapse of the housing and mortgage markets, caused a substantial disruption of the global finance industry.

 Furthermore, regulations triggered by the regulated firms' size or (what is more difficult to ascertain and evaluate) strategic significance will induce many institutions to avoid becoming large enough or strategic enough to be subject to the regulations, and the result may a less efficient banking industry, if scale and position in financial markets confer substantial benefits.

Then too, the idea of the systemic regulator doesn't match up with the concern that underlies the expression "firms too big to be allowed to fail." The concern is valid: a firm that has reason to think that it will be bailed out by the government if it gets into deep financial trouble will be able to borrow at lower interest rates than other firms, and this will give it a competitive advantage unrelated to superior efficiency. The managers and shareholders of the banks that have had to be bailed out by the government have taken a shellacking, but not the bondholders; and that is the basis for the fear that banks too big to be allowed to fail can borrow at lower rates--their bondholders don't have to worry that the banks will go broke and default on the bonds.

But even if the 20 biggest banks were split five ways, so that 100 banks instead of 20 banks accounted for the bulk of bank lending, the "too big to fail" problem would not be solved. It is not any individual bank that is too big to be allowed to fail, but the banking industry as a whole. Any single bank, even the largest, could have been allowed to fail without catastrophic consequences. The problem was that the bursting of the housing bubble impaired the solvency of a very large fraction of the banking industry (weighted by size of bank). Had that very large fraction consisted of 100 banks rather than 20 banks, the need for bailouts would have been no less urgent and the resulting windfalls for the creditors of those banks no smaller.

We also need to worry about the identity and incentives of a systemic regulator. The regulation of the American banking industry, broadly defined as it must be to include all financial intermediaries (that is, lenders of borrowed capital) rather than just commercial banks, because of the substitutability of the financial products sold by the different types of financial intermediary, is divided among a large number of federal and state agencies. Is the systemic regulator to be layered over them? Presumably so, and that would be a recipe for bureaucratic turf wars, delay, and loss of information and control.

Moreover, any agency that has a single mission is likely to perform it out without sufficient attention to the costs. An agency charged with preventing the collapse of the banking industry is likely to place an exaggerated emphasis on safety, for it will be blamed if there is a collapse, but it will not be praised for the economic benefits of a less safe, but more dynamic and profitable, banking industry. There is an analogy to the security officers who conduct background checks on applicants for jobs in the CIA and other intelligence agencies. They are too conservative in their recommendations because from a career standpoint it is better to err on the side of advising against hiring an applicant who might turn out to be a security risk; if he does, they will be blamed, but if instead he turns out to do a terrific job, his supervisors will get the credit.

A further objection to the idea of a systemic regulator is that because banking is thoroughly international, tighter regulation of U.S. banking, by reducing the profitability of U.S. banks, will tend to divert banking business to foreign banks. I would not give too much weight to that objection, however, because it is quite possible that the U.S. banking industry grew too large during recent years--to the point where its private value exceeded its social value. An efficient financial system creates wealth, but some unknown but sizable fraction of the profits that it generates are merely transfer payments from losers to winners in trades. Such transfers may merely rearrange rather than augment the wealth of society, for example by sucking talented people into the finance industry who might have a larger social product in some other field; the example I give in the book is Harvard Ph.Ds in physics who go to work for financial firms, which highly value physicists' mathematical skills.

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Richard A. Posner

Richard Posner is an author and federal appeals court judge. He has written more than 2500 published judicial opinions and continues to teach at the University of Chicago Law School. More

Richard A. Posner worked for several years in Washington during the Kennedy and Johnson Administrations. He worked for Justice William J. Brennan, Jr, the Solicitor General of the U.S., Thurgood Marshall, and as general counsel of President Johnson's Task Force on Communications Policy. Posner entered law teaching in 1968 at Stanford and became professor of law at the University of Chicago Law School in 1969. He was appointed Judge of the U.S. Court of Appeals for the Seventh Circuit in 1981 and served as Chief Judge from 1993 to 2000. He has written more than 2500 published judicial opinions and continues to teach at the University of Chicago Law School. His academic work has covered a broad range, with particular emphasis on the application of economics to law. His most recent books are How Judges Think (2008), Law and Literature (3d ed. 2009), A Failure of Capitalism: The Crisis of '08 and the Descent into Depression (2009). He has received the Thomas C. Schelling Award for scholarly contributions that have had an impact on public policy from the John F. Kennedy School of Government at Harvard University, and the Henry J. Friendly Medal from the American Law Institute.
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