Regulating Financial Services

December 12, 2009

by Jerry O’Driscoll  

On Friday, the House of Representatives passed a bill to alter the regulation of financial services.  The Senate has yet to act.  Still, the House passage advances President Obama’s agenda to change how financial services are regulated.  

How to regulate large, complex financial institutions remains a sticking point between the two houses. On the big issue, however, no radical change is being proposed.  Major institutions continue to face various subsidies to risk taking and the government proposes to offset these incentives through regulation.  The doctrine that some institutions are so large and complex — and interconnected — that they are deemed too big to fail remains in place (if not enhanced). In an earlier post, Mario Rizzo asked if there is “A Positive Program for Laissez-Faire?” That began a lively debate on the issue.  Most agreed that risk to the taxpayer, not size of the institution was the central policy concern. 

The idea of offsetting risk through regulation has been tried repeatedly and failed. Many want some variant of what is called “narrow banking” in which banks with insured deposits would be circumscribed in their activities and limited to traditional banking.  Another category of institutions could engage in “casino banking,” but would be denied access to insured deposits and public backing.  

The Achilles heel in this proposal was recently highlighted for me by a very thoughtful and knowledgeable legislator. No matter what policymakers promise in advance, they will bail out large casino banks.  In technical terms, there is an ineluctable time-inconsistency problem. In order to control risk, public policy must control size.  I think he is correct as a matter of Public Choice.  

To keep the taxpayer off the hook, financial institutions must be downsized.  How that should be done is a different matter.  Size equates to risk in the policy regime in place in all major countries.

7 Responses to “Regulating Financial Services”

  1. Mark B Says:

    Could the time-consistency problem be solved by a constitutional amendment? Or would that go to far? Is the issue to complex for an ammendment? Constitutional amendments should not be used for every little social engineering tweak that floats up each week, which is why they are hard to implement. But this is not a small issue, rather it is one that affects the social fabric of the nation.


  2. I sympathize with Mark on all counts. Many states have constitutional clauses forbidding the use of public monies to aid corporations. That would be much broader in scope and would have foreclosed all the bailouts.

  3. Bogdan Enache Says:

    The debate on regulatory reform, especially in the EU, is focused, as far as I understand, on three things: 1) higher capital ratios for financial institution 2) regulation of new financial instruments 3) regulation of the “shadow banking system”, aka hedge funds or invetment firms operating in off shore areas. This last points goes hand in hand with a new sort of financial protectionism.

  4. Walker Todd Says:

    Jerry and I disagree on this, but I advocate making the casino banks reorganize as partnerships (with identified individuals remaining fully and personally liable for the risks of the bank), which would solve the size/influence problem for the time being. Alternately, if we let them keep corporate charters, let them be time-limited again, say 10 to 20 years, as they were from the beginning of the Republic until 1927. I think the corporate form of the big risk-taking banks (the casino banks) is a major problem, and it might have to be dealt with by constitutional amendment (fat chance getting that through Congress without campaign finance reform). Jerry disagrees that corporate form is a problem (unless he has changed his mind lately). He suggested that state attorneys general could bring anti-fraud and anti-trust suits against offending banks; but the House bill still lets the OCC tell the states to go take a hike. So this remedy will be cut off at the pass.

    In the 1930s, the banks were herded into the Reconstruction Finance Corporation where the head, Jesse Jones, took resignation letters of senior officers as a condition of his loans in appropriate cases. Knowing that someone not in the hip pocket of the banks held resignation letters would avoid the necessity of debating a lot of the nonsense floating around about the House bill: Pay limits, risk-taking behaviors beyond the pale, accounting concealments, etc., all could be “punished” appropriately and with a minimum of fuss. Guess what? Bankers tend to behave more prudently when they know that a Jesse Jones has those letters.

    There is a contrary view out there, seeming to me to have arisen from the Ayn Rand community originally, saying that corporations were created on the eighth day and were present in the Garden of Eden. On this view, it is state interference in corporate behavior that is intolerable, rather than the traditional view that state action is necessary to create or sustain corporations in the first place. European and American traditions on this point also may be different, but simply because they are different, that does not mean that the American tradition is wrong.

    My view of the banking bill in the House is that it was not that great a reform bill in the first place, even if one were a liberal Democrat, and that the best thing to do after the lobbyists had their way with the bill is to extract (a) the consumer finance protection agency (which is necessary–bankers’ behavior on this point in the last 15 years or so has been increasingly beyond the pale) and (b) the Ron Paul audit bill (which ought to be extended to the gold holdings at Fort Knox and West Point), and then to put those two items in a pacakage that both sides should be willing to accept. Let only (a) and (b) survive, and let us fight these other issues in the Frank bill another day.

    My concern over the years has been that a lot of well-meaning theorists lack sufficient real-world banking or supervisory experience to understand how the hip bone is connected to the thigh bone, the thigh bone is connected to the knee bone, etc. The underlying struggle is between those who understand (and often and correctly deplore) certain connections (or the lack thereof) in banking and those who either don’t know or don’t care about those connections. On the latter point, I am thinking about political operatives like Larry Summers and Gerry Corrigan or their frequently used tools like Mike Bradfield. The AFL-CIO’s approach to money and banking also often seems to follow a similarly disconnected strategy.

    The connections matter. Corporate form matters. As one fairly knowledgeable House staffer put it to me, “The Democrats are too conflicted (bought or rented by lobbyists’ money), and the Republicans are simply too plainly dumb about money and banking to understand or act optimally on an understanding of how we got to where we are or what the path might be out of the wilderness.”

    This all adds up to a good formula for a Populist Revolt, but where is it?–Walker Todd

  5. Pete Says:

    Why not simply take away FDIC insurance from banks, or lower the amount to 20k per individual per bank? It would seem that this would do a lot towards controlling the reason for bailing out banks.


  6. To Pete: The movement is for government involvment in banking, not less. FDIC insurance plays a role, but more for small banks than big banks.

    To Walker: The principal, perhaps the only reason to adopt a C-Corp. structure today is to gain access to public credit markets. That, in turn, is driven by the tax code’s favorable treatment of debt versus equity. It would be more efficient to tackle the tax code.

    No one will do business on a large-scale today w/o some limitation of liability: LLC, LLP. S-Corp., etc. Thank the lawyers for that.


  7. […] I wanted to know what’s coming and was intrigued by Jerry O’Driscoll’s post on the topic, I plowed through Subtitles A and B about establishing the Financial Services Oversight Council and […]


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