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.