by Chidem Kurdas
Regulation advocates seem to regard the JP Morgan loss as the best thing since sliced bread. Thus Paul Krugman gleefully bawls out Mitt Romney for refusing to see it as a sign for greater government intervention.
Krugman repeats the by now well-known argument on banks, as a riff on “It’s a Wonderful Life.” The Jimmy Stewart character makes “a risky bet on some complex financial instrument,” loses the money and causes his bank to collapse. The moral: banks should not be allowed to take on much risk because “they put the whole economy in jeopardy” and “shouldn’t be allowed to run wild, since they are in effect gambling with taxpayers’ money.”
The fact is, banks make money by taking risk. That’s always been the business model. Even Bailey Building and Loan in “It’s a Wonderful Life” makes risky home loans—one might think of them as subprime. Traditional banks are entities that take deposits, invest the money and profit from the difference between what they pay depositors and what they make on investments. In the past the investments took the form of direct loans but banks can invest in a variety of ways.
Now and then something goes wrong. When there is a major market dislocation such as a property bust, borrowers default, leaving some banks insolvent. So, since 2007 more than 440 commercial banks have failed, according to the Federal Deposit Insurance Corp.
But the argument for greater regulation is not about these commercial banks. They have long been so heavily regulated that any more regulation would in effect turn them into government agencies. Obviously the multi-layered regulatory regime has not stopped banks from making bad investments and failing. Whether this is a loan to the local developer or a play on mortgage-backed securities makes no difference for the resulting insolvency. The notion that a “complex financial instrument” must be to blame is a red herring. Banks went under in droves in past financial crises before complex instruments were even invented.
In any case, the idea is that big banks’ risk taking should be overseen more tightly on the ground that they might damage the economy. Government bureaucracies are already deciding how much risk is allowed and what is excessive; the argument is for further expanding their remit.
Sure, banks make mistakes, but does anyone honestly believe government bureaucrats know better? They’ve never shown any evidence they understand the supposedly simpler risks small banks take. It is logically incoherent to suppose they understand the risks of big banks. If the Federal Reserve had any notion of the risks banks – big or small – were taking, it should not have allowed credit to grow so much in the early 2000s.
Given the government’s track record, it is absurd to presume the financial system will function better under more government tutelage. What will happen for sure is greater government control over the economy, moving the United States closer to state capitalism—not really a Jimmy Stewart world, more like a Mr. Bo world.