The Banks Are Big Because the Financial Crisis Isn't Over.

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In response to a new Washington Post story on how the financial sector's major players have just gotten bigger as a result of the government's drastic rescue efforts, Matt Yglesias comments

We seem to be mostly just consolidating while offering one-sided semi-guarantees with no meaningful new regulations. Prudence alone should keep a new crisis at bay for a little while, but basically as best one can see we’re setting ourselves up for another round of boom and bust.

But the part in bold is not really true -- there are meaningful regulations working their way through the legislative process. No, they're not what many economists would prescribe, they leave too many choices to the discretion of regulators, and they take an incentives-based approach to "Too Big To Fail" rather than an articulating a broader anti-trust philosophy. But the role of the Fed as systemic risk regulator for large and broadly-connected financial institutions is often misunderstood as simply ensuring that banks are prepared for a crisis. Here's how the WaPo describes it:

The administration's regulatory reform plan takes aim at this problem by penalizing banks for being big. It would require large institutions to hold more capital and pay higher regulatory fees, as well as allow the government to liquidate them in an orderly way if they begin to fail. The plan also seeks to bolster nontraditional channels of finance to create competition for large banks.

It's important to understand, though, that larger capital cushions and fees aren't just to make the big banks safer or more prudent. They actively prevent big banks from making higher profits because they limit leverage. Attacking the bankers' profit motive is key to making sure their are smaller financial institutions. The problem of implied government guarantees will likely be solved by the new liquidation authorities and especially the proposal that banks maintain actively updated plans to wind down their business in the cases of a crisis. (Expect those plans to be very specific about how screwed bondholders and investors will be if the banks go down.)

More importantly, the implied narrative of this story and Matt's comments -- that the steps taken to mitigate the crisis have resulted in a worse situation than we had before -- misses a key point: we are still in a financial crisis. The banks are not healthy because we are following policies from last fall's emergency rescue efforts. This is a time of transition while the administration tries to get its actual financial sector policy solutions through the legislature. Once regulatory reform is passed, it's a safe bet that the agencies will be taking action to agressively limit pernicious bank practices. (Besides FDIC Chair Sheila Bair, look for the appointees for both the proposed Consumer Financial Protection Agency and the proposed National Bank Supervisor to be pretty gung-ho on this front.)

A lot, unfortunately, depends on the legislature at this point. One good bit of news is that Congress, which is generally distrustful of the Fed, has the unusual opportunity of being institutionally inclined to be more progressive than the executive. That does depend on who ends up chairing the Senate Banking Committee; let's hope it's not Tim Johnson, who will be a force against reform should he take charge.

-- Tim Fernholz

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