It's not often that I disagree with Paul Krugman, but there are occasions where at least one of us is wrong. And the treatment of too big to fail (TBTF) banks is one of them.
Krugman argued in a column last week that breaking up the TBTF banks is not a necessary part of financial reform. Krugman pointed to the example of Canada as a country with a well-regulated financial system. Canada did not experience a financial crisis in 2008 in spite of the fact that five big banks essentially account for the whole of the Canadian banking system. On the other side, Krugman noted that the collapse of large numbers of small banks can also create a crisis, pointing to the chain of bank collapses at the start of the Great Depression.
These are valid points, but to paraphrase Dorothy in The Wizard of Oz: "we're not in Canada anymore." While Canadian banking regulation appears to have been effective thus far (we may want to see how they cope with a yet to deflate housing bubble before pronouncing it a success), Canada is a very different country from the United States. In Canada, they have had universal Medicare for 40 years. As the first President Bush used to say, it is a kinder, gentler, country.
This matters for financial regulation, because there is a level of independence and integrity on the part of the regulators in Canada that does not exist in the United States. The line in Washington is that if you want to talk to someone from Goldman Sachs, call the treasury department.
The close connection between the industry and the regulators matters because regulation will always require judgment calls. It also matters because regulation means limiting bank profits. The regulations are by definition about preventing banks from carrying on lines of business that are profitable.
Going back to the last crisis, our regulators should have cracked down on the junk mortgages that were being issued by the millions to buy homes at bubble-inflated prices. But this would have meant clamping down on banks that were making huge profits issuing the loans. It also would have meant clamping down on the investment banks that were making huge profits packaging them into securities and selling these securities all over the world.
To take an even more extreme case, the recent analysis of the Lehman bankruptcy showed that New York Federal Reserve Bank helped to hide Lehman's insolvency for months. It accepted Lehman's junk as collateral for short-term loans. This was a direct violation of the Fed's charter, which only allows it to accept investment grade assets as collateral, a definition that clearly did not include Lehman's "Repo 105s".
In these cases, our regulators instead used their judgment to decide that everything was just fine and looked the other way. Remarkably, no regulator was fired for these astounding failures in judgment. In fact, there was probably not even a single regulator who missed a promotion.
In the United States it will always be easy for regulators to look the other way, even when the ultimate consequences prove to be disastrous. By contrast, cracking down on politically connected banks is difficult for regulators. The banks' executives will call their friends in the administration and Congress to complain about the crazy regulator who is trying to keep them from running their business.
And, you can be sure that the banks will have a story. They pay smart people lots of money to develop those stories. The banks' mouthpieces will make a conscientious regulator look like a crazed vigilante who just doesn't understand modern finance. Just ask Brooksley Born, the head of the Commodities Futures Trading Commission who was stopped in her effort to regulate credit default swaps back in 1998.
Krugman is right that breaking up the banks does not guarantee good regulation. In addition to his Great Depression example, we also have the savings and loan disaster of the 80s. The S&Ls were overwhelmingly small institutions with even the largest being far below any conceivable TBTF threshold.
However, a break-up of the big banks will at least give the country some hope that things can change. As it stands now, the big banks are back on their feet, and in some cases more profitable than ever, feasting on the now explicit government guarantee of support in the event of a crisis. By my calculations, this guarantee could be worth as much as $34bn a year, more than one-third of the gross cost of the health care bill.
There are many aspects of regulatory reform that involve technical issues that the public will not follow. If we have to say what is different the day after financial reform is passed, rules on leverage limits and exchange-traded derivatives will not mean much, especially if they are enforced by people who accept Repo 105s as investment grade collateral.
If we break up Citigroup, Goldman, JP Morgan and the other giants, then we will know that something has changed. This break-up, along with a financial transactions tax, will lead to a qualitatively different financial industry.
(from the Guardian)
Simon Johnson: Fix The Dodd Bill -- Use The Kanjorski Amendment
At the heart of the currently proposed legislation on financial reform there is a simple premise: Key decisions about exact rules going forward must be made by regulators, not Congress. This is a mistake of breathtaking proportions.
It's a stupid idea. A genuinely stupid and unnecessary experiment advocated by a group of people who want revenge on Wall Street no matter what, and they apparently give not a rat's butt about the innocent people - jobs, jobs, jobs - their obsession might injure.
Overregulation could spawn a recession/depression.
A proper balance can feed a recovery. I would submit to you that the current reform packages progressing through congress are a better balance than the screeching of the wild-eyed mob.
We got into this mess because Glass Steagall was outdated. The Republicans caught the Democrats flat footed. Glass Steagall should have been modernized in the 1970s, but no, it was a sacred cow of the FDR years.
As someone wrote on another blog -- "the banksters rule until they don't rule... dr wu"
It's high time, sonof, it's high time.
Progressing through congress is the most substantial financial reform package since the Great Depression. It's like you don't even know it exists.
In the meantime, move your money.
There's no need to actively downsize large megabanks. At the same time, the case FOR large megabanks is a joke. The only reason they ever came into existence is because it paid to be large for the wrong (i.e. socially highly inefficient) kinds of reasons.
Of course there's also a certain point in having a couple of banks that can reliably offer multi-national transactions in bonds-issuance of governments, municipalities and large corporates. But this can be had with balance sheet sizes a fraction we see now, and it's a matter of competence and reputation and trust, and least of all a matter of size. There is ZERO case for megabanks. And because of that, they will go away automatically as soon as the costs they impose are internalized and borne by them instead of the taxpayer.
you write:
'The regulations are by definition about preventing banks from carrying on lines of business that are profitable.'
I disagree, and I think it is extremely bad politics to argue like that - especially when you want regulatory reform. Again: it is both false and a bad idea in my view. Not false because it is a bad idea, but false AND a bad idea.
Here's why: large parts of the business that fueled the crisis was NOT profitable on a long-term risk-adjusted view. And that holds even if you DO NOT factor in the effects that creating systemic risk has on banks when it bounces back on them.
The Treasury White Paper from June 2009 had it exactly right, and the lawmaking efforts are mostly heading in the right direction:
As soon as TBTF is effectively and CREDIBLY contained and as soon as the costs of financial crises are fully internalized, banks will shrink automatically because it no longer pays and because they no longer have safety havens against small and better competitors.
regulations would help banks avoid making the silliest mistake a capitalist can make:
to fail to be profitable in a long-term risk-adjusted view.
Banks have FAILED long before they did anything else like fraud or undue political influence.
The first and most important truth about the financial sector is that it has FAILED. According to their own criteria.
I'm glad there's a big jail being built somewhere (says Glenn Beak).
The Economists Who Missed the Housing Bubble Are Coming After Your Social Security
By Dean Baker - February 13, 2009, 4:13PM
Word has it that President Obama intends to appoint a task force the week after next which will be charged with "reforming" Social Security. According to inside gossip, the task force will be led entirely by economists who were not able to see the $8 trillion housing bubble, the collapse of which is giving the country its sharpest downturn since the Great Depression.
Stuff happens...
True, including the fact that banks never pushed sub-prime, nor interest-only mortgages, nor 50 year amortization plans, nor the largest monthly payment the spender could possibly afford. Nor did they package those off as more secure than they were and try to sell them on the market.
And so (sadly, as someone who is looking to buy a house) we do not have a housing bubble, and it is not simply there but yet to deflate. There is no looming foreclosure crisis, or even an unemployment crisis except insofar as our may exporters continue to suffer from America's weakness.
1) There most certainly IS a housing bubble.
2) Canadain banks were bailed out by the CHMC (the government mortgage insurer). One mjor bank was certain to fail., with heavy damage to the others. Canadian taxpayers are on the hook no less than their US counterparts. Hosuing prices only marginally deflated - they are now skyrpcketing.
3) Any spike in interest rates will bankrupt 10% of Canadian homeowners immediately - that's before job losses kick in.
4) The entire eastern half of Canada is in deep fiscal trouble (provincial budgets), with growth limited to gevernment spending and the FIRE sector. The West has bet everything on China and a robust, sustained US recovery.
When the next leg down occurs, Canada is going to be creamed.
For example at (1) you flatly state that there is a housing bubble. But if there had been one, I would have imagined that a one-year global recession would have offered ample opportunities for price re-alignment. If there is a bubble, why didn't this happen?
And comparing Canada and USA, in 2008 prior to the collapse almost 1 in 20 Americans was *already* 3 months in arrears on their mortgages (e.g. on the verge of financial collapse). The figure in Canada was less than half a percent. So how is it that a 'spike' in interest rates (and I assume you just mean normal increases, since rates are close to zero) would bankrupt 10% of homeowners?
I'd prefer to stick to these particulars, rather than the more general argument about Canada's regional economies, although for the record I think your representations on that count are also a bit simplistic.
You can see this in minor ways played out on our daily lives. They way people drive. The way they push their carts around the grocery store. The way they acquire music or software. We kid ourselves that we are just bending the rules to get a little of what’s owed to us. But it’s just rationalizing.
This is why I think so many of the people being victimized by the super-rich are so rabid to defend their money-funneling ways. Somewhere in a part of their brain that doesn’t get a lot face-time with the world, they recognize the pattern. And even though it’s being used against them, they don’t want to close the loop because someday they may get the chance to cash in on that strategy. And when you’re poor, and imagine getting riches, the idea of someone taking it from you is too awful to think about.
Acquiring wealth is great. Defending your right to be wealthy is fine. Hurting people to ensure that your wealth is protected is wrong. Rigging the system to ensure that no one else can acquire wealth is despicable, and we need to stop tolerating it.