We have previously argued that the approach to dealing with our problems by adding a layer of regulation is a mistake. The political, financial and academic communities are enamored of this approach. If only we could watch these guys more closely!
Most recently, NYU's Stern School of Business has put out a series of 2-page discussions and recommendations called "Restoring Financial Stability: How to Repair a Failed System".
This is a good read. I would like to take exception to Chapter 5, "Enhanced Regulation of Large Complex Financial Institutions (LCFIs)".
A key part of that Chapter reads:
"We believe that regulation by function is not enough in the case of LCFIs. For these institutions, we advocate a third option - a special, dedicated regulator for LCFIs. (authors' emphasis)
Au contraire. We have had enough foxes guarding enough henhouses. The regulator comes from the same milieu as the regulated and can't wait to join the institutions he regulated, especially a "LCFI" that has lots of money to pay rather than the parsimonious regulatory agency.
The simpler solution is to prohibit any LCFI from coming into existence that has governmental subsidy or poses a systemic risk to society/government.
The Internet provides a conceptual solution. The 'Net was developed to deal with a nuclear attack on the U.S. It allowed data and communications to take a meandering path through whatever nodes for data switching happened to survive the proposed attack. When you read this blog over the Internet, the packets of information get to you not through a dedicated pathway such as a traditional phone call, but rather through whatever communications path is open at the time. The system is redundant and can survive the loss of lots of interchanges. It takes a lot to destroy all Internet potential paths.
The same should be true of a modern financial system. LCFIs have proven that the purported benefits to society they offered were really licenses to gamble with what turned out to be our money when things went really, really bad. The posturing by politicians that now they really mean to stop the big bonuses etc. are for show. The truth lies in the apparent resuscitation of the TARP 1 plan by the Obama Administration for taxpayers to buy up the bad assets on these institutions' balance sheets. Why bother doing it unless it's a massive subsidy?
If, however, the financial system had a modern series of single-state, interstate or national banks, each one small, the failure of none would be systemically important. The benefits to businesses, travelers, North-South snowbirds, etc. would be present as it is now with BofA.
In order for the financial institutions to be small, they would have to have simple functions. They should little other than take deposits and make loans. And all their assets would have to be liquid. "Tier 3 assets" is an abomination as a concept.
Regarding complex financial instruments, leveraged pools of money would in my proposal be banned from borrowing from these banks. Let various people and entities lend to one another with private, risk capital. Thus, subject to whatever regulation and/or reporting is truly necessary, let them do what they want, but essentially stay out of regulating them. It's their money, after all.
One of the underlying points comes from my background as a physician. Anything a trusted physician is associated with gets some or all of the trust the patient has in the doctor, even if it is independent of the doctor's control. Similarly, once a "bank" gets into other lines of business, the average person and even a sophisticated investor associates the presumed safety and government guarantee of a bank deposit with the other functions that the holding company that owns the bank provides. One can put forth all the disclaimers one wants, but people will both misunderstand or forget those disclaimers, or at least will be subconsciously swayed to underestimate the risks. Let's not kid ourselves. How many average people understand to this day the difference between Citigroup, the holding company, and Citibank, the depository institution?
(In fact, if you Google "Citibank", your first click will be to a web page promoting Citi, presumably meaning Citigroup, rather than Citibank, which also gets mentioned now and then on the page but less prominently.)
"Prudential regulation" of large complex financial institutions is little more than putting more and more doctors on the case of a complex diabetic patient with high blood pressure who is prone to nicotine or alcohol addiction. Keeping this patient in balance is a constant struggle. And if the doctor is a friend of the patient and is also prone to sweet foods and nicotine or alcohol himself, fuggedaboutit. And if such a patient is a systemically important person, such as the Pope or President of the U.S., then what a burden on the doctor!
Keep your vices few and simple.
Let's also keep our banks simple as well; interconnected and properly regulated; but never too big to fail.