By Arnold Kling
I wrote this for the Mercatus Center.
The case for accentuating regulatory differences. We want to provide consumers with bank deposits that are insured. To protect taxpayers, we want to prevent insured banks from taking significant risks. Therefore, banks should be very closely regulated. On the other hand, we do not want to suppress risk-taking in general. Therefore, we should allow non-bank institutions much wider discretion to take risks, with the understanding that their liabilities are not insured or otherwise protected by taxpayers. In conclusion, we need to differentiate sharply between banks that are closely regulated and non-banks where the risks are borne entirely by private investors.
The case for reducing regulatory differences. We have seen that in a crunch the government cannot allow important financial institutions to fail. The federal government stepped in to guarantee money market funds and provide funds to AIG.. We have also seen that when institutions face differences in regulatory regimes, transactions take place that are motivated solely by regulatory arbitrage, to the detriment of the entire system. Moreover, it may not be possible to set up a system that insulates the regulated banking sector from spillover risks that are created by the unregulated sector. Therefore, we need to bring as many financial institutions as possible under a coherent regulatory regime.
Most of the paper concerns the not-constructive role that Basel capital regulations played in recent years. However, the issue of whether or not to try to have sharply different regulatory regimes for government-guaranteed institutions is a thorny one. I would dearly like to say, “As long as you’re not a bank, you are free to fail any way you like. On the other hand, if you are in charge of a bank, we’ll put you in jail if you run out of capital.” But that is probably too simplistic.