Simon Johnson on Geithner and Summers
By Arnold Kling
He is not happy with the “foundation” for regulatory reform proposed by the current and former Treasury Secretaries.
Their view: Regulation is overly focused on safety and soundness of individual banks. Reality: There was a complete failure of safety and soundness supervision. This must be fundamental to any financial system – without this, you’ll get mush every time.
I agree that Geithner and Summers get the diagnosis wrong, as do many others. The problem was not a gap in regulatory coverage. The problem was that Freddie Mac, Fannie Mae, and regulated banks held too little capital, using tactics that were approved by regulators, with Congress putting pressure on regulators to go easy. Geithner and Summers make the financial meltdown sound mysterious and complex. In fact, given the regulatory capital arbitrage that drained capital from the system, the meltdown was pretty straightforward.
In football terms, the problem was not a gap in the defensive coverage. The problem is that the defense got run over. Geithner and Summers want to change the defensive formation, but Johnson and I are concerned that the players still can’t tackle.
Johnson and I both approve of the attempt to make it easier to deal with under-capitalized firms without having to bail them out. That is the one proposal that is aligned with my view that it is better to try to make the financial system easy to fix than attempt to make it impossible to break.
Another key element in the easy-to-fix approach is to break up financial institutions that are too large and too complex. The economic benefits of financial behemoths are unclear. The social costs when they fail are now obvious. Even with smaller institutions, though, the possibility of highly correlated failures is one to lose sleep over. In that regard, a structure of institutions and regulators that is messy and has many overlaps may turn out to be more robust than one with a neat, clean organization chart.
Johnson raises the issue of bank executive compensation and incentives for risk-taking. I do not go along with him in suggesting that government change the compensation structure at banks. I don’t think that government should have to create incentives for executives to care about long-term franchise health. But if you made me the regulatory czar and told me that this was my responsibility, then I would still leave compensation structure alone. Instead, I would threaten any CEO of a failed bank with castration.