Bank Regulation is a Political Economy Problem
By Arnold Kling
Paul Volcker says financial innovation has not been a good thing.
Now, I have no doubts that it moves around the rents in the financial system, but not only this, as it seems to have vastly increased them.
You cannot get financial regulation right unless you think of it in terms of political economy. Instead, if you think in terms of “how can we optimally regulate so that banks have only incentives to do great things and no incentives to take excess risk,” you are on the wrong track.
The political economy challenge is to constrain the regulators. The problem is, “how can you design a system in which regulators do not extend government guarantees in a way that leads to abuse?”
A short answer might be, “Get rid of government guarantees.” But I think we’re too far down the road with deposit insurance to take it away.
Given that we have deposit insurance, the key is to limit its scope. You cannot do that unless banks are small. Big banks have a credible threat that says, “If you let me fail, the whole system is going down.” Policy makers do not have a credible counter-threat. The only hope is to break up the big banks before a crisis hits. As I’ve said before, it is absurd to suppose that you will exercise “resolution authority” to close a big bank during a crisis and at the same time say that it is unthinkable to break up big banks now.