With All Due Respect
By Arnold Kling
You might wish to go back to “old banking” but according to Gorton that stopped being profitable during the 1980s. There’s always an uninsured place to put your money, regulation can’t stop that, and such money can find its way back to help fund the banking system, right?
With all due respect*, one should ask why “old banking” became unprofitable in the 1980’s. I would suggest that the Basel capital accords made it so, and this was a bootleggers and baptists story. The baptists were regulators who wanted to avoid another savings and loan crisis. The bootleggers were politically powerful financial firms (Freddie, Fannie, Wall Street firms, big banks) who wanted a bigger piece of the mortgage pie.
The terms under which funds enter the banking system are affected by regulation. If uninsured creditors are really wink-wink insured, then the FDIC should charge higher deposit insurance premiums on banks with lots of uninsured debt. On the other hand, if uninsured debt is really going to convert to equity if the bank falls below its capital requirements, then the only issue is to make sure that Aunt Molly does not invest her life savings in funds that hold uninsured debt.
This is where I wind up in agreement with the Baseline Scenario lefties. The core problem is to reduce the political pull of the big banks. Thus, my preferred solution is to break up the big financial institutions. Do not allow them to have any more assets than Canadian banks–in terms of absolute dollars, not in terms of ratio of assets to GDP. Then you can come up with regulations that will get the incentives right.