Gary Gorton's Latest
By Arnold Kling
If the growth of shadow banking was facilitated by regulatory changes, then why not just reverse all these changes? Would such reversals bring us back to a safer system dominated by traditional banks? We do not believe that such a radical course is possible even if it were desirable, which it is not in our view. The regulatory changes were, in many cases, an endogenous response to the demand for efficient bankruptcy-free collateral in large financial transactions: if repo had not been granted this status, then the private sector would have tried to create a less efficient substitute.
Tyler Cowen pulls more quotes from the paper. I am not as enthusiastic as Tyler about it, although I recommend it for the institutional color.
Where I differ from Gorton is on a matter of emphasis. I think that most of the growth of shadow banking came about because Wall Street captured Congress and regulators. With Congress, it was a matter of muscle. With the regulators, it was a matter of dazzle. The Wall Street guys seemed so smart, and of course, they made so much money. You just had to believe that they were doing great things for the financial system and for the economy.
The specific policies (see Not What They Had in Mind) that resulted from this capture tilted government support in the mortgage market away from traditional lending and instead toward Freddie, Fannie, and AAA-rated mortgage-backed securities. With a more neutral set of policies, I am not convinced that we would have seen anything like the growth in securitization that in fact took place.
At a deeper level, Gorton is expressing confidence in two sets of experts where I do not share his confidence. One is the financial wizards who built the shadow banking system. In my view, the wizards have not lived up to their billing, nor did the system.
The other set of experts is regulators. Even assuming that Gorton’s fixes are sound theoretically, the experts have to implement them properly. Moreover, they have to be able to adapt to further innovation and, if my view is correct, they have to resist further efforts by Wall Street to create a regulatory environment that privatizes profits and socializes risk.
I am not saying that I have easy answers. As you know, my mantra is, “Don’t focus on making the financial system hard to break. Focus on making it easy to fix.” John Kay has some ideas on that score. I have various ideas as well, particularly reducing the tax advantage for debt relative to equity.