Inevitable Bank Risk
By Arnold Kling
Bondholders don’t and can’t have much idea what is going on inside the trading book of a bank. It doesn’t matter how financially sophisticated the bondholders are; the point is that the trading book must remain fairly confidential and a lot of risk can be put in the trading book.
On many issues, Cowen takes the position that we are more or less doomed to live with the status quo, and this is one of them. Read the entire post to see his reasoning.
I agree that financial intermediaries are likely to be too opaque for creditors to regulate. My sense is that if past performance is good, even sophisticated investors do not delve into the underlying balance sheet. If Enron fooled most of the people most of the time (and I suspect that even inside that firm few, if any, executives there understood that they were Picking up Nickels), then so can any bank.
Cowen alludes to and dismisses “corporate forms other than limited liability.” I continue to believe that if we do not have prison terms for bankers who take excessive risks, then the asymmetry between the potential gains and potential losses will be too high.
Cowen thinks that big government needs big finance, a position that any reader of Niall Ferguson would understand. That in turn implies that bankers will have political leverage, so that the idea of prison terms is off the table.