What's Different About Banks?
By Arnold Kling
I’ve been at a seminar discussing “too big to fail,” so bank regulation issues are top of mind.
I think that the most important thing that differentiates banks or bank-like firms from other firms is that it is easy for short-term results to be misleading. That is because banks borrow short and lend long.
When you invest your money with a financial institution, you do not know exactly what you are getting. You do not evaluate the assets of the institution, you do not know if it is well run, etc.
There are plenty of other products where we face this problem. Computers, cars, cell phones, and so on. But with those products, all consumers get quick feedback. If a computer manufacturer or retailer sells defective products, word will get around pretty soon. Reputation matters, and because word gets out quickly if the firm misbehaves, reputations are reliable.
In banking, you can get along for a while with a really defective strategy. There are many ways to write out-of-the-money options that pay off a little bit most of the time and every once in a while suffer catastrophic losses. You can maintain a good reputation for a long time, even though you do not deserve it.
What this means is that consumer-to-consumer feedback is not sufficient to police the banking industry. Instead, specialized monitors are needed to check up on what banks are doing. These could be private monitors, or they could be public monitors.
But who watches the watchers? If we had a system of private deposit insurance, or some such, how can we know that this system is being well managed? If we look at the securities rating agencies as models of how a private monitoring system works, then I think there is much to worry about.
Putting government in charge does not solve the problem. As we know, during the housing bubble, Congress and regulators were putting pressure on lenders to make more loans and to use lower credit standards. Again, this does not inspire confidence.