Ripping the Financial Reform Band-Aid

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The other day I said the political economy arguments for breaking up large banks confused me since if big banks have too much clout to regulate properly, then surely they have too much clout to break up. Bond Girl is back with a fairly convincing response:

If we buy into the idea that all we need is better regulation, or that better regulation is the only politically feasible solution and we should take what we can get, we will still be left with banks that are effectively self-regulated in practice. What the banks cannot directly procure they will find a way to game.

I think the biggest obstacle to breaking up the banks, on the other hand, is the fear that this will be a destabilizing event. What happened to the stock market when the president, stung by the Democrats’ loss in Massachusetts, announced the (rather toothless) Volcker Rule? If one talks seriously about radically changing the structure of the financial sector in this country as opposed to making incremental changes, people immediately start panicking over the possibility of revisiting the financial crisis. These fears are not entirely misplaced, and that is what makes them politically useful. (“We just navigated our way through the financial crisis and its fallout, so let’s not do anything stupid and rock the boat.”) The ironic thing about this situation, however, is that our fear of instability in the short-term is leading us to make decisions that only further destabilize our system in the medium term. I don’t know, maybe that is not all that ironic. Maybe we’ve all simply internalized the bank executives’ time horizon.

At any rate, why is it more difficult politically to regulate banks effectively rather than break them up? Breaking up the banks requires a political movement – get it done and move on. Effectively regulating too big to fail institutions, at best, requires a long-term political commitment and constant supervision, not just of the banks but of their supervisors, who largely depend upon the banks for information. That’s what seems overly optimistic to me.

In other words, probably easier to just pull the band-aid off once than try to grind the issue out over time.

But before you jump off a bridge in a fit of depressed fatalism, I do want to note that financial regulation shouldn’t be seen as a binary issue wherein we either create a system that “works” or one that “doesn’t work.” A system in which major financial crises occur every 25 years is a lot better than a system in which we get one every 10 years, even if both are accurately described as systems that a prone to crises because big banks are able to game the rules.

On the other hand, to make yourself even more depressed it is worth pointing out that probably the biggest source of bank political clout isn’t size or even money alone, but the combination of money with political and social prestige. And at this point, I’m genuinely puzzled as to what could break that prestige. You’d think a catastrophic series of screwups that lead to a severe worldwide recession would do the trick, but instead it seems to have enhanced the prestige of those bankers who managed to screw up less than their colleagues. It’s really terrifying.