Let's Not Extend “Old-Fashioned Bank Regulation”

Paul Krugman, Nobel-Prize winning economist and NYT columnist, recently wrote about his recommendations for financial sector reform.  He argues for expanded Wall Street regulation and suggests that banks that are too big to fail should stay that way. Somehow, they’re not a problem in his opinion. Interesting…

From The New York Times:

“Here’s how I see it. Breaking up big banks wouldn’t really solve our problems, because it’s perfectly possible to have a financial crisis that mainly takes the form of a run on smaller institutions. In fact, that’s precisely what happened in the 1930s, when most of the banks that collapsed were relatively small — small enough that the Federal Reserve believed that it was O.K. to let them fail. As it turned out, the Fed was dead wrong: the wave of small-bank failures was a catastrophe for the wider economy.

“The same would be true today. Breaking up big financial institutions wouldn’t prevent future crises, nor would it eliminate the need for bailouts when those crises happen. The next bailout wouldn’t be concentrated on a few big companies — but it would be a bailout all the same. I don’t have any love for financial giants, but I just don’t believe that breaking them up solves the key problem.

“So what’s the alternative to breaking up big financial institutions? The answer, I’d argue, is to update and extend old-fashioned bank regulation. After all, the U.S. banking system had a long period of stability after World War II, based on a combination of deposit insurance, which eliminated the threat of bank runs, and strict regulation of bank balance sheets, including both limits on risky lending and limits on leverage, the extent to which banks were allowed to finance investments with borrowed funds.”

As Krugman mentions, the 30s crisis was accelerated by bank client fears of losing their deposits. And, he’s right that because of the FDIC insuring deposits that sort of scare isn’t supposed to happen anymore. Now, the idea that this relates to the extreme risk taking by investment banks like Lehman Brothers seems like a stretch. By nature, banks, like any other company, always find ways to grotesquely contort themselves around regulation. Extending “old-fashioned bank regulation” is unlikely to help. As long as banks exist that are too big to fail, those institutions will know they still have a blank check to protect themselves on the downside and they’ll just keep on gambling. Since Krugman insists on teaching the “basics” as he sees them, you can read more at The New York Times’ coverage of Financial Reform 101.


Rocky Vega,
The Daily Reckoning

The Daily Reckoning