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Rot at the Core: John Quiggin says that to stop banks from engaging in risky activities we need to outlaw investment banking

October 10th, 2009 No comments

I commented last week on a blog post by leftist Aussie economist John Quiggin, who blamed the financial collapse on investment banks, and suggested that either:

(i) investment banking should be much more heavily regulated (“Properly
done, regulation of this kind would kill off investment banking of the
kind with which we are familiar.”), or

(ii) ultra-high Glass-Steagall-like barriers should be raised that prevent most transactions between investment banks and government-guaranteed banks.

Right; and the identical approach to outlawing drugs and tightening penalties for buying, selling, growing and producing has worked out great, hasn`t it?  (Well, it has, for our growing and ever-more invasive armies of regulators, police, prisons, and grug-related interventions abroad.)

Such proposed “solutions” left me head-scratching, since they entirely missed addressing the root of the problem, which Quiggin identifies here:

This is one instance of a more general point emerging from discussion of the financial crisis. As
Felix Salmon observes, the extraordinary profitability of investment
bank can most plausibly be explained by the hypothesis that risk is
being shifted, without compensation, to someone else
. Salmon focuses on the case of ignorant buyers, sold products they don’t understand. But, as
Arnold Kling observes, an equally important source of investment
banking profits is regulatory arbitrage at the expense of governments,
and, ultimately, the public at large
.

Why not observe that government efforts to make depositors “safe” by guaranteeing deposits has instead almost entirely blown up, at the expense of taxpayers, and engendered a system of spiralling risk-shifting and opacity that left even the largest and smartest investment banks unable to calculate their own exposures and scrambling for government protection? And wonder whether – instead of banning risk-taking and providing products used for risk-shifting and regulatory arbitrage – it`s time to introduce real discipline into the system by making depositors and investors, banks and investment banks, carry a little more of their own risks?

I left John the following comment (with typographical edit)

October 6th, 2009 at 20:48 | #27

John,
it seems to me that you`re missing an important part of the picture
(that Arnold Kling and others point to): namely, the “information
problem” that limits the ability of regulators to notice, much less
keep fingers in, all of the holes in the dike, along with the federal
interventions in banking that have provided the chief moral hazard
problems and the chief demand for the products that investment banks
sourced.

BIS and investment standards created for the purpose of limiting the
risk that the government put on taxpayers via deposit guarantees
instead fuelled demands for products that provided higher returns at
than other assets at the same risk-weightings, and for
“investment-grade” products – but where the sellers perversely
arranged/paid for the rating, instead of buyers. This nonsense is still
continuing; even as the FDIC is closing banks right and left, banks
about to fail can attract “brokered deposits” from investors chasing
higher interest rates than are available at the safer banks (as
deposits remain guaranteed), as management gambles for returns that
will keep them in office.

The unregulated buyers of CMOs and CDS should of course be left to
suffer the consequences of their own investments; the Fed`s
intervention in support of LTCM (and the investments by insured banks
and investment banks) simply contributed to the “too big to fail”
massive risk shifting that has come home to roost.

Federal regulators should be reconsidering their fundamental
preconceptions, and moving away from trying to micro-manage risks in a
futile whack-a-mole enterprise, toward one that places more
responsibility for risk analysis on depositors and investors.
Otherwise, we will see simply empty promises, and more risk shifted to
taxpayers.

http://mises.org/Community/blogs/tokyotom/search.aspx?q=limited+liability

We`ll be better off if everyone has more of their own skin in the game.