The Corner

Bank Secrets and Size

Arnold Kling wants Washington to “break up the banks.” Richard Vigilante and Andrew Redleaf want Washington to make the banks reveal all. But neither breaking banks up nor cracking them open would fix the financial system.  


Kling is right that we don’t have a free market in finance. It’s a huge problem. You can’t build a free-market economy atop a centrally planned credit-allocation system.


But size isn’t the main culprit. Whether it’s made up of three big firms or 300 small firms, the financial industry, thanks to government policy, is unnecessarily vulnerable to making the same mistake across the board and bankrupting itself.


Washington encourages this monomania by deciding for markets what types of debt investments are risky (loans to start-ups) and what kind aren’t risky (AAA-rated mortgage bonds). Washington then allows financial firms to borrow more money against the “safe” investments.


Because firms can make more profit with borrowed money, they gravitate toward these “safe” holdings and make more of them when the natural supply runs out. With the government encouraging financial companies to act in concert, they might as well be big; it doesn’t really matter.

Washington can start to fix this problem by being consistent in its limits on borrowing. If regulators were to require a certain percentage of non-borrowed capital – like a down payment on a house — behind any debt or derivative instrument, financial firms would make thousands of different mistakes instead of the same mistake.


The economy then could withstand these unique mistakes. Consider: A free-market economy can withstand the failure of one industrial firm, but a centrally planned economy can’t withstand the failure of its entire industrial policy. It’s the same idea here.


Because competition strengthens markets, encouraging financial firms to make competing decisions on risk would help wean investors off their expectation of bailouts. It would work in tandem with other necessary policies. Requiring firms to trade derivatives on exchanges, for example, would quell investor fear in a crisis by quarantining some risk. Requiring firms to put more capital down against their own short-term borrowings would cut their vulnerability to acute panic.


As their investors learned not to expect bailouts, financial firms would likely shrink themselves, accomplishing Kling’s goal without government break-ups. As Kling notes, the benefits of financial supermarkets — besides bailouts for their lenders under the current regime — are questionable.


What about following Vigilante and Redleaf’s advice, fixing finance by making financial firms reveal all of their holdings once a week? Redleaf and Vigilante would apply this proposal — the “one really radical, really earthshaking, and really effective reform conservatives should be shouting for” — to all investment firms with more than $10 million in assets.


Transparency is certainly vital to free markets. During the credit bubble, the smart money, including short-sellers like David Einhorn, analyzed facts to expose the financial system as a mirage. The facts they used were public because earlier securities laws made them so: Laws dating back to 1933 and 1934 mandate regular, fair disclosure of pertinent corporate and market information.

These rules need updating. Just as exchanges must disclose stock volume and pricing data, financial firms should have to disclose similar data on credit-default swaps and other opaque financial instruments. Then, the world could know whether a financial instrument is worth what millions of people making independent decisions think it’s worth (like an Exxon share) or what two buddies at colluding investment banks say it’s worth (like a little-traded collateralized debt obligation).

But there’s no evidence that total financial-information availability “absolutely would have kept the mortgage crisis from becoming more than a speed bump and certainly would have prevented the banking collapse of September ’08,” as Vigilante and Redleaf say.

In the mid-2000s, skeptical observers easily learned that speculators were flipping real estate with no cash down using money borrowed via big financial institutions. But the investors who provided the debt that fueled the bubble assumed that asset prices would keep rising. Failing that, they figured from two decades’ worth of history that the government wouldn’t let lenders to big financial firms take losses.

The solution that Vigilante and Redleaf suggest would encourage this bailout mentality. Full disclosure would be part of a tradeoff in return for financial firms’ “astonishing privileges” as “quasi-public institutions,” they suggest. Defining an investment firm with $10 million in assets as a “quasi-public institution” would expand the markets’ definition of too big to fail.

This expectation, in turn, would overwhelm any benefits from line-by-line data on financial firms’ holdings. If you know that a firm benefits from “astonishing privileges” as a “quasi-public institution,” why would you care about the quality of its investments?

Limiting the definition to the biggest or most complex firms wouldn’t help, either. The only remedy for Citigroup’s status as a “quasi-public institution” is to take away that status. Nothing can substitute for lenders’ fear of failure.

Nicole Gelinas, contributing editor to the Manhattan Institute’s City Journal, is author of After the Fall: Saving Capitalism trom Wall Street — and Washington.


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