Financial Regulation is a Challenge

Regulators play a game against a tough opponent

By the way, I am scheduled to appear on a livestream put on by Reason at 1 PM New York time today.

Tyler Cowen writes,

Raising the FDIC protection limit from $250,000 to ??? raises political eyebrows in a dramatic manner. For one thing, the FDIC would then be seen as guaranteeing a much larger part of the financial system. Over time, the pressures for the government to protect yet additional parts of the financial system will grow, just as they did after the bailouts from the 2008-2009 financial crisis. Furthermore, if the FDIC keeps on increasing its protections in the quest for financial stability, that means a larger FDIC, a larger regulatory apparatus, perhaps higher capital requirements, and over time higher premia for banks to pay to the FDIC.  …

As that scenario unfolds, there will be all the more incentives to supply more lending and also deposit-taking services outside the formal and more heavily regulated banking sector. Rather than pushing more resources into the larger banks, this policy would push additional resources outside the formal banking system altogether. That would mean less power, oversight and scrutiny from the Fed and also from other regulatory bodies. Typically American banks are more tightly regulated and monitored than are non-bank financial entities.

Think of government protection as a subsidy, and regulation as a tax. The goal of financial markets will be to maximize the benefits from the subsidy and minimize the costs of the tax. The participants in the market are very clever at doing that. The government is probably not going to win that game, which I once called The Chess Game of Financial Regulation.

John Cochrane writes,

This debacle goes to prove that the whole architecture is hopeless: guarantee depositors and other creditors, regulators will make sure that banks don't take too many risks. If they can't see this, patching the ship again will not work. 

If banks channeled all deposits into interest-paying reserves or short-term treasury debt, and financed all long-term lending with long-term liabilities, maturity-matched long-term debt and lots of equity, we would end private sector financial crises forever. Are the benefits of the current system worth it? (Plug for "towards a run-free financial system." "Private sector" because a sovereign debt crisis is something else entirely.) 

Unfortunately, just as there are incentives for banks to lean on government, there are incentives for government to lean on banks. So regulation is unlikely to align with the public interest. Again, see my well-timed article reviewing Niall Ferguson’s The Cash Nexus.