As Erik Kain notes, the point I made yesterday isn’t limited to the telecommunications industry. It applies with equal force in banking.
A good example of this principle at work is Cato scholar Lawrence White’s 2004 call for greater regulation of Fannie Mae and Freddie Mac. White argued that full repeal of these companies’ various state-granted privileges would be the best way to deal with these entities. But given that that was unlikely to happen he advocated more aggressive regulation as a second-best alternative. In retrospect, it’s obvious that this was the right position to take.
The same point applies to the “too big to fail” banks. In an ideal world, the bailouts wouldn’t have happened and most of these firms would be emerging from bankruptcy around now. But we don’t live in that world, and we’re not likely to get there before the next financial crisis.
Probably the most important moment in last year’s fight over banking regulation was the failure of the Kaufman-Brown amendment, which would have established a maximum size for banks in an effort to forestall future “too big to fail” problems. It was supported by a handful of savvy conservatives like Tim Carney, but most free-market conservatives and libertarians ignored it. I’m not going to point any fingers, since I was barely paying attention to the financial reform debate myself. But I do wish more supporters of the free market had followed Carney’s lead.
Couldn’t agree more re the dangers of concentration in the banking industry. Couldn’t disagree more that competition is the cure. Competition in financial services has produced more problems than benefits, and one of the main reasons why is that competition itself has been a big driver of concentration.
As history has proven over and over, bankers are lemmings — they’ve “gotta keep dancing” as long as the music’s playing. In the past few decades, as regulations were discarded or unenforced, competition was what pushed financial services out of plain-vanilla banking and capital markets instruments, which were increasingly commoditized, into ever more exotic, poorly understood and ultimately dangerous instruments and practices which promised bigger returns, which themselves became commoditized, incentivizing further “financial innovation”… rinse and repeat. The only unpredictable element in the cycle is just when the crash happens and the lemmings all find themselves in mid-air on their way together to the bottom of the cliff.
Competition, which was supposed to “cure” the S&L industry by making it easier to compete with the banks, brought us the S&L crisis which, among other things, resulted in large parts of the obsolete S&L industry being scarfed up by bigger banks. Competition brought us the marginal mortgage practices in the 2000s which got more and more fraudulent as the business was commoditized — followed by the left-overs of the biggest players in the housing business being scarfed up by the surviving FIs, who just got more gargantuan. Competition brought us AIG — followed by the left-overs being scarfed up by the surviving FIs, who just got more gargantuan. Competition brought us IBs taking advantage of regulatory forbearance to erect stratospheric leverage ratios that brought down most of them — followed by the left-overs being scarfed up by the survivors who just got more gargantuan. And so on and so forth, including in the list of competitive innovations the arrival of interstate banking, globalized cross-border expansion, disintermediation out of the formal banking sector into capital markets, etc.
The rapid increase in scope and quantity of competition over the past four decades has tracked closely with consolidation in the financial sector. Where consolidation hasn’t occurred — the rise of the shadow banking system — competition between the “regulated” industry and the unregulated portion has worked like a virus on the safety and soundness of the regulated portion, which was one problem (among many) with Fannie and Freddie.
I definitely agreed in the 1990s and 2000s with those who advocated more regulation of Fannie and Freddie. In fact, I thought they should be significantly down-sized and returned to what they were originally designed for as public utilities, at which point the implicit GSE guarantee wouldn’t have been a problem. The “privatize the profits, socialize the losses” set-up was glaringly obvious by the 1990s and, as the GSE managements were encouraged to expand in size and run the GSEs as profit-maximizers for management and shareholders, the risks were becoming all too evident. But I certainly didn’t agree with what was typically the preferred option being strongly pushed on the Right, like at Cato, in lieu of better regulation — privatization.
We didn’t need a bunch of small Fannie/Freddies without the implicit GSE guarantee. The FIs who were pushing Fannie/Freddie privatization just wanted to get their hands, cheap, on balance sheets and market share, but when they looked closely at running those businesses without the implicit government guarantee, it wasn’t very attractive. So the Cato-like privatization proposals didn’t get a big, sustained push from industry players. And privatization didn’t make any sense in theory. If there was actually a market need for mortgage-market intermediaries without government backing, it was also an investment opportunity and the market would have (and in many ways did during the hottest period of the bubble) “solve” that particular “problem” (for a few years with the originate-distribute securitization model that by-passed the GSEs).
For a market dominated by 30-year instruments like our housing mortgage market, there are some decent arguments for an public utility like (government-owned) Fannie to act as in effect a buffer to smooth supply and demand as economic activity and interest rates change. And there are some significant social goods, especially during economic downturns, to having our housing market structured by 30-year obligations (so long as homeowners have adequate equity against those obligations). There’s still a place for a modestly-sized safe, boring, plain vanilla long-term mortgage intermediary between depository institutions and capital markets, and with the government backing, supplying a reasonable flow of high-quality assets to the capital markets for which there’s significant demand, especially during economic downturns. The conundrum we’re facing today is how to return Fannie/Freddie to a modest role, given that right now they’re the only thing keeping the mortgage market from completely freezing up again.
As for the financial system more generally, the major problem we’re facing is how to put the genie back in the bottle after 4 decades of eroding or dismantling the various walls that had segmented the financial system after the Great Depression. I don’t think it’s possible (or even desirable) to stuff the genie back in. There have been some benefits from innovations in financial services, and the global capital markets aren’t going away. But thinking we’re going to cure our problems with more, not less, competition is a pipe dream that flies in the face of both theory (how financial systems aren’t like ordinary product markets) and the historical evidence.
Essentially, a depository institution uses its balance sheet very differently from a securities firm or from a hedge fund, etc., etc. And the expected rate of return on equity for each of those types of businesses should reflect those differences. Competition in the sector has encouraged everybody to try to get hedge-fund-type returns from their entire consolidated (excessively leveraged) balance sheets. Apart from the fact that plain-vanilla banking can’t safely generate hedge-fund-type returns, no human (or computerized risk-management system) can manage the complexity that continues to increase as more and more disparate lines of business get combined into global behemoths, each line of business with different uses and risks of capital. Nor can these increasingly complex capital and operating structures be justified on the basis of risk diversification — as we’ve learned all too recently, when things get bad correlations can rapidly go to 1.
I expect (probably after at least another melt-down) that we’ll see more efforts like the UK’s to, for example, ring-fence high-street banking (essentially the old-fashioned depository and lending functions) from other, risker activities. And the attempts to segregate trading activities and derivatives will eventually get more teeth after another blow-up or three.
I do believe an important place remains for competition within segments of the financial system and I’d like to see the big banks broken up not only for Too-Big-To-Fail reasons but partly for competitive reasons — and in the process segregate low-risk-low-return banking from other financial services. But the scope of competition needs to be much more clearly defined and managed by laws and regulations if competition is to produce benefits rather than continue to contribute to global economic disasters. Proposals such as breaking up and privatizing Fannie and Freddie for “competitive reasons” misses the entire point.
nadezhda, I think I’m sympathetic to your motivations, but your suggestions seem incoherent at first blush. You conflate multiple forms of competition, and then denounce them all in one fell swoop. Most of the problems you cite seem to be related to competition for capital (if a formerly-conservative bank found it difficult to issue debt or equity, that bank might “compete” for investment by becoming less conservative, in effect taking compensation in return for taking on additional risk), but even that seems an infelicitous framing.
A bank that serves retail customers better than its competitors, profits in a sustainable manner, and that is laudable (although quite unlikely; see below). A bank that “profits” by increasing its long-term risks does not have a sustainable model, and we can be sure that executives are raiding the bank in ways that cannot be clawed back. Personally I’m happy to see the latter bank fail, although I hope to have enough information to make sure all my money is out first. (Since I’m poor enough to rely on the FDIC for this risk exposure I guess I’m a bit hypocritical.) Other people are very concerned with preventing this sort of bank failure, but it seems that ameliorating these sorts of top-down concerns causes more problems yet.
We see this cycle of consolidation and increasing risk exposure in other industries besides banking, but it’s not my impression that we see this in industries that are growing and/or becoming more productive. Many of the functions of banks have been usurped by nimbler competitors from younger industries (e.g. Visa, PayPal, Amazon, Wal-Mart, CoinStar, eTrade, Countrywide, etc.), so it’s unlikely that banks are growing in any sustainable way. We ought to consider the possibility that we soon won’t need banks at all, and that conclusion might motivate different thinking about banking regulation. Just as in telecoms, there is some subset of bank regulations that can encourage competition, but there is also another subset that allows banks of the sort we have now to exist at all. Perhaps someday we might be able to throw out all banking laws, and be rid of banks as such completely. In the near term, I agree with Timothy that competition is an excellent proxy for consumer well-being.