We need a theory of bank "regulatability"

In my previous post, I related Paul Krugman’s argument that deregulation — not “too big to fail” or easy money — caused The Great Recession.

But an interview response by Krugman’s fellow economics Nobel laureate Joe Stiglitz suggests a flaw in Krugman’s logic:

[Former Fed Chairman Paul Volcker] said that if banks are too big to fail, then they’re too big to be managed, they’re too complex, there is no person who can really manage anything of that complexity.

Krugman argued that Canadian banks were also “too big to fail” because five banks control most financial business in Canada. But size relative to the marketplace is only one measure of size. Absolute size matters also.

Imagine that fifty banks each control, say, 2% of the world’s financial markets. Fifty rival banks is certainly enough to create strong market competition. And the failure of 2% or 4% of the world’s banks might well be manageable. But, Volcker might well argue, each of those fifty banks is still so large and complex that regulating them would be nearly impossible.

A Canadian bank with 15% of the Canadian market may be small enough (in absolute terms) to be regulatable whereas an American bank with just 5% or 10% of the U.S. market (plus sizeable overseas business) may be vastly larger and more complex and, therefore, unregulatable.

Before we can effectively regulate modern banks, we need a theory of “regulatability.” Factors affecting “regulatability” include: * Absolute size * Degree of transnational dispersion of activities and regulatory authority * Amount of leverage (borrowing) * The variety, complexity and volatility of the financial instruments a bank trades * The correlation structure of financial instruments held by the bank (i.e., is the bank heavily exposed to certain possible world events, or will the effect on the bank’s asset portfolio of events likely cancel out) * Exposure to other large institutions (e.g., if Bank B fails, might that trigger a domino effect on other banks?) * Ability to “capture” the SEC and Congress, thus escaping regulation through non-enforcement or legal loopholes

Posted by James on Monday, February 01, 2010