Tuesday, April 13, 2010

Financial upheaval gov't caused and sustained

Bank Secrets and Size [Nicole Gelinas/NRO]

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.

(For links and the rest of the piece) Keep reading this post . . .

http://corner.nationalreview.com/post/?q=MDZkNzcwZWYyNjcyOTFmNjhlNjQ0MDg1NzBmYzk2Njk=

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