Financial paradise

Wall Street trader

Thatcher and Reagan were both visionaries who believed in the rationality of markets, and infected us all with their enthusiasm: we thought that global savings would reach every corner of the world, benefitting poor countries in need of investment. Interest rates would fall due to the competitive offer. What happened is that banks wallowed in the mire and financed easy profits, but did not properly calculate risks, especially political ones. Financial innovation, which many thought was going to be the “great leap forward”, only hid the true risks that were accumulating.

Meanwhile the financial system seized an increasingly large piece of global GDP, and the holy “Too Big to Fail” fear –referring to the fact that some institutions which could represent a systemic risk would get state assistance if necessary – was born.

Krugman says that the Dodd-Frank Bill is in danger, precisely because despite its clear shortcomings, it has been effective in preventing the recurrence of those risks that led to the crisis. But it is annoying for Wall Street. It wants to return to doing round business as it used to, protected by deregulation and the doctrine of the EMH, the efficiency of markets, which has received so many Nobel prizes.

I am highlighting some paragraphs by Krugman below. For him the most destabilizing factor is the sum of two problems. Namely, the “Too Big to Fail” concept combined with the increasing complexity of financial transactions. These have turned institutions (particularly investment banks) into “chimeras, partly banks, partly hedge funds, partly insurance companies…”

This situation makes it impossible to regulate and supervise, and leads to the need for last-minute bailouts.

What about the problem of the financial industry structure, sometimes over-simplified by the phrase “too big to fail“? Dodd-Frank seems to be yielding real results there as well. In fact, more than many supporters expected.

As I’ve just suggested, “too big to fail” doesn’t quite get at the problem here. What was really lethal was the interaction between size and complexity. Financial institutions had become chimeras: part bank, part hedge fund, part insurance company, and so on. This complexity allowed them to evade regulation, yet be rescued from the consequences when their bets went bad. And bankers’ ability to have it both ways helped set America up for disaster.

The decline in these practices confirm that the Dodd-Frank law was working: once again there was a revival amongst traditional deposit banks and un-supervised “shadow banking” was decreasing. The possibility of making high-risk operations look like normal operations was no longer easy.

Dodd-Frank addressed this problem by letting regulators subject “systemically important” financial institutions to extra regulation, and seize control of such institutions at times of crisis, as opposed to simply bailing them out. And it required that financial institutions in general put up more capital, reducing both their incentive to take excessive risks and the possibility that risk-taking would lead to bankruptcy.

 All of this seems to be working. “Shadow banking,” which created bank-type risks while evading bank-type regulation, is in on the way out. You can see evidence of this in cases like that of General Electric. A manufacturing firm that turned itself into a financial wheeler-dealer, but is now trying to return to its roots. You can also see it in the overall numbers, where conventional banking —namely banking subject to relatively strong regulation — has made a comeback. Evading the rules, it seems, isn’t as appealing as it used to be.

And yet, pressure to return to that former “financial paradise” doesn’t cease.

 

 

About the Author

Miguel Navascués
Miguel Navascués has worked as an economist at the Bank of Spain for 30 years, and focuses on international and monetary economics. He blogs in Spanish at: http://http://www.miguelnavascues.com/

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