By James Kwak
Andrew Haldane (of “doom loop” fame) has another provocative paper, “The $100 Billion Question,” delivered in Hong Kong last week. A central theme of the paper is what Haldane sets up as a debate between taxation and prohibition as approaches to solving the problem of “banking pollution” — the systemic risk externality created by the banking industry. Taxation is higher capital and liquidity requirements; prohibition is structural reforms that limit the size or scope of financial institutions. Drawing on work by Weitzman and Merton, Haldane discusses when one approach would be superior to the other.
The advantages of prohibition include modularity (ability of a system to withstand a collapse of one component), robustness (likelihood that regulations will work when needed), and better incentives (since tail risk is a function of banker behavior — not weather patterns — the risk-seeking nature of banking means that no capital level will necessarily be high enough).
Here’s Haldane on robustness:
“There is a literature on how best to regulate systems in the face of such Knightian uncertainty.
It suggests some guideposts for regulation of financial systems. First, keep it simple. Complex
control of a complex system is a recipe for confusion at best, catastrophe at worst. . . .
“Second, faced with uncertainty, the best approach is often to choose a strategy which avoids the
extreme tails of the distribution. Technically, economists call this a “minimax” strategy –
minimising the likelihood of the worst outcome. Paranoia can sometimes be an optimal strategy.
“Third, simple, loss-minimising strategies are often best achieved through what economists call
‘mechanism design’ and what non-economists call ‘structural reform’. . . . In the words of economist John Kay, it is about regulating structure not
“Taken together, these three features define a ‘robust’ regulatory regime – robust to uncertainties
from within and outside the system. Using these robustness criteria, it is possible to assess
whether restrictions might be preferable to taxation in tackling banking pollution.”
The disadvantages include lost economies of scale and scope — but, as Haldane discusses, these don’t exist in banking beyond a moderate size threshold.
In the United States, it seems pretty certain that the administration and Congress have chosen the taxation route. But Haldane thinks the debate is not over in the long term:
“We are at the start of a great debate on the future structure of finance, not the end. Some fear that
momentum for radical financial reform will be lost. But financial crises leave a scar. This time’s
sovereign scar should act as a lasting reminder of the criticality of reform. . . .
“The history of banking is that risk expands to exhaust available resources. Tail risk is bigger in
banking because it is created, not endowed. For that reason, it is possible that no amount of
capital or liquidity may ever be quite enough. Profit incentives may place risk one step beyond
regulation. That means banking reform may need to look beyond regulation to the underlying
structure of finance if we are not to risk another sparrow toppling the dominos.
“Today’s financial structure is dense and complex, like a tropical rainforest. Like the rainforests,
when it works well it is a source of richness. Yet it is, as events have shown, at the same time
fragile. Simpler financial eco-systems offer the promise of greater robustness, at some cost in
richness. In the light of a costly financial crisis, both eco-systems should be explored in seeking
answers to the $100 billion question.”
It’s pretty clear which side he’s on.