By James Kwak
Ever since the financial crisis, there has been an on-again, off-again debate over the right model for financial regulation. On the one hand are those who favor simpler rules—such as a simple leverage limit based on total unweighted assets—on the grounds that they are easier to monitor and tougher to game. On the other hand are those who favor complex rules—such as the Dodd-Frank Act, which has so far generated over 8,000 pages of rules—on the grounds that the world is complicated so we need complicated rules. For the most part, this has been a shouting match over broad principles.
A friend sent me Andrew Haldane’s paper from Jackson Hole a couple of weeks ago, “The Dog and the Frisbee.” (The title refers to the ability of a dog—or a child—to catch a frisbee by following a single visual heuristic, ignoring factors such as the rotational speed of the frisbee or wind currents.) Now we have evidence.
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).
“Banking on the State” by Andrew Haldane and Piergiorgio Alessandri is making waves in official circles. Haldane, Executive Director for Financial Stability at the Bank of England, is widely regarded as both a technical expert and as someone who can communicate his points effectively to policymakers. He is obviously closely in line – although not in complete agreement – with the thinking of Mervyn King, governor of the Bank of England.
Haldane and Alessandri offer a tough, perhaps bleak assessment. Our boom-bust-bailout cycle is, in their view, a “doom loop”. Banks have an incentive to take excessive risk and every time they and their creditors are bailed out, we create the conditions for the next crisis.
Any banker who denies this is the case lacks self-awareness or any sense of history, or perhaps just wants to do it again. Continue reading