Each year TIME co-hosts the opening panel at Davos. And each year some schmuck like me has to immediately write up a story about the discussion to make the deadline of our European magazine edition. Since I’ll be working on that for a good chunk of the day, I thought I’d leave you with some early thoughts from one of our panelists—University of Chicago finance professor (and former IMFer) Raghuram Rajan.
Yesterday in an op-ed in the Financial Times Rajan critiqued the notion that we desperately need to regulate the size and propriety trading desks of big banks—an idea that has quickly gained traction in the wake of being dubbed the Volcker Rule.
Rajan holds that size itself is hardly a good indicator of systemic risk. With $1 trillion under management, the mutual fund firm Vanguard doesn’t pose a big threat, although the much smaller Bear Stearns certainly did. As for prop trading, Rajan raises the same questions others have: “How does one tell proprietary trading from marketmaking or hedging? Moreover, isn’t the real problem the banks’ appetite for risk? Unless all forms of risk-taking are banned, will banks not find other ways to take on risk, including lending to dodgy customers?”
Rajan’s solution to the first problem is human judgement:
Instead of imposing a blanket ban on institutions growing beyond a certain size, regulators should use more subtle mechanisms such as prohibiting mergers of large banks or encouraging the break-up of large banks that seem to have a propensity for getting into trouble. While there are always concerns about whether regulators will use these sorts of powers arbitrarily, they are no more difficult for legislators and courts to oversee than are powers based on anti-competitive considerations.
I’m not sure I have as much faith in the current execution of anti-trust law as Rajan does, although I am quite happy to hear him saying that big is not necessarily bad—and that propensity to take risk does not always follow from it. Consider that in the Great Depression 9,000 banks failed in the U.S. (a nation of many tiny, unconnected banks), but none did in Canada (a country that only had ten big ones).
I think that in the United States the size and risk do often go hand-in-hand—perhaps because of our insistence that corporations not just be profitable, but also compulsively increase earnings every quarter. Yet it is possible to have a system of big, less-risky institutions, and I think it’s important to keep that in mind so that when we talk about risk and size we know which end is up.
Rajan also presents an alternative to singling out and limiting certain activities like prop trading: getting rid of deposit insurance. The idea here is that since the advent of the money-market fund, people who want to be able to get money back on a day’s notice have had a safe alternative to bank deposits. So why help banks—including imprudent ones—collect deposits by handing out a government seal of approval? He writes:
For large, well-diversified banks, deposit insurance merely contributes to excess. We will bail out these banks anyway in a time of general panic. Why encourage the poorly managed ones to grow without market scrutiny by giving them deposit insurance along the way?
Considering how the money markets seized up in the fall of 2008, and some investors actually couldn’t get their money back in a timely manner, I’m not so sure I agree with the premise. But I still appreciate Rajan presenting an alternative to what’s already on the table, and I hope he expands on the idea later today.