Is too much competition the problem with our banking system?

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We all know the problem with the American financial system. It’s that a few institutions have become too big and interconnected to fail. And so, instead of letting creative destruction work its magic and purge the rottenness out of our financial sector, we’re engaged in a sloppy, counterproductive, hugely expensive effort to keep these ailing giants alive.

It’s a compelling enough story. Heck, I’ve bought into it from time to time. But what if it’s got things completely backwards?

For one thing, it doesn’t really square with the historical record: The U.S. had a rollickingly free financial system populated entirely by small-enough-to-fail financial institutions all the way through the 1930s, yet went through devastating financial crises every 15 -20 years.

It also doesn’t really square with the comparative success of the Canadian banking system, which evolved along the centralized, statist lines envisioned by Alexander Hamilton instead of according to the competitive Jacksonian model that prevailed here.

It also doesn’t really square with the evolution of the current financial crisis, which began out on the unregulated and extremely competitive fringes of the system and only hit the big banks relatively late in the game.

Maybe, just maybe, we would be better off with a heavily regulated, highly profitable oligopoly of large financial institutions. That’s the counterintuitive case John Hempton has been making in his blog for the past couple of days:

The standard dogma … is that competition is almost everywhere a good thing.  But I would have the other view.  My view is that competition in financial services causes massive financial crises.

You want fat, lazy banks, the reasoning goes, because fat, lazy banks don’t take crazy risks. You can still have a dynamic, competitive, innovative rest of the economy. But those traits only spell trouble in finance.