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Yesterday, Treasury Secretary Geithner presented an outline of his approach to regulating the financial system. The four pillars of that approach seem to be:

  1. Increased power and regulatory centralization to deal with the problem of systemic risk
  2. Increased protections for consumers and investors buying financial products
  3. Closing regulatory gaps by shifting that organizes regulation based on financial functions, not types of financial institutions
  4. International coordination among regulators

This all sounds good to me, and an improvement over where we are today. But reading Geithner’s discussion of systemic risk - the topic he focused on yesterday - I kept thinking it had been too long since he read Frog and Toad to his children.

The section on systemic risk reads like this (emphasis added, feel free to skim):

To ensure appropriate focus and accountability for financial stability we need to establish a single entity with responsibility for consolidated supervision of systemically important firms and for systemically important payment and settlement systems and activities.

. . . [W]e must create higher standards for all systemically important financial firms regardless of whether they own a depository institution, to account for the risk that the distress or failure of such a firm could impose on the financial system and the economy. We will work with Congress to enact legislation that defines the characteristics of covered firms, sets objectives and principles for their oversight, and assigns responsibility for regulating these firms.

In identifying systemically important firms, we believe that the characteristics to be considered should include: the financial system’s interdependence with the firm, the firm’s size, leverage (including off-balance sheet exposures), and degree of reliance on short-term funding, and the importance of the firm as a source of credit for households, businesses, and governments and as a source of liquidity for the financial system.

Given the existence of “systemically important firms,” I agree they need careful regulation. But why does Geithner assume that they have to exist at all?

There are a few main things that made companies like AIG (NYSE:AIG) and Citigroup (NYSE:C) systematically important. One was interconnectedness: they did business with lots of counterparties. One was complexity: when push came to shove, the regulators were not able to assess the potential damage a failure could cause, and therefore erred on the side of bailing them out. But the big one was size, and this is why we call it Too Big To Fail. The companies in question were so big, and had so many liabilities, that they could cause a lot of damage if they suddenly defaulted on those liabilities.

Interconnectedness is not going to go away. Complexity may not go away completely, but increased supervision could give regulators a better grasp on complexity. For example, all firms could be required to provide detailed information about their positions to regulators, in a standardized format, so that it could be imported into aggregate computer models; data about positions would be kept only by the regulator and not made public. Complexity could also be reduced by limiting the number of businesses an institution is allowed to engage in (like under Glass-Steagall, but updated for today’s world). But size can definitely go away, simply by setting a cap on the volume of assets any institution is allowed to hold (and doing something about off-balance sheet entities). And if a highly interconnected, highly complex but small financial institution fails, the system as a whole would be fine.

What would such a world look like? There would be a lot of small- and medium-sized banks that collected deposits and lent money to households and businesses. There would be brokerage and asset management firms that you used to invest your savings. There would be hedge funds and private equity firms that rich people and other institutional investors used to invest their money. There would be investment banks that helped companies issue equity and debt securities. There would be boutique firms that did research and other boutiques that M&A advising. For any financial service anyone wanted, there would be a company that provided that service; it just wouldn’t necessarily provide every other service, and it wouldn’t have $2 trillion in assets. It would look something like the 1970s.

What’s wrong with this picture? Some people would argue that it would limit financial innovation. But there is no correlation (or a negative one) between the size of a firm and its degree of innovation. Nor do you need to operate a financial supermarket to innovate: mortgage-backed securities were pioneered by Salomon Brothers, an investment bank under the old definition. Finally, perhaps we could use a little less innovation.

Some would argue that costs would be higher, because smaller firms would be less able to capture economies of scale and scope. First, casual empiricism debunks this theory immediately. When I got my mortgage on my house, I got a much lower rate at a small community bank (which holds onto its mortgages rather than reselling them) than at any national bank. National banks also typically offer the lowest rates to savings customers, except when they are about to fail and desperately need cash from depositors. Second, even if this were the case, perhaps slightly higher costs are a price worth paying for reduced systemic risk.

Basically, this is the issue that Ronald Coase discussed in “The Nature of the Firm” (Wikipedia summary; paper). A firm’s optimal size is reached when the transaction costs of doing business in the market equal the administrative costs of managing the firm; the bigger the firm, the higher the administrative costs. Clearly some financial institutions reached a level of scale and complexity where they simply could not even understand what they were doing, let alone manage their risks appropriately; they were too big, looked at just from their own perspective (and excluding the implicit Too Big To Fail subsidy). To this equation, we now need to add the social costs (negative externalities) of being Too Big To Fail: moral hazard, socialized losses, and so on.

To some people, the idea of size caps will seem anti-capitalist (or even un-American). However, that viewpoint is based on a misunderstanding of what the modern large corporation actually looks like. In the United States, supposedly the most dynamic capitalist economy in the world, our corporations are run almost exclusively as giant bureaucracies with a rigidly hierarchical decision-making structure. When I was in the business world, I saw several of these entities from the inside or up close, and they are identical: there’s barely a trace of the free market to be found. Even in the technology industry, the biggest companies, like Cisco and Oracle, expand by buying innovation from startup companies where the innovating actually happens. (Some large technology companies expand by copying innovations made by startup companies, but that’s another subject.)

Geithner’s testimony yesterday did contain at least one important insight:

In general, the design and degree of conservatism of the prudential requirements applicable to such firms should take into account the inherent inability of regulators to predict future outcomes.

When you are designing regulation, you have to bear in mind that the world will change. But this is another reason why simpler is better, and the simplest solution is simply to prevent firms from becoming Too Big To Fail in the first place. First, you have to expect that no matter how clever your regulatory scheme, some firms will be even more clever in finding ways to evade the system and blow themselves up. You are far better off if they are small when they blow up than if they are big.

Second, one of the “future outcomes” you have to protect against is that the firms being regulated will try to change the regulations. So one prerequisite to a successful regulatory structure is limiting the political power of the firms being regulated. This is, ultimately, the most important reason why smaller is better.

Update: Paul Krugman says something similar in his op-ed today:

America emerged from the Great Depression with a tightly regulated banking system, which made finance a staid, even boring business. Banks attracted depositors by providing convenient branch locations and maybe a free toaster or two; they used the money thus attracted to make loans, and that was that.

And the financial system wasn’t just boring. It was also, by today’s standards, small. Even during the “go-go years,” the bull market of the 1960s, finance and insurance together accounted for less than 4 percent of G.D.P. The relative unimportance of finance was reflected in the list of stocks making up the Dow Jones Industrial Average, which until 1982 contained not a single financial company.

It all sounds primitive by today’s standards. Yet that boring, primitive financial system serviced an economy that doubled living standards over the course of a generation.

Update 2: Calculated Risk has this gem which I meant to include in my original post but forgot:

Imagine if the Federal Reserve had been the “systemic-risk regulator” during the bubble.

According to Greenspan in 2005 “we don’t perceive that there is a national bubble”, just “a little froth”, and even in March 2007 Bernanke said “the impact on the broader economy and financial markets of the problems in the subprime market seems likely to be contained”.

How would a systemic-risk regulator help if they miss the problem?

So it’s good to have a systemic risk regulator, but it’s best to minimize the chances of systemic risk getting big in the first place.