The Prudent Banker-Self Regulation Myth Lives On

A recent posting at Seeking Alpha contains the following citation from a speech made by a professor of Economics at George Mason University on how we need a new rule of law to prevent financial crises in the future:

If it is known that nobody is “too big to fail”, or too well connected to fail, then lenders will not let financial firms leverage up cheaply in the belief that they will be protected.

The statement sounds very reminiscent of the doctrine that the free market is capable of regulating itself because the self-preservation interests of the relevant lender's shareholders will encourage prudent behavior. This is more or less the same doctrine which Alan Greenspan admitted, not so long ago in testimony to Congress, was his big misconception.

The problem with this laissez faire mythology is that the interests of the managers/traders/financial engineers at the big lenders are not aligned with those of the shareholders. Much of the decision-making of the business lenders/financial firms is conducted by guns for hire who have moved on to pastures new (including yachts on the Caribbean/Mediterranean) by the time their imprudent lending judgments become evident.

Comments

[john s. gordon:]

well there are prudent banks in the u.s.a and in the world but they are not located on wall st. therefore regulation is a must.
after the enron caper sarbox became necessary even though it is a burden to the many businesses that operate ethically.
> jack

Nov 02 08:59 AM

[Clive Corcoran:]

jack

I agree that not all banks are imprudent but the so called "light touch" regulations - effectively on both sides of the Atlantic - allowed monster banks to emerge with inadequate risk controls. As of today the UK are beginning the break up of two such monsters - Royal Bank of Scotland and Lloyds/HBOS. It would be good if this was the start of a trend.

Nov 02 09:45 AM

[John Lounsbury:]

Clive - - -

You need more readers because there are those who would debate you.

However, I am not one of them.

Nov 02 08:04 PM

[PainfullyAware:]

Just like the "Separation Of Church And State" is Valid - Favoring one church over another is invalid - so, The Separation of "Savings Banks" and "Investment Banks" must receive the same segregation.

Too Big To Fail Is A Fallacy.

Nov 02 08:33 PM

[john s. gordon:]

clive - i agree, break em up into chunks that are capable of being managed. we have had too much out-of-control with masters of the universe lining their pockets with loot.
it is ironic that there is a move afoot in the u.s congress today (11/06/09) to emasculate sarbox right @ the time that we need it the most.
> jack

Nov 06 03:16 PM