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My last post recommended draconian regulation for bailed-out banks and some regulation of all banks which accept federally insured deposits. Reader Lupus Nomen pointed out an apparent inconsistency in a comment on Vermont Tiger.

Tom, All of these suggestions make a lot of sense. But they also sound a lot like "big government" regulation, which I thought, according to Vermont Tiger at least, was nothing more than a python strangling the "productive sector" to death.

The different people who write for Tiger have different opinions on almost any subject so I can only speak for myself. However I do think that over-regulation is a "python" strangling not only the private but also the public sector. So what am I doing suggesting all these regulations for banks?

First, second, and third – once a company gets get bailed out with public money, it is no longer regulated by competition. Failure is how the marketplace punishes stupid and reckless behavior. Fear of failure discourages such behavior. The behavior of big investment banks post-bailout but pre- any meaningful regulation has made absolutely clear how quickly this arrogance can grow and how damaging it is. Institutions which government has insulated from market failure MUST be regulated by government. We not only have a right to regulate them, we have a responsibility to do so.

So do we want a regulated banking system forever?

No. Government should not be making investment decisions. Government shouldn't be deciding who gets loans. That's why the first regulation needs to be break up the banks that are "too big to fail". No institution which is subject to market discipline and shareholder votes – neither of which is perfect, BTW – needs to have the government deciding how much its CEO gets paid or the details of how it conducts its business within the broad bounds of the law including antitrust and liability for bad behavior.

But there's one more exception as far as banks are concerned: Federal deposit insurance. If we the people are providing insurance for bank deposits, we have to have a way to make sure that the institutions holding the deposits don't take advantage of being insured by us in order to make inappropriately risky investments with the depositors' money. We need to make sure that the institutions have sufficient capital to make claims against the insurance pool unlikely. A private insurer would do the same thing.

A purist would say we shouldn't have federal deposit insurance for just this reason. I disagree (with some discomfort) on pragmatic grounds. Federal deposit insurance has ended the scourge of bank runs which left small savers either putting their money unproductively in a mattress or holding the bag for bank mistakes or misdeeds. But insurance requires supervision by the insurer.

I may rethink my opinion on this if banks don't start paying more interest than mattresses do.

Source: When Financial Regulation Is Justified