The bailouts next time

Matt Zeitlin proposes a tiered system of regulation for financial institutions, on the premise that the biggest banks should not be taking huge risks just to make the wealthy wealthier.

So, looking forward to how we want to regulate the financial sector, a few things seem obvious.

One, impose a simple rule on financial institutions. Either, you can be big — so big that your insolvency would threaten the collapse of the world economy — and not do anything risky or you can be small and do whatever the hell you want. Another way to thread the needle here would be to require banks like Citigroup, or anything that’s “too big too fail,” to pay into a super-FDIC, essentially to buy bailout insurance, so that if and when they need to be bailed out, it’s not a huge, sudden expense on the taxpayer. Or you simply let hedge funds do all the exotic stuff and tell banks to, well, be banks. Or, hell, you could just not let financial institutions get too big. For example, you could say that investment banks have to be partnerships and not let them become publicly traded companies (and thus get so big) or, on a smaller scale, just limit how much leverage can be used.

The merit of this proposal (or similar proposals) lies in how well it matches what the general public expects of banks. Many bank customers are just looking for a place to park their checking account, and may not necessarily care if their savings account earns .05% instead of .06% interest. What people do care about is 1. not losing their money, as in the Great Depression, and 2. not seeing billions of tax dollars go to prop up tottering banks, as in the present crisis. On a macroeconomic scale, however, bans on risky investments for large banks might depress economic activity, since less money will be moving around in high-risk transactions. High economic growth is, unfortunately, correlated with high risk, and the challenge of regulating financial institutions lies in striking a good balance between fostering growth while inhibiting risk.

I think the best part of Zeitlin’s suggestion is the “super-FDIC” for the biggest banks – the ones most likely to serve the general public rather than niches of well-educated, risk-loving investors. A super-FDIC (an FDIC on steroids?) would offer a bank and its customers increased financial security, in exchange for prohibiting the bank from using deposits in unacceptably risky ways. Mandating membership in such an institution for banks above a certain size would be a nightmare: legislating the cutoff line and policing banks who might cross it from year to year would be just two likely difficulties in that scenario. However, a better approach might consist of letting banks above a certain size voluntarily join this ULTRA FDIC, and encouraging that member banks advertise their membership to their customers. This tweak to Zeitlin’s proposal does not eliminate entirely the plan’s dampening of economic activity, but it seems to achieve the goal of risk reduction in a way that might be more agreeable to legislators, and less constraining of capital.