The Great Debate©: Regulate or Restrict Banking Activities?

Written by John Lounsbury
There are at least three schools of thought on what the correct policy direction for the banking industry should be. Two of them are in the title: (1) Tighten regulation of banking activities, or (2) restrict what activities can be undertaken by banks. The third (not included in this debate) is to continue with the current strategy of few restrictions and relaxed regulation. Though not included in the debate presented here this is a choice that has many supporters, particularly within the banking community.
The two positions are presented here by Elliott Morss (article already posted at Global Economic Intersection) and Amar Bhide (piece published by Baron’s Saturday 23 June 2012). Morss takes the position that regulation is a proven failure and therefore restrictions that would limit securitization are needed. Bhide says that restrictions on activities would introduce inefficiencies to banking and better regulation is the proper approach.
by Elliott Morss, GEI Opinion blog, 23 June 2012
Almost all the world’s economic ills in the last decade are attributable to unwarranted risks taken by banks. And all the remedies start by bailing out the banks, leaving the millions who lost their jobs resulting from the banks’ reckless acts to fend on for themselves. In what follows, I document these assertions. I also argue that tighter banks regulations will not work and why the only solution is to require banks to hold the loans they make until they mature.
Banks Caused the Global Recession and the European Crises
a. The Global Recession
By late 2007, there was a speculative US real estate bubble. What caused it? US banks and Federal agencies buying up mortgages, creating new derivative instruments, and selling them off. That worked for them until the real estate bubble burst. Suddenly, there was no market for the various forms of real estate “paper”, causing the near complete collapse of US banks. As I have documented, the panic resulting from the perception that the US banking system was about to collapse – led to global stock market losses of $36 trillion and real estate losses of another $14 trillion. People suddenly felt poorer, much poorer. And the “wealth effects” of those losses caused a sharp cutback in consumer and business expenditures worldwide and the resulting global recession.
b. The European Crises
Like the US, some European nations (the UK, Ireland, and Spain) had real estate bubbles. The Irish government is in the trouble it is in today because it bought up bad bank real estate paper. In other countries (including the US), banks foolishly “enabled” the governments of Greece, Ireland, Italy, Portugal, and Spain to continue down unsustainable deficit paths. Consider Greece: in 2007, it was clear that buying Greek government debt made no sense. 2007 was a boom year, but the Greek government was running a deficit of almost 7% of GDP and its debt already exceeded 100% of its GDP. Today, what was quite apparent would happen back then has happened. It is still running a large government deficit; and even after defaulting on 70% of its debt, the remainder has grown to an unsustainable 150%+ of GDP.
by Amar Bhide, Baron’s, 23 June 2012
The 848-page Dodd-Frank Act overflows with abstruse rules that have profound consequences, but attract little public attention. One such rule requires banks to keep at least 5% of the risk of the mortgages they originate, instead of passing it all off to buyers of securitized mortgages. Co-sponsor Rep. Barney Frank (D., Mass.) explained the theory: If banks have skin in the game, “we’ll just get better-quality loans.”
Regulators published a 97-page proposed rule in the Federal Register in April 2011 to implement the risk-retention requirements. Bankers lobbied against the proposal, arguing that it would retard the securitization of mortgages, deprive the housing industry of funds, and impede an economic recovery. Regulators retreated. A year has now gone by without a final rule.
Good riddance to the rule, but not because it would have hurt housing. Forcing banks to retain risks is unwarranted. Along with most other provisions of Dodd-Frank, it constitutes regulatory asphyxiation. Smothering the Federal Deposit Insurance Corp., the Securities and Exchange Commission, and the Federal Reserve with ambiguous new responsibilities for curing minor or imagined nuisances makes it impossible for regulators to focus on their crucial tasks. Worse, the rule would help perpetuate the excessive conversion of old-fashioned bank loans into tradable securities.
Maintaining the soundness of banks should be the regulators’ job No. 1. The banking system requires good and well-enforced rules to counter its inherent fragility. Just as traffic on unpoliced roads is chaotic, even if most drivers are naturally law-abiding, unregulated banks tend to implode, even if most bankers are inherently prudent.
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elliott-morss-photo1Elliott Morss has a broad background in international finance and economics. He holds a Political Economy from The Johns Hopkins University and has taught at the University of Michigan, Harvard, Boston University, Brandeis and the University of Palermo in Buenos Aires. During his career he worked in the Fiscal Affairs Department at the IMF with assignments in more than 45 countries. In addition, Elliott was a principle in a firm that became the largest contractor to USAID (United States Agency for International Development) and co-founded (and was president) of the Asia-Pacific Group with investments in Cambodia, China and Myanmar. He has co-authored seven books and published more than 50 professional journal articles. Elliott writes at his blog Morss Global Finance.

amar-bhide-SMALLAmar Bhidé is Thomas Schmidheiny Professor at the Fletcher School of Law and Diplomacy, Tufts University. He is author of the widely acclaimed book: “A Call for Judgement” – Oxford University Press (2010). See here. Bhidé is a founding member of the Center on Capitalism and Society and spearheaded the launch of its eponymous journal, Capitalism and Society(published by the Berkeley Electronic Press) which he now edits (with Prof. Edmund Phelps). He is also a member of the Council on Foreign Relations and a Fellow of the Royal Society of Arts (RSA).Bhidé was previously the Laurence D. Glaubinger Professor of Business at Columbia University. He served on the faculties of Harvard Business School (from 1988 to 2000) and the University of Chicago’s Graduate School of Business. A former Senior Engagement Manager at McKinsey & Company and proprietary trader at E.F. Hutton, Bhidé served on the staff of the Brady Commission which investigated the stock market crash. See full bio.

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