The primary goal of any new financially regulatory regime should be, simply, that no company can be so big or important that its failure would dramatically destabilize the system.
We’ll never prevent failure — nor would we want to — but we want to make sure that anybody can go down for the count without need of a bailout. This goal isn’t just so that we eliminate future bailouts (though that’d be a nice effect) but so that counterparties to these institutions can’t take excessive risk with the knowledge that the government will be there to back them up. As studies have shown that this is a contributing factor to financial crises, it has to be killed if possible.
But it’s not clear that the new regulatory system unveiled by Tim Geithner solves this problem. In fact, it may make things worse.
In his NYT column, Marginal Revolution blogger Tyler Cowen explains:
What the banking system needs is creditors who monitor risk and cut their exposure when that risk is too high. Unlike regulators, creditors and counterparties know the details of a deal and have their own money on the line.
But in both the bailouts and in the new proposals, the government is effectively neutralising creditors as a force for financial safety. This suggests a scary possibility — that the next regulatory regime could end up even worse than the last.
The more closely a financial institution is regulated, the more it will be assumed that its creditors enjoy federal protection. We may be creating a class of institutions whose borrowing is, in effect, guaranteed by the government.
We’ve railed on this several times, the fact that bank bondholders have been the only parties not to share some of the pain. The message has been: Lend to whomever the hell you like, we’ll protect you before anyone else. It’s exactly the mesage that will contribute to the next meltdown.