25 May 2011

Worst of Both Worlds

Tom Clougherty, on the Independent Commission on Banking’s recent proposals:

I hope this isn’t the case, but if it is, it probably suggests a far more radical regulatory approach than the Independent Commission on Banking has considered. It might even point in the direction of ‘narrow’ or ‘limited purpose’ banking, which would involve imposing strict structural divisions in the finance industry, and require banks to hold dramatically higher levels of liquid reserves. Bank of England governor Mervyn King has nodded in this direction.
Of course, I’d much prefer the free market option, but the trouble with the Independent Commission on Banking’s proposals is – arguably – that they do neither one thing nor the other. They don’t eliminate moral hazard and risk subsidies or restore real market discipline to the financial sector. But they don’t offer a particularly strong regulatory response either. As such, the banking sector is liable to cause more problems in future.

Regulation is the natural and proper response to subsidies.  If the government is going to subsidize something, it is only natural that the government also regulates it in order to ensure that the new incentives don’t lead to financial (or behavioral) malarkey.  In fact, the general purpose of incentives is not to upend the market, but rather to tweak it slightly.  Of course, not all consequences can be appreciated in advance, which is generally why regulation is an inevitable response to subsidies.

As such, there are two proper responses to subsidies:  either abolish them, or regulate the recipients.  The baking commission appears to have taken the worst approach, which combines the free-market approach to regulation coupled with an interventionist approach to subsidies.  One need not be a genius to see that this plan is doomed.  If the banking commission desires to be successful, it needs to have a consistent philosophical approach:  either free markets or proper intervention.  It does not need some half-way measure combining the two.  Compromise is counterproductive and damaging in the long-run, and so the commission simply needs to get off the fence.

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