Why banking begets crony capitalism?

Megan McArdle wrote an essay yesterday on the regulatory background of the Euro crisis. It looks like Megan generalized too far in her conclusions. But the segment on EU banking regulation is correct — that banks were required by regulators to hold more and more of what turns out to be “not-riskless” assets.

In the EU the definition of riskless included the sovereign debt of other EU nations. But the 2006 Basel 2 assessment of specific country risk was never enforced in the EU. As a consequence the EU banks did not book reserves against possible defaults among the sovereigns in their capital account. So Greece, Ireland, Portugal sovereign debt is on the EU banks balance sheets as risk-free capital. That makes a very big hole when a “risk free” asset is marked to a (generous) 50% haircut.

Among the comments to Megan’s piece was this one by circleglider [in reply to TakuanSoho]. I thought circleglider neatly captured the incentives affecting regulators and bankers in most OECD countries. Is there a flaw in this outline?

The knee jerk libertarian instinct is to say “See! Government regulation doesn’t work!”

I think you can draw a fairly clean line between regulations designed to reduce fraud, and regulations designed to manage behavior to achieve goals the government desires.

In practice, no such clean line exists. Both U.S. and European banking regulations are so complex as to be absolutely prescriptive.

The world’s largest banks – the kinds that both take deposits, underwrite securities, and trade for their own portfolios – are not able to behave as independent market actors. Their decisions are always made in cooperation (or collusion) with national regulators. So when these banks loose billions on mortgages or Mediterranean sovereign debt, we as a society – through the regulatory mechanisms that our elected officials have erected – are responsible for those losses.

This implies that the world’s largest financial institutions are really instruments of national policy… and that’s precisely correct. Deutsche Bank, Société Générale, Barclays, JP Morgan Chase, ICBC, etc., all operate in tight consultation with their respective national regulators and elected officials. Individual nations believe that very large banks offer competitive advantages, and they implement these beliefs by encouraging their banks to grow. This is the fundamental reason why “too big to fail” institutions exist: the developed world believes that really big banks offer real advantages to their host nations.

Of course, if these large banks are in reality “nationalized,” then both profits and losses should be nationalized, too. In some countries, this is how things work. But in the U.S. (and some European countries), profits are privatized and losses are socialized. Somewhat unsurprisingly, the people who work in these banks and in their regulatory agencies believe that this arrangement is O.K. Most bankers see themselves as extensions of government, helping to implement consensus social and economic policy. And most regulators see themselves as working with their banks to accomplish these common goals, too. And, of course, most government regulators hope to someday work directly for one of these large banks so that they, too, can enjoy privatized profits.

This is the true libertarian critique of the modern regulatory state: it’s not regulation, it’s crony capitalism. And as long as we as a society keep asking for more and more regulation of banks (or of any other industry), we’ll have more and more crony capitalism.

The only solution is to deregulate and privatize both profits and losses. Of course there must be some basic regulations designed to prevent fraud. But today’s modern regulatory state is so far removed from this basic concept as to be unidentifiable. In banking, one of the most important characteristics of such a deregulation would be denying deposit insurance to truly deregulated banks – and prohibiting insured banks from using those deposits to trade for their own accounts. This sounds a lot like “reimplementing Glass-Steagall.” But truly effective banking deregulation entails much more than simply turning the clock back twelve years.

This is how the real estate bubble is linked to today’s sovereign debt crisis. There isn’t a “bubble” in Greek or Italian debt – instead, regulators explicitly told banks to buy these securities on the assumption that they were as good as cash. And several national government deliberately lied about their finances (and several, including France, continue to do so). Today’s problem stems from governments instructing their banks to finance their public debts and then intentionally misleading those banks about the risks of those debts. No wonder Europe’s leaders appear to be indecisive – they know that they’re the villains, and they don’t want to be caught. And most of the press (and groups like Occupy Wall Street) actively help these governments obscure the truth.

Read the whole thing. For advanced credit: is there a way to design the incentives so that crony capitalism does not happen?