Some finance reform talk

Creating constructive financial regulations is not an easy task.  Banks spend hundreds of millions of dollars lobbying to weaken regulations, and then spend hundreds of millions more attempting to circumvent them. Complicating the problem is that bureaucrats and law makers often have little to no understanding of the complexities involved; and the ones that do have the necessary understanding are often past, or likely to be in the future, employees of the banks they are regulating. 

I have found two major schools of thought regarding how to address this dilemma.  One is to focus less on regulating banks, and instead concentrate on setting up the necessary infrastructure to clean up the mess should another crash happen. Greg Mankiw calls it crisis insurance.  While I think this could be part of a solution, the difficulty is how to effectively implement it.  For the past thirty years banks have justified taking on an extraordinary amount of risk because the "models" they were using to value complex derivatives didn't account for the possibility of a decline in housing prices.  The problem then for future crisis insurance is how to value the premiums (based on riskiness), when it has just been proven that both banks and regulators do not know how to value risk properly.  This just means that taxpayers will be stuck holding the bag again.

The other main solution is to eliminate big banks; break them up. The first part of this is to restore Glass-Steagall, separating commercial and investment banks. The second part is to cap the size of all banks. The general idea is that small banks can't cause systemic risk. I like this idea a bit more because it accepts the ineptitude of both bankers and the government to regulate the industry. The problem with such strong wide-ranging regulations is that banks will immediately have a tremendous incentive to drill holes in them through lobbying, etc.... So they become unsustainable, not to mention, that they are politically untenable right now.  

The compromise that passed the senate yesterday was that derivatives will be traded on a regulated exchange, hedge funds will be regulated, and banks will not be allowed to invest their own money without benefiting their clients, amongst others. 

In the long run, I am not as worried as most people. Regulators will catch up with finance; it's only a matter of time. Banks have been attempting to circumvent regulations for two hundred years, and this round of fighting probably won't be any different. My main concern is making sure democracy and the competitive market are not hijacked in the meantime.  Banks have been able to insulate themselves since the era of deregulation through lobbying and large-scale purchases on the congress and bureaucracy.  Separating this link would go a long way to improving the prospects of successful regulation.  To do this, the government must have the incentive to regulate and stop the build up of these massive mega-monopoly banks. The simplest and most effective solution is campaign finance reform.  Government officials have become beholden only to those who pay for their campaign, which unfortunately is not most of us. 

Some Links:
1. A good overview of the crisis insurance argument --Greg Mankiw
2. A good overview of the break 'em up argument --Robert Reich
3.  One of the first papers to address this problem -- George Stiglitz