Monday, February 15, 2010

Does size matter?

In the February 8, 2010 issue of New York Magazine, Hugo Lindgren analyzes the politics behind the proposed regulatory reform in response to the recent financial crisis. Though he posits that politically, the reforms are a good idea, he suggests that the reforms might not actually serve their intended function. It is this latter point that I wish to focus on here. Lindgren perceptively asks the following questions:

If the size of institutions is at the core of the problem, what explains the 140, mostly tiny failed banks last year that cleaned out the reserves of the Federal Deposit Insurance Corporation? Was it really proprietary trading that drove banks to the brink…?

These are questions that not only expose the flaws in current regulatory proposals, but also beg an even more important question that I will address shortly. But first, let’s unpack some of the above insights. For all the fanfare about “the big banks” and “too big to fail,” there is something peculiar about the stigma applied to these large financial institutions when their smaller counterparts faced the exact same fate. As a result, we can state definitively that size had absolutely nothing to do with bringing down the banks. Size just makes for exciting news segments.

In terms of the proprietary trading element, the analysis is very similar. Proprietary trading desks are no doubt risky ventures with bank capital exposed to levered trading, but again, if smaller financial institutions with no proprietary trading desks whatsoever failed as well, then we can state definitively that proprietary trading had absolutely nothing to do with bringing down the banks. It is a fundamental component of economic analysis that correlation does not equal causation; it is true that the big banks had proprietary trading desks and it is true that the big banks failed, but it is not necessarily true that having proprietary trading desks means that banks will fail. Volcker, are you listening?

And finally, it is most critical to take Lindgren’s argument one step further. If we observed that banking institutions, consumer businesses, real estate, and just about every other element of the modern economy tanked in unison, then the culprit we should be looking for in some way spans the entire economy, not just a few specific segments of it. I can think of only one piece of the modern economic puzzle that fits this description: money. Well, who controls the type, quantity, and price of money? The central bank.