Economist's View: 'Is Finance Too Competitive?'

I don't have any problem at all with the call for more competition in the financial industry, especially measures such as reducing bank size to the minimum efficient scale to reduce their systemic importance and political power. I do have a problem, however, with the idea that competition can substitute for regulation, i.e. that these markets can be left alone to self-regulate:

Is Finance Too Competitive?, by Raghuram Rajan,Commentary, Project Syndicate: Many economists are advocating for regulation that would make banking ?boring? and uncompetitive once again. After a crisis, it is not uncommon to hear calls to limit competition. ...

The overwhelming evidence, though, is that financial competition promotes innovation. Much of the innovation in finance in the US and Europe came after it was deregulated in the 1980?s ? that is, after it stopped being boring.

The critics of finance, however, believe that innovation has been the problem. Instead of Schumpeter?s ?creative destruction,? bankers have engaged in destructive creation in order to gouge customers at every opportunity while shielding themselves behind a veil of complexity from the prying eyes of regulators (and even top management). ... Hence, the critics are calling for limits on competition to discourage innovation.

Of course, the critics are right to argue that not all innovations in finance have been useful, and that some have been downright destructive. By and large, however, innovations such as interest-rate swaps and junk bonds have been immensely beneficial... Even mortgage-backed securities, which were at the center of the financial crisis that erupted in 2008, have important uses... The problem was not with the innovation, but with how it was used ? that is, with financiers? incentives.

And competition does play a role here. Competition makes it harder to make money, and thus depletes the future rents (and stock prices) of the incompetent. In an ordinary industry, incompetent firms (and their employees) would be forced to exit. In the financial sector, the incompetent take on more risk, hoping to hit the jackpot, even while the regulator protects them by deeming them too systemically important to fail.

Instead of abandoning competition and giving banks protected monopolies once again, the public would be better served by making it easier to close banks when they get into trouble. Instead of making banking boring, let us make it a normal industry, susceptible to destruction in the face of creativity.

This seems to imply that breaking banks into smaller pieces makes the system immune to taking on too much risk and the problems that come with it, but we had banking problems in eras where most banks are small -- cascading bank failures in response to a large shock are still possible -- so making markets as competitive as we can, including breaking firms into smaller pieces and allowing easy failure, is no guarantee that financial meltdowns will be avoided (it may, in fact, be harder to step in and save the system when you have to fix many, many small banks instead of a few big ones). I think more competition in this industry is a good idea, but we shouldn't be fooled into thinking that means we can stop worrying about the stability of the system. The focus of the article is innovation, but that is not where the main vulnerability lies. Market failures that allow the equivalent of bank runs on the shadow banking system are a much bigger problem, and this problem cannot be solved by simply reducing firm-size. Regulation to reduce the chances of cascading failure will still be needed.

Posted by Mark Thoma on Tuesday, November 13, 2012 at 09:53 AM in Economics, Financial System, Market Failure, Regulation?| Permalink? Comments?(8)

Source: http://economistsview.typepad.com/economistsview/2012/11/is-finance-too-competitive.html

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