A Dimon for Your Thoughts
I've been watching bits of JPMorgan CEO Jamie Dimon's testimony before the Senate Banking Committee on his firm's trading loss of $2 billion.
Perhaps my favorite moment was Senator Bob Corker's line of questioning, in which he asked Dimon if the Dodd-Frank law has made the American financial system significantly safer. Despite a few attempts at evasion from Dimon, Corker persisted until he got Dimon to admit "I don't know." (In the WSJ's feed, the conversation is noted at 11 a.m.) Roughly a half hour later, to Senator Mike Johanns, Dimon said that Dodd-Frank was costing JP Morgan $1 billion a year in compliance, and he said at another point that Dodd-Frank's costs were even higher to smaller community banks as a percentage of total operation costs.
I don't always establish comprehensive regulatory schemes whose costs run in the billions of dollars, but when I do, I make sure that there are net benefits. (This is a pop culture reference.)
I've written only a little bit about Dodd-Frank on this blog, mainly because financial regulation is not a field in which I consider myself all that knowledgeable. In the past, I wrote that the evisceration of the spirit of Dodd-Frank was predictable, given the concentrated power of the financial industry, and I also wrote in defense of "bright-line" regulations in response to Arnold Kling's call for "principles-based regulation."
But watching Dimon testify, I'm beginning to think that the very premise that the United States can, through appropriate regulations, eliminate or contain systemic risk is flawed. You don't need to be a regulatory wizard to be able to see that what is broken is not our regulations, but the idea of regulations as panacea.
I think the only way to really understand systemic risk, and why it is a problem requiring collective action at all, is to see it as a negative externality. Too often, conversations about systemic risk abstract it into some sort of mystery force we don't know how to deal with except through command-and-control regulation and supervision. But we know that regulation is not the only way to internalize externalities -- Pigouvian taxes work too. (There's one mention of "public goods" in this speech by St. Louis Federal Reserve Bank president James Bullard...and then it turns directly to regulation.)
Yet systemic risk is, in some very important ways, as simple a negative externality as air pollution. When banks make loans, or nonbank financial companies engage in securities trading, buying or selling insurance, underwriting, investing, etc., all of those activities create a private expected benefit and a private expected cost. But they also create a positive social expected cost, mainly in the form of counterparty risk.
Like air pollutants, which have a per-unit social cost, systemic risk too can be looked at in this way. Without the need of a regulator to compute assessments of systemic risk for each individual firm, we should be able to determine the social expected cost of systemic risk by looking at firm size, firm revenue, various measures of portfolio risk, etc. Developing equations to quantify the level and cost of systemic risk may not be easy, but it certainly is going to be easier, more successful, and more efficient than individual-firm systemic risk assessment.
More importantly, such practices would avoid the games of hide-and-seek with regulators and the dubious practices, as with JP's C.I.O. office.
With our social cost function, we can then consider the ways in which a Pigouvian tax is best applied. I would not go as far as recommending a tax on its face, as is done in this VoxEU article -- it will never happen in the US, and there are other levers. Instead, what make more sense is something like this proposal from Cato's Mark Calabria to limit the extent of deposit insurance available at systemically-risky financial institutions. (As a matter of fact, Matt Yglesias has said some positive things about Calabria's idea too.)
What Calabria ultimately is proposing is a backdoor Pigouvian tax. I would modify his proposal slightly, saying that the level of deposit insurance should fall as our social cost function measuring systemic risk rises. At a small bank, or a bank which has a very conservative loan portfolio, or whatever else, the individual depositor would be eligible for more FDIC backing than would a depositor at a large or risky bank. That would create an incentive for individuals to be conscious of deposit risk, and for banks to manage their size and risk appropriately and, most importantly, efficiently. (There is an efficient nonzero level of systemic risk.)
Where deposit insurance isn't relevant, there are other levers, such as reserve requirements, other liquidity requirements, the discount rate, etc., through which a per-unit cost can be passed back through onto the social-cost creators (the systemically-risky banks).
I really think that economists need to push harder for less intrusive ways of resolving systemic risk as a negative-externality problem than command-and-control regulation. As the conversation on financial system reform returns, let's look for more market-oriented, Pigouvian solutions.