From my perspective, we’ve never grasped the nettle of what we want our banking system to do. Classically, banks turn savings into capital, and classically they do it pretty directly, by taking deposits and lending to businesses and consumers. Banks are supposed to be good at evaluating the individual risks associated with these loans, as well as constructing portfolios of sufficient diversification to minimize the risk of them getting any of those individual evaluations wrong. Bank regulation is supposed to keep banks from pushing the envelope on either front in the interests of higher profit.
In our modern world, most of what banks do is intermediate in more complicated ways. They don’t do a whole lot of evaluation of individual loan decisions; instead, they are expert at aggregating and repackaging financial risk. The upside to this is that a much larger world of borrowers can access a much larger world of lenders, which should push down the cost of lending generally, and thereby facilitate growth. The downside, which has only manifested itself over time, is a financial system with an ever-increasing aversion to real risk (because nobody involved in large institutions can really evaluate it, and small institutions cannot achieve economies of scale to compete effectively with the large ones), coupled with an ever-increasing appetite for complexity that provides inherent reflexive self-justification (you need a really complex and well-paid operation to manage that complexity, so finance can never reliably be shrunk as a percentage of the economy).
I can’t help but believe that financial regulation and innovation in capital rules has facilitated the above development. In a world where hedge funds do more and more of the direct lending to small businesses – the kind of activity that used to be bread-and-butter for FDIC-insured banks – whatever financial regulation is doing, it isn’t forcing insured banks to return to their “proper” core economic function. And the kinds of activities that 716 tries to push out into uninsured subsidiaries are precisely the kinds of activities where much of the real risk lies in the tail of the distribution – the place where crises come from.
The repeal of 716 matters not because “push-out” was such a successful or important reform, but because it shows how the terms of debate have changed. We’re now debating whether it’s “time” to weaken financial reform, and let the banks operate more “efficiently,” when financial reform never actually achieved its core goal of taming finance’s role in the economy.
The core question is not whether uncleared derivatives are too risky to live in an insured bank, but whether we’re creating incentives to take risk or to hide it. Banks are supposed to do the former. They have a lot of natural incentives to do the latter. Financial regulation needs to be exceptionally vigilant about sniffing out that kind of behavior and punishing it. Encouraging banks to stuff those risks in an uninsured subsidiary that could then, in a crisis, bring down an insured bank doesn’t strike me as an especially auspicious solution. Scrapping that solution because it isn’t capital efficient, and replacing it with nothing, is even more alarming, because it implies that no solution is necessary. Bankers and politicians agree: the problem no longer exists. Which is exactly when we should start worrying that it’s about to smack the economy in the face yet again.