Monday, March 01, 2010

Climbing Mount Improbable

I've touched on this before, but Mark Thoma has another sound reason for why we need a new Glass-Steagall act - the evolutionary pressures on banks. The argument is quite elegant, really.

Given a choice between a retail-only bank and a bank that's 99% retail but has a small investment-banking arm, the latter will (in the boom times) show greater profits and dividends, hence will be preferred by shareholders. This encourages them to play the markets, rewards those who do, and punishes those who do not. Similarly, a highly-levered bank will turn greater boom-time profits than a less-leveraged one - so anyone not using as much leverage as possible will turn lower profits and hence be less "fit". Thus banks are encouraged to do ever-riskier things with their money.

In nature, what stops risk-taking behaviour is death and serious injury: we've been conditioned by millennia of evolution to have various rational (and irrational) fears precisely because heights and snakes and fire and dogs are dangerous, and fear is nature's way of codifying that hard-won knowledge for the benefit of the species.

But that doesn't apply to banks now: they're too big to fail, the governments have implicitly (and explicitly) guaranteed their survival. Risk-taking no longer has any risk, so leverage to the hilt and trade whatever instruments offer the greatest upside - there is no downside, thanks to the taxpayer! Departments will keep on growing, as more people and more trades means more profits, making the banks bigger and hence securing their existence.

Whether this is a conscious decision to pursue short-term profits at all costs, or just organic growth of companies and teams who the markets reward for their success, is largely unknowable and almost completely irrelevant. The lesson from evolutionary biology is that a species without natural predators will specialise to an alarming degree, even to the point - like the dodo and the kakapo - where their survival is threatened by even the slightest shock, and a mildly-bored housecat can decimate the population. With no predation, and financial gravity repealed by governments, banks will maximise their profitability by becoming huge and fragile: exactly what we saw in the 1920s and in the 2000s.

The cure is simple, and was correctly enacted in 1932: separate the retail banks (who must be saved) and the investment banks (who can take risks... but who might be killed by them).

- KoW

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