Regulate the asset or liability side of banks’ balance sheets?

Warren Mosler (who runs a bank) said in this article that, “The hard lesson of banking history is that the liability side of banking is not the place for market discipline. Therefore, with banks funded without limit by government insured deposits and loans from the central bank, discipline is entirely on the asset side.”
 
Well assuming vast amounts of taxpayers' money may have to be spent rescuing private banks (in Warren’s words “with banks funded without limit by government…”) then clearly we have to impose rules as to what banks can do with the money at their disposal, and with a view to limiting the amount of taxpayer money that may be lost.

But that begs a big question, namely why should taxpayers stand behind banks or “money lenders” at all? The state doesn’t stand behind restaurants or garages, and quite right.

Now the obvious answer to that might seem to be that banks are essential for the economy to function, ergo the state must stand behind them. Well OK: one of the main activities of banks, namely the safe storage of deposits and transfer of money from one person or firm to another cannot be allowed to fail. That’s so to speak one of the essential bits of the economy’s “plumbing”.

As to the other main activity, money lending, there’s no earthly reason why a large money lender cannot be allowed to fail, just as long as none of the above “safe deposit” money is lost. That is, as long as those who lose their money are shareholders or bondholders, why should we care?

In any case, it’s highly unlikely that a money lender loses ALL the money it has loaned out. Far more likely is that loans turn out to be worth less than 100cents in the dollar: i.e. that borrowers can only repay say 90cents for every dollar borrowed.


Complexity.

Next, if the asset side of banks’ balance sheets is regulated, the rules turn out to be horrendously complicated. For a start, just look at the rules proposed by Warren himself in his article.

But that’s nothing. Dodd-Frank consists of a good ten thousand pages, and even that has turned out, at least according to some, to be a mess. As Prof John Cochrane put it, “In recent months the realization has sunk in across the country that the 2010 Dodd-Frank financial-reform legislation is a colossal mess.”

Or as Richard Fisher, president of the Dallas Fed put it,

“We contend that Dodd–Frank has not done enough to corral TBTF banks and that, on balance, the act has made things worse, not better.”


Innovation and taking risks.

Returning for a moment to the above point that letting money lenders go bust doesn’t matter, another problem with regulating them with a view to ensuring they DON’T go bust is that that cuts down, by definition, on the amount of risky lending. But it’s precisely risky loans that can turn out to be winners. That is, many attempts at technological advances fail and those concerned lose money. But some of them turn out to be winners. Thus if we regulate the asset side of bank balance sheets, that inevitably reduces funding for potential winners.

And if I want to make risky loans VIA A BANK, then again, there is no reason for taxpayers to get involved.


Conclusion.

Warren is right to say that ASSUMING taxpayers’ money is put at risk in order to save banks, then government must interfere with the way banks are run. But that involves horrendously complicated legislation which is of doubtful effectiveness. Plus it hinders the taking of perfectly legitimate risks.

A far simpler solution is to separate out two functions performed by banks. First there is the storage and transfer of money which bank customers want to be totally safe. That should be tightly regulated. As to the lending of money, that can be left to the free market. If those concerned make a killing, good for them. If they go bust, there’s no reason for anyone else to be concerned.

If you lend to a corporation buy buying its bonds on the stock exchange, taxpayers don’t stand behind you. So why should taxpayers stand behind you when the money you’ve put in a bank is loaned on  to a corporation with a view to earning you some interest?