Technology, Cost Structure, and Failure of Banking Regulation Shyam Sunder, Yale University (Joint work with Vivek Chaudhuri, Monash University and Gylfi Magnusson, University of Iceland) Accounting, Economics, and Law Network Meetings of the Society for Advancement of Socio- Economics London, July 4, 2015

An Overview Seeking an economic explanation for the failure of bank regulation (beyond incompetence and malfeasance) Components of the story line: – Computer and communications technology – Shift in cost structure of the industry – Large economies of scale: natural monopoly – Consolidation of the industry into mega-banks – Political economy: the 800 lb. gorilla problem – Limits of regulation in a democratic polity – Limits of regulation in a virtual industry (innovation) What can be done?

What Can Be Done? The traditional approaches to regulation have not worked, and are unlikely to work – Virtual industry problem – Political economy problem Some suggestions for dealing with the first problem No idea yet about how to deal with the second

Affirmative Definition of Covered Banks Limit access to deposit insurance and central bank lending to only those banks that engage in a pre-specified list of transactions The terms of these transactions are also pre- specified, and the banks cannot modify them (beyond filling in a number) No “innovation” is permitted The regulatory authority may allow additional activities only after extensive field testing in the future

Permitted Transactions for Banks Inside the Regulatory Fence Checking accounts and term deposits Term and revolving loans Credit cards Safety deposit boxes Check clearing and wire transfers

Not Permitted for Banks Inside the Regulatory Fence No transactions with banks outside the system No clearing of payments outside the system No brokerage or insurance No financial innovation Separate mortgage banks

Complexity and Innovation Financial innovation usually defended for making markets more complete (state-spanning set of securities) to permit better price discovery, liquidity, allocation of risk Most financial innovation has generated “illth”, not wealth for society by selling complexity to even the sophisticated Iowa ethanol company Creativity is accounting has never been seen as a good thing Ditto for finance

Good Finance Good finance, like good accounting, plumbing, and electrical wiring is boring work paying ordinary wages Excitement in these matters is a sign of serious trouble Philippon and Reshef’s work on 100 years of wages and education in the financial services industry

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