This Overhaul Could Undermine The Banking System

Repeat after me: The financial economy exists to serve the real economy, not vice versa. In 1991, Congress is in danger of ignoring this fundamental truth as it attempts to overhaul our financial system.

In ascending order from the particular to the general, the present problems are these: First, the Federal Deposit Insurance Corp. is running out of money. Second, the current regulatory system makes it too easy for bankers to foist losses onto taxpayers. Third, commercial banks have lost their traditional profitable loan business to the commercial-paper market and new types of securities, leading banks into riskier businesses such as real estate development and Third World lending. And fourth, the entire banking system is now dangerously shaky, which spills over onto the real economy and risks a credit implosion.

The policy challenge has been framed as follows. On the one hand, Congress must shore up the structure of supervision and deposit insurance to reward sound banks, punish profligate ones, and protect taxpayers. Paradoxically, it should also liberate banks from Depression-era regulations so they can enter more profitable businesses such as insurance and securities underwriting. That, in turn, should help recapitalize the banking system.

As this debate plays out, Congress has more enthusiasm for tightening the supervisory apparatus, while the Bush Treasury Dept. is more eager to give the banks new powers. Seemingly, the obvious trade-off is stiffer supervision based on market tests in exchange for abolition of venerable laws, such as the Glass-Steagall Act, that keep banks out of the securities business.

NEARSIGHTED REFORM. But this emerging consensus, directed at the immediate malady, is ultimately myopic. It does little to remedy the deeper mismatch between the needs of the real economy and those of the financial economy--and may actually worsen the problem. As countless students of comparative economics have observed, America's real economy suffers from short time horizons and impatient capital. In turn, the impatience of money markets for high yields every quarter makes corporate managers impatient for the quick buck.

In the 1980s, the entire system became more speculative. Hostile takeovers, or the threat of them, were substituted for more ordinary forms of corporate competition and accountability. Bankers, the natural repository of concern for the long term, became more like everyone else. More of the financial system became "securitized." Secondary markets were created for just about every kind of financial paper--which meant loans were turned into securities that financial markets, in their wisdom, could instantly value. This all worked fine when markets were booming. But on the downside, many of these markets turned out to be shallow and inflexible. When times turned tough, buyers vanished--and nobody knew the real "value" of many assets. This was particularly tough for banks, whose balance sheets are based on asset values.

EDUCATED GUESSES. Financial intermediaries--banks--exist in large part because the value of every asset cannot be instantaneously calculated by money markets. The worth of real assets depends in part on how astutely management makes midcourse corrections and on the state of the overall economy and its several subeconomies. A condominium or a microchip plant is a bonanza or a fiasco depending on whether it can ride out short-term storms and on whether customers ultimately materialize. The caprice of money markets can kill a sound business. Financial markets make educated guesses about the future and value assets accordingly. But they do not predict the actual future (that's why opportunities for arbitrage exist). In contrast, bankers, good ones at least, can help influence the future--by making informed judgments about their customers and working with them. Junk-bond financing is a poor substitute for a long-term liaison with a commercial banker.

In the marketization vogue of the 1980s, economists proceeded as if the ideal world were one giant money market. On one side of the transaction, rational investors would choose among an infinite number of securities, based on increasingly perfect information. On the other side, entrepreneurs would compete for capital. This sort of world leaves virtually no room for commercial bankers--people whose job it is to know the details of actual businesses and to lend "on character" for a relatively long term. But the real world is not, and cannot be, one giant, perfectly liquid money market. We are finding that out, as bankers come under increasing regulatory pressure to "mark to market" assets whose value is inherently imponderable.

In short, by attempting to make both the business of banking and the business of bank regulation more "marketized," policymakers run the risk of putting commercial banks out of business and contributing to the disease of short-term thinking. Our strongest competitors, Germany and Japan, are famed for their ability to plan for the long term--and their banks play a role quite opposite from the one envisioned for America's financial system. I have some thoughts on proposed regulatory changes, but that's another column.

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