The Paulson Plan, or Why Do We Regulate Banks Anyway?

It’s easy to take potshots at the Paulson plan, and I haven’t resisted doing that, especially its embrace of new regulations, but is there anything to like about it?

Sure. It’s nice to see an attempt to harmonize a system of complex, overlapping regulations that numb the mind, make lawyers rich, and stall innovation and competition. As Paulson concedes, parts of the regulatory superstructure for the U.S. banking system have been around since the 1860s, and modernization is overdue.

Faint praise? Admittedly. But I generally struggle with the justification for most banking regulations. Yes, the taxpayer is on the hook because a) the Fed is the lender of last resort, and b) we have deposit insurance, so we need to have a governmental presence. But that is circular, in that it begs the question of why we have a governmental presence in the first place. What is it that’s so darn special about banking that we’re willing to bear the price of bank bailouts, regulations, etc., just to make sure we don’t have a repeat of bank runs?

It sometimes seems like we regulate banks because this cosseted industry surrounded by governmental safety nets attracts and employs too many nitwits who require us to keep an eye on them.


  1. Because bank failures can result in destitution for elderly depositors? In fact did so on a large scale for generations before the New Deal? Do you want your grandmother trying to figure out how to buy private insurance on her CD’s?
    “…seems like we regulate banks because this cosseted industry surrounded by governmental safety nets attracts and employs too many nitwits…”
    The problem isn’t the nitwits, it’s the con men.

  2. I find the regulatory concern for small depositors rings a bit hollow given the average American has $1450 to their name and would be good as new 1 or 2 paychecks after a bank system collapse, and most of the poor don’t even have bank accounts.

  3. Josh Stern says:

    The absence of FDIC insured deposits would lead to a lot of inefficiencies. People would keep more cash “in a mattress”, they would spread their deposits around more institutions (more redundant paperwork and bookkeeping), and the jerk the money out faster at various hints of a financial downturn.

  4. Paul Kedrosky says:

    Josh — That’s likely true, but at least by thinking in those terms we can make concrete the costs. What bothers me is simply taking on faith that this sub-optimal solution is second-best, when it’s almost certainly far from it.

  5. Well, after you guys kill all banking regulations, I suppose retirees can just learn how to use if they want the “full faith and credit” of the United States behind their savings. I wanted to say “let them eat T-bills”, but then I noticed that Treasury auctions are really pretty accessible these days. Maybe this isn’t such a silly idea for retirees.
    This bulletin from the Federal Reserve suggests (table 5-b, bottom of page 13) about 15% of all households own CDs and the value of those CDs is actually remarkably flat across incomes of $10k to $90k per year — probably because the low income people are older and have more savings. It also says about 30% of households headed by someone 65 or older own CDs. 22 million such households (source) makes 6.6 million 65+ w/CDs. The Fed bulletin then suggests these 6.6 million households own a median of $20k in CDs. Compare 6.6m to the 2m figure we hear for eventual subprime foreclosures and then stop picturing young first-time homeowners in foreclosure and start picturing retired people on fixed incomes who can’t “start over”.
    It also points out that about 90% of American households have a “transactional account” of some kind.
    I think it’s worth some trouble to protect small depositors from bank runs. What shouldn’t be protected are the golden parachuted executives and the equity holders in badly managed banks. The regulation that’s needed is to correct the bad incentives the managers and owners currently have. Unfortunately, scrapping the regs would probably just free them up to play even more exotic games at the expense of their depositors.