Has Financial Regulation Made the Financial Sector More Stable?

President Obama, in the wake of the financial crisis, passed a multitude of financial regulations aimed meant to reduce the risk of future financial crises. Paul Krugman, of course, gave Obama a raving review. He wrote:

Did reform go far enough? No. In particular, while banks are being forced to hold more capital, a key force for stability, they really should be holding much more. But Wall Street and its allies wouldn’t be screaming so loudly, and spending so much money in an effort to gut the law, if it weren’t an important step in the right direction. For all its limitations, financial reform is a success story.

While Krugman doesn’t think the regulation went far enough, at least it’s a start. And I actually agree: banks should hold more capital.  Even the Adam Smith Institute–which, just looking at the name, you can guess what their political leanings are–supports higher minimum bank capital requirements.

But, with all of these accomplishments, I wouldn’t call these new regulations “a success story.” Bank capital reserve increases are a positive, but do they outweigh the negatives?

An interesting study by the Federal Reserve Bank of Richmond finds that “61 percent of the liabilities of the financial system are subject to explicit or implicit protection from loss by the federal government.” Why is that a problem?

Because of simple incentives. If your money is insured, you are willing to take more risks with that cash than you otherwise wouldn’t. A risky loan or investment makes more sense if you can expect full or partial recompense from the government than if there were no (or less) insurance overall. If risky investments as a whole begin to go south, the economy will enter a collapse–like we did in 2008. Except this time will probably be worse, as interest rates are already close to zero and the Federal Reserve has fewer tools in its toolbox than it had in 2008.

It is impossible to know which effect will outweigh the other. Capital requirements make crisis less likely; Federal insurance, on the other hand, makes it more likely. Only time will tell whether or not these new rules will have any impact on the rate of financial crisis in this country.

As the evidence on the efficacy of these regulations is somewhat ambiguous, and there are known problems with these laws, we should consider changing–or outright repeal and replacement of–these laws.

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