Financial Deregulation: A Question of Efficiency or Distribution?

How can we better protect Main Street from the externalities of Wall Street?

If recent trends continue, 2015 is on track to become the year with the highest levels of US wealth concentration in decades, challenging records that were set during the Roaring 1920s. Almost a quarter of all US wealth (more than $10 trillion) is currently held by the richest 0.1% of households – more than what is held by the bottom 90%.[i] One of the greatest sources of wealth for the top 0.1% class of super-rich is Wall Street, and Wall Street is also the source of the financial crisis that inflicted much economic pain on the bottom 90% in recent years. This has understandably led to a widespread feeling in American society that the rules governing Wall Street are stacked in favor of a small elite, at the expense of Main Street.

However, much of the recent academic work in economics ignores the distributive effects of financial regulation and focuses solely on efficiency. By contrast, our recent paper on “The Redistributive Effects of Financial Deregulation” in the Journal of Monetary Economics puts the focus squarely on distributional considerations.[ii]

Our analysis is based on the observation that losses in the financial sector can impose massive costs on the real economy. Figure 1 illustrates this phenomenon: during the 2008 financial crisis, banks took large losses which raised interest rate spreads and lowered access to credit for the real economy, which in turn reduced the earnings of workers. When financial institutions decide how much risk to take on, they do not take into account these losses. Instead, they take on more risk than is good for the rest of the economy.

The costs that Wall Street imposes on Main Street during a crisis are what economists call externalities, and these externalities provide a strong rationale for regulatory intervention. This is analogous to the rationale for regulation of other industries that can impose large negative externalities. For instance, nuclear power plants have an incentive to cut safety expenditures to raise their profits, exposing us to a greater risk of a nuclear meltdown, and so governments regulate the safety standards at these plants. Likewise, the financial sector has an incentive to invest in risky assets to raise returns, even though this raises the risk of a financial meltdown.

What can we do about this problem? First, we need to acknowledge that there is a distributive conflict between Wall Street and Main Street that will not go away. There is no reasonable level of risk-taking that Wall Street will be happy with, since they can always raise profits by further increasing risk. However, there is a safe level of risky investment that ensures stable credit provision to the real economy and satisfies Main Street.

We have focused our work on the externalities associated with the large output losses caused by financial crises rather than the externalities arising from bailouts, which are the center of most political debates. Even though output losses are more difficult to attribute to specific actors who can serve as political scapegoats, they are usually an order of magnitude larger than bailouts and consequently deserve far greater attention in the political debate. Thus, designing our financial system solely with the goal of avoiding bailouts is misguided, particularly when credit crunches impose much greater externalities.

In fact, we argue in the paper that the most insidious consequence of bailouts is not that they lead to an explicit transfer from Main Street to Wall Street but that they could lead to an even larger implicit transfer by encouraging greater risk-taking and thereby exposing the economy to more credit crunches. Moreover, it may be difficult to commit to not providing bailouts once a financial crisis has occurred because the real sector may prefer to provide a bailout rather than suffer a severe credit crunch. By contrast, regulating risk-taking directly does not suffer from this commitment problem.

We show a number of additional factors that provide Wall Street with greater incentives to take on risk. First, financial innovations that expand the set of risky assets available to banks may worsen the distributive conflict and may also allow banks to circumvent regulations, to their benefit and the real economy’s detriment. Second, a more concentrated banking system has incentives to take on greater risks, with greater externalities. Finally, asymmetric compensation schemes that reward bank managers more on the upside than they penalize them on the downside contribute to greater risk-taking and greater externalities. All these factors benefit Wall Street at the expense of Main Street.

How can we better protect Main Street from the externalities of Wall Street? The simplest way is to regulate risk-taking by banks, whether by increasing their capital adequacy requirements, separating risky investment activities like proprietary trading from systemically important traditional banking, limiting payouts that endanger the capitalization of the financial sector, or using structural policies including limits on asymmetric compensation schemes to reduce incentives for risk-taking. Unfortunately, the current movement towards rolling back financial regulation may serve the interests of Wall Street well but continues to expose Main Street to the risk of financial meltdowns.

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