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A Financial System Built on Bail-Outs?

Summary:
In a Wall Street Journal opinion piece and an accompanying paper and blog post, John Cochrane and Amit Seru argue that vested interests prevent change towards a simpler, better-working financial system. They describe various “bail-outs” since 2020, in the U.S. financial sector and elsewhere. They point out that in Switzerland, too, the government orchestrated takeover of Credit Suisse by UBS relied on taxpayer support. And they conclude that regulatory measures after the great financial crisis including the implementation of the Dodd-Frank act failed. Instead, Cochrane and Seru favor narrow banking (they prefer to call it “equity-financed banking and narrow deposit-taking”): Our basic financial regulatory architecture allows a fragile and highly leveraged financial system but counts on

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In a Wall Street Journal opinion piece and an accompanying paper and blog post, John Cochrane and Amit Seru argue that vested interests prevent change towards a simpler, better-working financial system. They describe various “bail-outs” since 2020, in the U.S. financial sector and elsewhere. They point out that in Switzerland, too, the government orchestrated takeover of Credit Suisse by UBS relied on taxpayer support. And they conclude that regulatory measures after the great financial crisis including the implementation of the Dodd-Frank act failed. Instead, Cochrane and Seru favor narrow banking (they prefer to call it “equity-financed banking and narrow deposit-taking”):

Our basic financial regulatory architecture allows a fragile and highly leveraged financial system but counts on regulators and complex rules to spot and contain risk. That basic architecture has suffered an institutional failure. And nobody has the decency to apologize, to investigate, to talk about constraining incentives, or even to promise “never again.” The institutions pat themselves on the back for saving the world. They want to expand the complex rule book with the “Basel 3 endgame” having nothing to do with recent failures, regulate a fanciful “climate risk to the financial system,” and bail out even more next time.

But the government’s ability to borrow or print money without inflation is finite, as we have recently seen. When the next crisis comes, the U.S. may simply be unable to bail out an even more fragile financial system.

The solution is straightforward. Risky bank investments must be financed by equity and long-term debt, as they are in the private credit market. Deposits must be funneled narrowly to reserves or short-term Treasurys. Then banks can’t fail or suffer runs. All of this can be done without government regulation to assess asset risk. We’ve understood this system for a century. The standard objections have been answered. The Fed could simply stop blocking run-proof institutions from emerging, as it did with its recent denial of the Narrow Bank’s request for a master account.

Dodd-Frank’s promise to end bailouts has failed. Inflation shows us that the government is near its limit to borrow or print money to fund bailouts. Fortunately, plans for a bailout-free financial system are sitting on the shelf. They need only the will to overcome the powerful interests that benefit from the current system.

Dirk Niepelt
Dirk Niepelt is Director of the Study Center Gerzensee and Professor at the University of Bern. A research fellow at the Centre for Economic Policy Research (CEPR, London), CESifo (Munich) research network member and member of the macroeconomic committee of the Verein für Socialpolitik, he served on the board of the Swiss Society of Economics and Statistics and was an invited professor at the University of Lausanne as well as a visiting professor at the Institute for International Economic Studies (IIES) at Stockholm University.

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