In 2007, the damage was limited: there was a lot of fallout in the world of hedge funds, but the stock market continued to rise, and the systemic implications seemed to be contained. But the adoption of the Gaussian copula function was much more widespread than a bunch of hedge funds: it was embraced at pretty much every CDO origination and trading desk on Wall Street. And when the entire financial system starts using essentially the same model, the systemic devastation which can result is enormous.
The use of flawed mathematical models (and all financial models will have flaws) causes lemming-like behavior by banks. This leads to the kind of financial crisis we are passing through.
Salmon argues for limits on bank size and also do not let banks do thinks that their regulators can not understand.
My feeling is that the best way to go is to set some very clear and simple rules, much as the Spanish central bank did, and refuse to allow banks to build enormous businesses doing things that the regulators don’t understand. And secondly to place a cap on banks’ balance sheets — I think something around $300 billion is reasonable, and that there’s no reason why any bank should be bigger than that. Alternatively, if you are bigger than that, then you have to become much more constrained in what kind of activities you’re involved in: you should basically just be doing plain-vanilla deposit-taking, borrowing, and lending.
Regards bank size: Would we then just get lots of smaller banks making the same mistake? I'd like to know the mortgage default rates of the average small, medium, and large bank in 2008 and 2009. Did the smaller ones perform better?
|Share |||By Randall Parker at 2009 April 15 09:24 PM Economics Financial Regulation|