Making banks a 'normal' industry
- By Raghuram Rajan
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E-mail Shanghai Daily, November 27, 2012
Firm ground v treadmill
An analogy may be useful. A monopoly is like running on firm ground. Nothing compels you to move, but if you do, you move forward. The faster you run, the more scenery you see - so you have some incentive to run fast.
Competition is like a treadmill. If you stand still, you get swept off. But when you run, you can never really get ahead of the treadmill and cover new terrain - so you never run faster than the speed that is set.
So which industrial structure is better for encouraging you to run? It depends.
Perhaps one can have the best of both worlds if one starts on a treadmill, but can jump off if one runs particularly fast - the system is competitive, but those who are particularly innovative secure some monopoly rents for a while. This is what a strong system of patent protection does.
But patents are ineffective in some industries, like finance.
The overwhelming evidence, though, is that financial competition promotes innovation.
Much of the innovation in finance in the US and Europe came after it was deregulated in the 1980s - that is, after it stopped being boring.
The critics of finance, however, believe that innovation has been the problem.
Instead of Schumpeter's "creative destruction," bankers have engaged in destructive creation in order to gouge customers at every opportunity while shielding themselves behind a veil of complexity from the prying eyes of regulators (and even top management).
Of course, the critics are right to argue that not all innovations in finance have been useful, and that some have been downright destructive. By and large, however, innovations such as interest-rate swaps and junk bonds have been immensely beneficial, allowing a variety of firms to emerge and obtain financing in a way that simply was not possible before.
Even mortgage-backed securities, which were at the center of the financial crisis that erupted in 2008, have important uses in spreading home and auto ownership. The problem was not with the innovation, but with how it was used - that is, with financiers' incentives.
And competition does play a role here. Competition makes it harder to make money. In an ordinary industry, incompetent firms would be forced to exit.
In the financial sector, the incompetent take on more risk, hoping to hit the jackpot, even while the regulator protects them by deeming them too systemically important to fail.
Instead of abandoning competition and giving banks protected monopolies once again, the public would be better served by making it easier to close banks when they get into trouble.
Instead of making banking boring, let us make it a normal industry, susceptible to destruction in the face of creativity.
Raghuram Rajan is professor of finance at the University of Chicago Booth School of Business and the chief economic adviser to the government of India. Copyright: Project Syndicate, 2012.www.project-syndicate.org. Shanghai Daily condensed the article.
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