As the House Committee on Financial Services meets to hear the expert testimony of witnesses concerning the regulation of the financial system, the measures that have been introduced to support the system are laying the groundwork for a new domestic financial architecture. Hyman Minsky suggests that the basic principle behind any reformulation of the regulatory system should limit the size and activities of financial institutions, and should be dictated by the ability of supervisors, examiners, and regulators to understand the institutions' operations. Following Minsky's preference for bank holding company structures, Senior Scholar Jan Kregel proposes the creation of numerous types of subsidiaries within the holding company. The aim would be to limit each type of holding company to a range of activities that were sufficiently linked to their core function and to ensure that each company was small enough to be effectively managed and supervised.

Jan Kregel

English

Research Papers in Economics

The Levy Economics Institute of Bard College
Policy Note
2008 / 5
Senior Scholar            is a distinguished visiting research professor at the Center for Full Employment and Price Stability, University
of Missouri–Kansas City.
The Levy Economics Institute is publishing this research with the conviction that it is a constructive and positive contribution to the discus-
siononrelevantpolicyissues.NeithertheInstitute’sBoardof Governorsnoritsadvisersnecessarilyendorseanyproposalmadebytheauthor.
Copyright © 2008 The Levy Economics Institute
WILL THE PAULSON BAILOUT
PRODUCE THE BASIS FOR ANOTHER
MINSKY MOMENT?
          
As the House Committee on Financial Services meets to hear the expert testimony of witnesses
concerning the regulation of the U.S. financial system, the measures that have been introduced to
support the system are being implemented and are laying the groundwork for a new domestic
financial architecture.This process can be seen clearly in the disappearance of all the major invest-
ment banks and their reappearance as financial holding companies. The Federal Reserve (Fed)
and U.S. Treasury seem to be supporting a model in which the funds made available through the
Emergency Economic Stabilization Act (2008) are used by stronger holding companies,with sub-
stantial core deposits from commercial banking activities, to merge with weaker financial institu-
tions.TheNewYorkTimesreportsthataccordingtogovernmentofficials,“TheTreasuryDepartment
hopes to spur a new round of mergers by steering some of the money in its $250 billion rescue
package to banks that are willing to buy weaker rivals.”1
The experience of the past weeks has led some to call for a return to a system similar to that
created by the Banking Act of 1933. These discussions recall those that took place in the mid-
1990s,when the United States contemplated liberalizing its financial system and debated the ben-
efits of a universal banking system, as opposed to a system based on bank holding companies.
Before he died in 1996, Hyman P. Minsky was actively involved in these discussions. The
unpublished drafts of his work show that he was not in favor of returning to a Glass-Steagall system2 Policy Note, 2008 / 5
of banksegregationbecauseof thedramaticchangesinfinancial
innovations that had taken place since the Great Depression. In
particular, he emphasized that money managers of large insti-
tutional investors,such as pension funds and insurance compa-
nies, had replaced the loan officer in decisions concerning the
extension of credit.
However, Minsky highlighted one aspect of the Glass-
Steagall Act (1933) that provided the basis for any reregulation
of the financial system. “It was believed that the safety and
soundness of banks and savings and loan associations were pro-
moted by narrow definitions of their permissible activities,” he
noted. “In particular the scope of permissible activities by a
depository institution was to be limited to what examiners and
supervisors could readily understand. This objective of exam-
inability and supervisability supported the separation of com-
mercial and investment banking: it was not so much the
differences and riskiness as it was the ease of understanding the
operationsthatledtotheseparationof investmentandcommer-
cial banking.”2
This objective suggests that the basic principle behind any
reformulationof theregulatorysystem shouldlimitthesizeand
activities of financial institutions,and should be dictated by the
ability of supervisors, examiners, and regulators to understand
the institutions’ operations. The reorganization of the financial
system that appears to be taking place with the backing of the
Fed and the Treasury does not seem to respect this principle.
Instead,it seems to support larger financial institutions that are
created by merging weak institutions with stronger ones on the
presumption that large institutions have a lower likelihood of
failure. Experience, however, suggests otherwise.
Thereis clearevidencethat partof thecurrentfinancialcri-
sis is due to the fact that regulators were unable to understand
and evaluate the risks undertaken by even middle-sized finan-
cial institutions. Indeed, one justification for self-regulation
recently proposed by large global banks was that regulators did
not understand their activities. In addition, the report from the
Senior Supervisors Group that deals with risk management,3 in
addition to frequent public declarations by top managers, sug-
gest that the management of these financial institutions was
similarly incapable of understanding and evaluating the risks
undertaken by their institutions.
In written testimony to the House Committee on Oversight
and Government Reform on October 23, 2008, former Federal
Reserve Board chairman Alan Greenspan admitted that the
attempts to use self-regulation and counterparty surveillance
have also failed:“Those of us who have looked to the self-interest
of lending institutions to protect shareholders’ equity (myself
especially) are in a state of shocked disbelief.Such counterparty
surveillance is a central pillar of our financial markets’ state of
balance. If it fails, as occurred this year, market stability is
undermined.”
Thus, bank top management was no better informed than
the regulators. In a New York Times article, Klaus-Peter Müller,
head of the New York branch of Commerzbank for more than
a decade, noted that bankers did not adequately understand
these investments and relied too heavily on high-grade credit
ratings from agencies that helped put together the products,
then rated them.This ignorance of the risks extended to the top
echelons of the banks. “Did I know in March of ’04 that there
was a U.S. subprime market” that was going to face serious
problems in the next few years? said Müller.“No, I didn’t have
the slightest idea. I was a happy man then.”4
Josef Ackermann of Deutsche Bank echoes the thought.At
a July 2007 luncheon attended by chief executives of leading
banks, political leaders, and senior Fed officials to discuss the
looming risks to the financial system,the deepening woes in the
subprime mortgage market did not figure high on the agenda,
he said. “We clearly underestimated the impact on completely
different asset classes.”5
If the present trend of bank mergers continues, the resolu-
tion of the crisis will likely produce sizable banks and other
financial institutions that cannot be regulated or managed;and,
as Minsky always predicted, this “resolution” will lay the basis
for another financial crisis. Government ownership and partic-
ipation in banks will do nothing to alleviate the problem.
Minskydidnotfavor theintroductionof universalbanking
as practiced in Europe: “The evidence from history indicates
that such wider scope institutions are not necessary for the
United States economy to do well.” In general he supported a
bank holding company structure because it would“allow banks
and other businesses to be joined in an enterprise which has a
wide range of subsidiaries, each subsidiary having its own
assigned capital. A failure of a particular subsidiary would not
impair the capital and the ability of other subsidiaries to oper-
ate.”Inlightof theexperienceof AIG,thispositionseemsexces-
sively optimistic. However, it also seems likely that the bank
holding company structure will remain the dominant structure
in the United States.The Levy Economics Institute of Bard College 3
Minsky also favored bank holding company structures
because each subsidiary would have a relatively well-defined
function, thereby making it easier for regulators—and examin-
ers and supervisors—to understand the operations of the busi-
ness. Thus, particular lines of business could be effectively and
independently regulated within the overall holding company
structure. Again, this suggestion seems overly optimistic, given
our experience since the introduction of the Financial Services
Modernization Act (1999) a decade ago.
That legislation provides two types of holding company
structure:banksandotherfinancialinstitutionsthathaveawider
scale of financial market activities. A third alternative, which
respects the basic principle that financial institutions should be
organized in a way that can be efficiently and effectively regu-
lated and supervised, would be the creation of numerous types
of subsidiaries within the holding company, but with tighter
limitations on the range of activities allowed each subsidiary.
In particular, the two basic functions of the financial sys-
tem based on Glass Steagall could be preserved: that is, the pro-
vision of a safe, secure transaction system, and store of value,
and the provision of sufficient financing at a reasonable cost for
a productive investment. Holding companies providing trans-
action services, a store of value, or financing (for housing, con-
sumers, or related activities) would then be limited to closely
related activities only. A separate group of holding companies,
with the appropriate related sets of activities, would provide
underwriting and capital market services for the financing of
productive investment. The aim would be to limit each type of
holding company to a range of activities that were sufficiently
linked to their core function and to ensure that each company
was small enough to be effectively managed and supervised.
References
1. “U.S. Is Said To Be Urging Mergers In Banking,”Mark
Landler, New York Times, October 21, 2008. p. B1.
2. “Reforming Banking in 1995—Repeal of the Glass Steagall
Act, Some Basic Issues.”Minsky Archive. The Levy
Economics Institute. No date.
3. “Observations on Risk Management Practices during the
Recent Market Turbulence,”Senior Supervisors Group
Issues Report on Risk Management, March 6, 2008, p. 9.
4. “A Banker in Germany Says Trouble Is Not Over.”Mark
Landler, New York Times, November 27, 2007.
5. “Deutsche Bank’s Chief Proves Right for Times.”Mark
Landler, New York Times. August 1, 2008.
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Reforming Banking in 1995—Repeal of the Glass Steagall Act, Some Basic Issues.”Minsky Archive. The Levy Economics Institute. No date.

"Will the Paulson Bailout Produce the Basis for Another Minsky Moment?"

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