This is a terrific speech from Fed Governor Daniel K. Tarullo. He gives you a different perspective (not entirely new though) on thinking about financial firms and their regulation.
He says economists should use insights from Industrial Organisation Economics (IO) to help understand the developments in financial markets:
Since the crisis, both academic work and regulatory reform have given a much more prominent place to macroprudential regulation. The Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank Act) introduced a variety of new policy levers, including capital surcharges, resolution plan requirements, consideration of systemic risk effects in reviewing and ruling on applications for mergers among financial firms, and even the ability to require the reduction in size or scope of large financial conglomerates.
At a conceptual level, effective implementation of these policy tools requires that we incorporate systemic risk into the normative framework of what constitutes a socially efficient outcome. The goal of macroprudential regulation is to require firms to internalize the externalities they impose on the stability of the financial system as a whole. Thus, we need a way to incorporate systemic externalities into the models of firm and investor behavior that inform regulatory and supervisory policies. At the same time, we have to evaluate the costs associated with systemic events, which by their nature are relatively rare, in light of the basic goals of promoting productive efficiency, access to credit, and financial innovation.
Here–in filling out this analytic framework–is where the perspectives, questions, and conclusions of IO literature may usefully be applied. Many financial markets are far from perfectly competitive. Instead, they are characterized by large firms with significant market shares and sustained positive economic profits, a fact not always reflected in financial analysis and regulation. Yet IO economists, who have studied a variety of topics arising from concentrated market structures, have themselves generally focused on areas other than financial markets, with the important but limited exception of competition issues in commercial banking. I would venture to guess that the very peculiarities of financial markets that motivated the evolution of an entire subdiscipline in economics complicate application of conventional IO learning to these markets. This is why I believe that some interchange between IO and finance researchers is important.
He points to three areas where IO economics will be of immense use:
- Scale and Scope Economies in Financial Services — What is the optimal size for financial firms? What does scale and scope of economies in finance imply? What are the costs and benefits of scale economies in finance? Are large firms beneficial to economies or are they just too big to fail who become bigger because of moral hazard?
- Cooperation and Competition among Financial Institutions — IO economics on non-finance firms shows some cooperation between firms is useful. However, financial firms anyways do cooperate as they are linked to each other via wholesale funding markets etc. Some even cooperate to set up institutions, exchanges, payment systems etc. However, such cooperation also leads to crisis as if you allow one to fail others follow. What is the best way out in such situations? How should resolution frameworks of troubled firms be designed so impact on the whole system is minimal.
Another issue here is when two finance firms merge, do they bring value (by offering more and cheaper services) or destroy value (via TBTF route).
- Market Structure and Externalities: How risk taking by one financial firm could impose externality on the whole system. Whether there should be a more concentrated financial market with few large diversified players is better or less-concentrated and less diversified smaller players financial market is better? What are the trade-offs for both?
Then one can apply IO to understand financial innovation and incentive practices by fin firms.
Superb stuff. Helps you understand all these complex issues of finance much better. The speech easily leads to multiple PhD theses in areas of finance and industrial economics…I am assuming we would see very exciting literature on this mixture in future…