Bigwig economist Stiglitz' message to world leaders: still too much risk in banks

A year into the G-20 effort to stabilize global financial markets, Nobel Prize-winning economist Joseph Stiglitz is not exactly giving leaders of the world's major economies high marks. In fact, the professor of economics at Columbia University argues that bank problems are bigger now than they were before the collapse of Lehman Brothers a year ago. "In the U.S. and many other countries, the too-big-to-fail banks have become even bigger," Stiglitz told Bloomberg News during an interview Sunday in Paris. "The problems are worse than they were in 2007 before the crisis."

Stiglitz' view mirrors that of former U.S. Federal Reserve Chairman Paul Volcker, who has advised President Barack Obama to decrease the size of banks. Nevertheless, in the year after the U.S. Federal Reserve and Treasury allocated more than $23 trillion in public funds to stabilize the financial system, re-liquefy credit markets and shore up troubled banks, Citigroup (C) is about as large as it was before the crisis and the Bank of America (BAC) has grown.
Stiglitz said the U.S. government's reform effort has run into powerful banking and financial service lobbies in Washington, who have extensive Congressional support in both the Republican and Democratic parties. Stiglitz' hope is that next week's G-20 meeting in Pittsburgh will lead to increased pressure on the U.S. to widen oversight of banks and further reduce systemic risk created by the size of financial institution operations.

"We aren't doing anything significant so far, and the banks are pushing back," Stiglitz told Bloomberg. "The leaders of the G-20 will make some small steps forward, given the power of the banks" and "any step forward is a move in the right direction."

A former economist for the World Bank, Stiglitz, among many other economists, has called for a decrease in the size of financial institutions. The fear is that institutional size could continue to create companies that are "too big to fail," leading to more perilous situations. One logical remedy is to decrease their size so that they don't create systemic risk and don't need government bailouts.

A second reason G-20 leaders may focus on bank size is their efforts to limit bank executive pays and bonuses are going nowhere. Many in part blame "perverse incentives" for helping to create the excessive risk during the 2005-2008 leveraging bubble. Germany favors pay caps, but France has called them unworkable, arguing that bankers would simply find loopholes, The Independent of the United Kingdom reported. Meanwhile, the United States and the United Kingdom are opposed to caps on pay.

Economic Analysis: Although Stiglitz brings up good points, he may have been embellishing his arguments somewhat. There's no doubt that major reforms are needed when it comes to systemic risk, the size of institutions, bank capitalization, and how banks' compensation plan affect risk. But it's somewhat of a stretch to argue that the financial problems facing the world's major economies are bigger now than they were one year ago, at the outset of the crisis. As a result of the infusion of public dollars, the U.S., Europe, Asia and other regions clearly are in a stronger financial condition today than they were 12 months ago.

The problem is, the global economy remains in danger of a repeat. The rules must be changed to limit both systemic risk and change the psychology of institutions that believe the government will and must bail them out if they fail.

Investors, obviously, know there are no quick and easy solutions to this problem. There will be winners and losers. But solutions must be found. Put another way, if unchecked excesses continue and government intervention is required again, so much of the private banking sector will become public that the term "capitalist economy" may very well become meaningless.
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