Free markets in the financial industry

I had a crazy thought. There is a huge economic policy debate as a result of the financial crisis about how much regulation is necessary. The Chicago School, the main proponents of the free market approach, is based on Milton Friedman’s work. The best description I have ever seen is here. Pro regulation is coming from every angle now in a variety of forms.

So why not let the free market decide. Why don’t we create two types of financial institutions? We used to have separate regulations for investment banks and retail banks. This division was blurred by the deregulation trend of the past few decades and obliterated in the past year. Why not recreate it, but along a different dimension?

Lets create one stream that is fully regulated. In exchange for strict capital requirements, oversight, and following a consumer bill of rights of some kind, these institutions would be eligible for FDIC insurance and while not an implicit guarantee (we don’t want the Freddie and Fannie fiasco redux) perhaps they would get some kind of assistance in the face of a financial meltdown. Depositors and investors would know to expect lower average returns and less upside on their investments in exchange for less downside risk.

The other stream would have looser requirements and less regulation. But they would have no insurance and absolutely zero chance of any public assistance no matter how bad things get. Investors and depositors in these banks would know that they were taking bigger risk for the bigger potential returns of financial innovations like CDOs and CDSs.

Of course there are lots of details that I haven’t thought through that could make this a silly idea. But as an approach, I think it is a good way to let the free market decide how much of a free market we need in the financial sector.