Why Regulate Banks?
European Banking - The Dangers of Deregulation
Abolish The Bank of England!

Why Regulate Banks?
Why do we regulate banks? As George Benston and George Kaufman point out in an article in the May 1996 issue of the Economic Journal, they don't serve food that might sicken unsuspecting customers and they don't deal in dangerous materials that might explode or cause plagues. Rather, they provide checking accounts and investment services, make loans, and facilitate financial transactions. Why should we be concerned about what they do any more than we are about what any ordinary business does?

Most economists agree that unregulated businesses generally serve consumers and the economy best if markets are competitive. But banking in most countries tends to be regulated. Professors Benston and Kaufman examine a variety of valid and less valid reasons why:

One reason might be that banks produce the nation's money supply - cheques. To protect our money, banks should not be allowed to take great risks that might cause them to fail. But today, the central bank controls the money supply. If people are concerned about a bank's failing, they simply transfer their funds to another bank. Of course a bank failure is costly to some people; but so is the failure of any firm of comparable size.
Another possible reason is maintenance of the public's confidence in the banking system. Unless people are confident, the argument goes, they might all try to withdraw their funds at once. If so, the bank will fail because it is likely to suffer losses on hurried disposal of assets to meet the withdrawals. This argument has some serious flaws: first, there is very little evidence that there were 'runs' on banks that were not insolvent. Runs on insolvent banks are beneficial, as they both force the regulators to deal with the bank and keep bad bankers from making more mistakes in a bid to make it solvent again. Second, if bankers are afraid of runs, they will be encouraged to manage their banks more carefully and prudently.
A third reason is that deposit insurance is provided by law or practice by governments of most countries. If depositors are protected from loss, they have little reason for concern. This may save them some trouble, but it also frees some banks to take greater risks. The cost of these risks is borne first by well run banks that have to bail out the depositors of banks that fail by paying insurance premiums or assessments; and second by taxpayers when the insurance agency's funds are exhausted and the government pays the bill. But it is not necessary or desirable for government officials to restrict what banks do. All that is necessary is for the banks to hold sufficient capital so that the owners bear the cost of losses and mistakes. The government's job is to make sure that banks actually do hold enough capital.
Prior to deposit insurance, the most important reason that banks have been regulated in the past is political: to benefit government officials, their friends, bankers or their competitors. Early bank regulation took the form of restricting entry into banking to produce monopoly banks. Governments, officials, and their friends either owned these banks or got loans at favourable interest rates. Banks' activities were generally restricted to benefit their competitors. Consumers were and still are the losers.
Benston and Kaufman conclude that if there were no deposit insurance, there would be no appropriate role for bank regulation for economic reasons, assuming that the goal is to benefit consumers. Given deposit insurance, the appropriate role for government regulators is to ascertain that banks have sufficient capital to absorb most losses and, when they do not, oversee them closely until they repair the shortfall or cease operations with minimum, if any, loss to depositors, the insurance agency, or taxpayers.

ENDS

Note for Editors: 'The Appropriate Role of Bank Regulation' by George Benston and George Kaufman is published in the May 1996 issue of the Economic Journal in the Controversy section: 'Should We Regulate the Financial System?'. Benston is at Emory University; Kaufman is at the Loyola University of Chicago.

For Further Information: contact RES/ESRC Media Consultant for Economics Romesh Vaitilingam on 0171-878-2919, or authors George Benston on 001-404-727-6123 or George Kaufman on 001-312-915-6000.

Date: 16 May 1996

European Banking - The Dangers of Deregulation Deregulation, the diffusion of financial markets, and steps towards monetary integration between a range of very different banking systems in Europe pose new challenges for prudential regulation. Since the purpose is to promote confidence in the banking system, it is vital that attention is paid to the history, institutional arrangements and psyche of different national banking systems - what it is that promotes confidence in each case. Such issues tend to have been glossed over in the push for a uniform European monetary policy. That is the message from Sheila Dow of the University of Stirling in an article in the May 1996 issue of the Economic Journal.
Dow takes on the proponents of deregulation and 'free banking', arguing that the state should continue to regulate the banking system since the money supply consists largely of bank deposits. Money is different from other goods: it is the glue which binds the economic process. In a world of uncertainty, we need an asset of (relatively) certain value by which to denominate contracts, to accept as payment, and to hold when other assets have the possibility of capital loss.

Dow notes that proposals for free banking would subject the valuation of money itself to uncertainty. At best, she argues, historical experience suggests that the outcome of free banking would be that the market would respond by treating as money the liabilities only of the largest, confidence-inspiring bank or banks. This bank or banks would then in effect act like a central bank. At worst, generalized free banking would cause chaos.

Historically, the state has regulated the banking system and supported it in times of difficulty. The result has been that bank deposits have inspired almost as much confidence as notes and coin, allowing the banking system to expand and credit to be created to finance economic growth. Such regulation is justified by economic theory: the confidence in bank deposits, in their 'moneyness', is a public good. Furthermore, without regulation, bank failures would be more likely, threatening confidence in other banks.

Free banking proposals rest crucially on the capacity of the market to discipline banks into pursuing prudent lending policies. But this argument is presented at the level of individual banks, presuming a stable financial environment. In fact, generally the risk of individual bank failure is highest when the whole financial system is fragile, that is, when other banks are also at risk. Fragile financial conditions arise when the market as a whole has been over-optimistic about asset values, a situation which would be given full rein in the absence of regulation.

While it is true that central banks too have no easy access to full knowledge, they are nevertheless in a position to take a global view and influence events through a combination of regulation, supervision, provision of a lender-of-last-resort facility and deposit insurance. Recent debt crises in emerging markets illustrate the scope of inadequate knowledge to allow the emergence of excessive default risk, the significance of which can be long ignored. In that case, the market found a solution in the regulatory and supervisory capacity (and knowledge base) of the IMF, that is, something akin to a world central bank.

Free banking enthusiasts suggest that Scotland's experience with free banking in the eighteenth and nineteenth centuries shows how it could operate successfully today. But in fact, that experience suggests that the market itself will encourage concentration in one or a few large banks, which then operate like a central bank. Thus, for example, during an episode when the value of smaller banks' notes was particularly uncertain, a popular outcry led to intervention by the largest banks.

Free bankers also point to periods of financial instability that have arisen in spite of bank regulation. But much of that instability was due to attempts at money supply manipulation rather than inadequate prudential regulation. Certainly, though, there is no justification for complacency, particularly with the prospect of the potentially huge upheavals of European monetary integration.

ENDS

Note for Editors: 'Why the Banking System Should be Regulated' by Sheila Dow is published in the May 1996 issue of the Economic Journal in the Controversy section: 'Should We Regulate the Financial System?'. Dow is at the University of Stirling.

For Further information: contact Sheila Dow on 01786-467485 (fax 01786-467469 or e-mail: s.c.dow@stirling.ac.uk) or RES/ESRC Media Consultant for Economics Romesh Vaitilingam on 0171-878-2919.

Date: 16 May 1996

Abolish The Bank of England! The Bank of England should be abolished and market forces unleashed to promote a safe and sound UK banking system - 'free banking'. Such a reform would increase banks' financial strength and make the banking system as a whole more stable. It would also reduce the likelihood of future bank failures, diminishing the threat of repeats of the recent Barings and BCCI fiascos. That is the message from Kevin Dowd of Sheffield Hallam University in an article published in the May 1996 issue of the Economic Journal.
Professor Dowd notes that it is commonly taken for granted that the UK banking system needs the Bank of England to protect its stability. This assumption underlies the Bank's role as guardian and lender of last resort to the banking system and, indeed, is one of the key justifications for its existence.

In fact, the very opposite is true. The protection that the Bank of England provides to commercial banks reduces their incentives to protect themselves. The anticipation of Bank support should they get into difficulties leads banks to take more risks and make less effort to protect their own financial heath. The result is that bank failure crises are more rather than less likely. The Bank of England is the cause rather than the cure for banking instability.

Dowd argues that abolishing the Bank would remove this artificial support and force the banks to rely on themselves for their own protection. The need to reassure depositors would then force the banks to cultivate depositor confidence, and they could only do so by maintaining high standards of financial safety and soundness.

Dowd's research suggests that:

There is nothing distinctive about 'money' or banking that makes the financial services sector an exception to the general rule that free trade is best
A safe and sound banking system can only be established by providing incentives for banks to take responsibility for their own financial health.
The existence of the depositor protection scheme and the lender of last resort undermine the market forces that would otherwise force banks to maintain their own financial health.
The Bank of England is incapable of fulfilling its largely self-appointed role as guardian of the banking system - as confirmed by the recent BCCI and Barings fiascos.
Most professional economists irrationally take the 'need' for a central bank for granted, despite the fact that few of them have ever seriously examined the arguments or evidence on the issue.
The claims that central banks are unnecessary and undermine banking stability are supported by a wealth of historical evidence. There are many historical instances of 'free banking' systems without central banks, for example, Scotland prior to 1845. These systems were considerably more stable than systems with central banks.
No system will ever provide a perfect guarantee against bank failures, but abolishing the Bank of England would at least minimize the chances of bank failures and minimize the collateral damage that such failures inflict.
Dowd argues that tinkering with the present system is pointless. Unless more radical reforms are undertaken, we can expect bank failures to be a regular occurrence, and the Bank of England will be unable to avert them.

ENDS

Note for Editors: 'The Case for Financial Laissez-Faire' by Kevin Dowd is published in the May 1996 issue of the Economic Journal in the Controversy section: 'Should We Regulate the Financial System?'. Dowd is Professor of Economics at Sheffield Hallam University.

For Further Information: contact Kevin Dowd on 0114-255-6508 or 0114-253-3666, or RES Media Consultant for Economics Romesh Vaitilingam on 0171-878-2919.