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Financial regulation, economic growth and crises.

Regulation is described in the Oxford Dictionary of Economics as rules individuals or rms are obliged to follow; or the procedure for deciding and enforcing such rules. As always, nancial and banking institutions are more strictly regulated than those that conduct general business. The most basic justication for much stricter controls is the concerns that failures of the nancial and banking systems disrupt the economy in a way that general businesses do not. Too big to fail is a term that gained popularity during the 2007-10 global nancial crisis - implying that a number of nancial institutions have become so large that their failure would mean disaster to the economy. In this essay, the case for regulation of nancial and banking systems to prevent crises will be examined along with the case against excessive regulation which the proponents argue could stie economic growth. Regulating nancial and banking institutions always increases the cost burden1 to the nal consumers. The banking industry enjoys huge economies of scale, but both Dowd (1996) and Benston & Kaufman (1996) nd no evidence that such economies of scale lead to a natural monopoly. The ability of banks to act as intermediaries that pool in demand deposits and other short- and long-term xed deposits puts them in a good position to negotiate favorable rates when lending. These economies of scale should also be passed to the bank customers. Regulation hinders this important pass through. For example, regulation to reduce competition among different nancial institutions create a degree of oligopoly or even monopoly behavior in the industry. The Glass-Steagall Act of 1933 prevented competition between the commercial banks and investment banks. This allowed inefcient investment or commercial banks to operate freely without the risk of entrants. The Glass-Steagall Act also prohibited banks from competing for depositors by raising their interest payments on demand deposits. This kind of ceiling severely reduces competition and puts the depositors at a disadvantage because the rates cannot exceed a certain regulated level. Though now it has been revoked, the regulation on bank branching2 was also a serious threat to the welfare of the customers because of increased transaction costs. Benston and Kaufman (1996) argue that banking monopolies and cartels resulted from regulation that restrict entry or subsidize certain banks - in other words, reduce competition. On the other hand, many economists support competition regulations in this industry. The classic argument is laid out in Goodhart (1988, p.47-9 and 1991, p.15). The competition among players in the banking industry can be very destructive. It will start off with a few risk loving managers who want to build their empire. They will take on high risks (loans to fund high risk projects, subprime mortgages) and command high returns. The more risk averse bankers cannot sit still and lose business, and would therefore issue equally, if not more risky loans. This situation will expand asset side of the banks balance sheets with toxic loans. Such a situation cannot be maintained for long and will eventually collapse when the assets fail to realize returns, which will be the beginning of a nationwide economic decline. Benston (1964) dismisses this idea with his study of the destructive

Such costs are extremely difcult to measure. It is because they are not imposed by the government per se, rather they result from the regulation itself and are not easily traceable.

The McFadden Act of 1927 prohibited interstate branching. Banks were allowed to branch only in the state they were established. It was repealed by the Riegle-Neal Interstate Banking and Branching Efciency Act of 1994.

competition situation in the 1920s arguing that the competition is rational. Dowd (1996) also dismisses this idea noting that it is the long-term incentive for this risk averse bankers not to follow suit so that when the other risk taking banks are failing, they win over customers. However the 2007 credit crunch is a vivid example of destructive competition with global repercussions. Another argument posed against regulation is that it increases the risk of crisis because of incentive mismatch. Specically the deposit insurance by the government (in the U.S. the Federal Deposit Insurance Act of 1950). This guarantees the depositors their money back in the case of bank insolvency. The depositors now lose the incentive to monitor bank activity and risk taking because regardless of the situation they have a money back guarantee. Adverse selection kicks in and allows risk lovers to enter the industry (Mishkin & Eakins, 2009). The result is that nancial institutions will engage in more risk taking behavior commanding higher returns and risk collapsing with toxic assets. Banks also lose the motive to remain strong (with high capital ratio) because the other banks can easily outcompete them with lower capital ratios being able to offer good rates to depositors (Dowd, 1996). Risk taking behavior escalates further. Who is the loser in the end? The people who pay tax, because their taxes will be the ones to rescue the collapsing banks. As an example, during the credit crunch in the U.S., a total of more than $700 billion (5% of GDP) was spent to purchase failing bank assets. This sum could have been spent elsewhere with more welfare like health and education. Demirg-Kunt and Detragiache (2002) measuring the effects of deposit insurance on bank fragility, found that high coverage limits and a broader scope positively contribute to the danger of a crisis3. The counter argument to the above is intuitive. The infamous bank runs. Without deposit insurance, depositors risk losing their money if there is a bank failure. Here depositors would be careful to monitor the risk taking behavior of their banks. Because of asymmetric information, depositors would be unable to distinguish between good and bad banks if say only a few banks fail. Everyone would be dashing to withdraw. The textbook effects are catastrophic - closure of banks, drying up of credit, shutdown of the payment system and an economic slump. It remains a strong and valid point for the proponents of regulators. Critics oppose this, saying that no or little literature backs the contagion effect claim that solvent banks can suddenly become insolvent (see Kaufman, 1984). Further, to assume that depositors would monitor risk taking behavior of banks is also unrealistic, because it is very difcult to obtain day to day risk information. Even if it was possible, banks still have the incentive to sugar coat negative information - increasing the asymmetry. The incentive mismatch issue is curbed by other forms of regulation like restricting asset holding and capital requirements. This lead to the Basel Accord (enforced 1992) requirements on credit risk. Banks were required to hold capital equal to 8% of riskweighted assets. This regulation was supposed to discipline banks because with higher capital holdings, they have much more to lose in case of failure and should take on less risk. This has come into much criticism because of regulatory capital arbitrage (RCA) practiced by banks to reduce their capital ratios below the regulatory one. The consequences of RCA are many, the most serious being that they mask the true nancial conditions of the banks, making it difcult to know whether the banks are sound (Jones, 2000). Financial innovations like securitization, special-purpose vehicles and others also make it difcult for bank supervisors attempting to enforce the requirements. At the root of

This is supported by a number of other researches. See Barth, Caprio & Levine (2002) pg.15-27 and World Bank, Finance for Growth: Policy Choices in a Volatile World (2001).

the 2007 nancial crisis lies such nancial innovations4 that managed to conceal the true nancial situation of banks thus leading to their demise. The very regulation that tries to provide banks an incentive to reduce risk increases the risk taking and eventually leads to a crisis. One of Basel II main aims is to align the divergence between regulatory capital requirements and the real economic capital, but critics argue that it will eventually be circumnavigated by clever bankers. Basel III is the toughest and specically responds to the global nancial crisis. However, its implementation could reduce world GDP growth by between 0.05 and 0.15 per annum due to the high costs of holding capital to banks (Slovik & Cournde, 2011). In conclusion, I believe the discussion as to which level of regulation to adopt is a cyclical one. It will never end because it doesnt address the root of the problem. There has been 13 nancial crises in the nineteenth century, 17 in the twentieth and 5 in the current one and each has adverse effect on GDP. Critics fall on either side of the argument and all of them fail5 to fully defend one position. The problem is not how much to regulate, it is the innate fragility of the fractional reserve banking system that was established by the Federal Reserve System in 1913. If we ever hope to achieve economic growth and make nancial crises history, debating on regulation wont help. Rather, efforts should be made to rethink the banking structure that is the root of all crises. Word Count: 1480

Collateralized Mortgage Obligations, Credit Default Swaps, Structured Investment Vehicles, Collateralized Debt Obligations and others.

In the wake of the global nancial crisis, the Federal Reserve Chairman Ben S. Bernanke made strong statements blaming the regulatory agencies for failing to supervise the nancial institutions.

References: Benston, G. and Kaufman, G. (1996) The appropriate role of bank regulation, The Economic Journal, 106(May), p.688-697. Benston, G. (1964) Interest payments on demand deposits and bank investment behaviour, Journal of Political Economy, 72(October), p.431-49. Demirg-Kunt, A. and Detragiache, E. (2000) Does Deposit Insurance Increase Banking System Stability? An Empirical Investigation, Econometric Society, 1(1751), p.22-4. Dowd, K. (1996) The case for nancial laissez-faire, The Economic Journal, 106(May), p. 679-687. Goodhart, C. (1988) The Evolution of Central Banks, Cambridge, MA: MIT Press Books, p. 47-9. Jones, D. (2000) Emerging problems with the Basel Capital Accord: Regulatory capital arbitrage and related issues, Journal of Banking & Finance, 24(2000), p.35-8. Slovik, P. and Cournde, B. (2011) Macroeconomic Impact of Basel III, OECD Economics Department Working Papers, 13(844), p.5-13. Stanley G. Eakins, F. (2009) Financial Markets and Institutions, 6th ed. Boston, MA: Pearson Education, Inc, p.512-15.