# Why Regulate? - Modern Banking

Rationale for Regulating Financial/Banking Markets

Most markets are subject to some degree of regulation for a variety of reasons.

1. There is a need to protect the consumer: ‘‘caveat emptor’’ (‘‘let the buyer beware’’) is considered insufficient – putting too much responsibility on the consumer for many goods and services that lack transparency.
2. To check the abuse of oligopolistic and monopoly power: there are many markets in which just one or a few firms operate. The degree of monopoly power held by these firms will affect the pricing of their products. For example, in a pure monopoly, the amount of output produced by the monopolist is lower and the price charged is higher compared to firms operating in a perfectly competitive market. Governments react either by introducing measures to encourage greater competition and/or monitoring the price set by these firms, and if necessary, intervening to force the firms to reduce prices.
3. To protect the public from criminal activity.
4. To deal with the effects of externalities: the effects of the actions of one agent in the economy on others, which is not reflected through the price mechanism. There are positive and negative externalities. If a neighbour’s property is kept in good order, other neighbours benefit not just from enhanced property values but because it is pleasant to look at neighbourhood houses and gardens. A classic example of a negative externality is pollution. Industrial output in the USA can pollute the rivers, lakes and air in Canada. Governments intervene to minimise the effects of negative externalities. For example, the Canadian government might try to reach an agreement with the USA to reduce emissions.

In financial markets, these principles apply to the following.

1. Protecting the investor: the quality of many financial products is not easily observed, which makes it important for the investor to be kept fully informed about the risks he or she incurs when purchasing a financial product. Investors are expected to assume some of this responsibility, but often, government directives are needed to ensure financial firms provide adequate information.
2. The concentration of financial firms in the market place: the financial sector is made up of many different markets, from retail banking markets to global bond markets.
3. The competitive structure of each of these markets varies considerably. Global markets tend to be more competitive if firms from all over the world are active in them. Some domestic markets have only a few firms offering banking services. In 2001, the UK’s Competition Commission ruled against the proposed merger of Lloyds TSB and Abbey National on the grounds that it would leave the retail banking market too concentrated. In 1998, the federal government of Canada refused the proposed mergers of the Toronto Dominion Bank with the Canadian Imperial Bank of Commerce and the Royal Bank of Canada with the Bank of Montreal on the grounds that the Canadian system would be too concentrated.

4. Illegal activities: agents who engage in financial fraud, money laundering and tax evasion.
5. Externalities: the problem is actions by agents which undermine the stability of the financial system. In the financial markets, contagion often results in negative externalities. For example, in 1998, when it became apparent that a hedge fund, Long Term Capital Markets (LTCM), was about to collapse, concern that its failure might threaten the stability of global financial markets was so great that New York’s Federal Reserve Bank intervened and arranged for its rescue by a consortium of international banks, at a total cost of $3.625 billion. The main contributors were the counterparties with very large exposures, and included Goldman Sachs, Salomon Smith Barney, Bankers Trust, Deutsche Bank, JP Morgan, Merrill Lynch, Morgan Stanley, Credit Suisse, UBS, Chase Manhattan, Barclays Capital ($300 million each); Soci´et´e G´en´erale, Lehman Brothers, Paribas (\$100 million each).2 Though public (taxpayers’) money was not used in the LTCM bailout, it was the Federal Reserve Bank of New York which pressured the banks to bail out LTCM because of potential global knock-on effects.

There are many cases where central banks or other financial regulators have intervened to rescue a bank or banks to protect the rest of the banking system. Contagion, or the spread of bank problems from one bank to the banking system, arises for a number of reasons. To the extent that banks offer fairly homogeneous products to customers, they are collectively exposed to the same risk. At the micro level, a marginal borrower will seek out all the banks until one makes the loan. At the macro level, all banks are affected by events such as changes in monetary policy.

The reputation of banks is extremely important because of the lack of transparency on bank balance sheets, their intermediary function and the cost of acquiring information. Any market rumour can undermine depositor confidence. The banking system is particularly vulnerable to contagion effects, when lack of confidence associated with one poorly performing bank spreads to other, healthy banks. It arises because customers know that once a run on a bank begins, liquidated bank assets will decline in value very quickly, so they will want to withdraw their deposits before a run. Thus, even healthy banks may be subject to a bank run. If most banks are affected, the financial system may well collapse.

The vulnerability of banking to contagion creates systemic risk; the risk that disturbances in a financial institution or market will spread across the financial system, leading to widespread bank runs by wholesale and retail depositors, and possibly, collapse of the banking system. An extensive collapse will result in the loss of intermediation, money transmission and liquidity services offered by banks which, in turn, will cause an inefficient allocation of resources in the economy. In the extreme, the economy could revert to barter exchange.

Systemic banking risks are aggravated by the interbank and euromarkets, play a crucial role in the global banking scene. The interbank market acts as a risk absorber and risk spreader but at the same time makes the global banking system vulnerable to certain exogenous shocks.

Additional problems arise because of the macroeconomic role played by banks; they help to implement government monetary policy. For example, the government may use the banks (changing a reserve ratio or setting a base rate) to achieve certain inflation and/or monetary growth targets. If the banking system collapses, there may be a dramatic reduction in the money supply, with the usual macroeconomic implications.

Thus, bank failures can create substantial negative externalities or social costs, in addition to the obvious private costs of failure. So in most countries, to minimise the chance of governments having to rescue a bank or banks, the national banking systems are singled out for special regulation, known as prudential regulation, which is typically more comprehensive than regulation of other sectors of the economy, even other parts of the financial sector. The prudential regulation of banks is concerned with minimising the social costs of bank failure (which lead to the collapse of the financial system) but at the same time, ensuring that banks do not take advantage of the fact they are singled out for special regulation, and possibly protection. For example, many countries offer some form of deposit protection to bolster confidence and counter bank runs. Experience has shown that to be fully effective, 100% deposit insurance is often required. These schemes escalate moral hazard problems, and part of the regulatory role will be to ensure such problems are minimised.

It will become apparent that prudential regulation focuses on bank regulation at the micro level, i.e. ensuring each bank behaves in a prudent manner, to prevent systemic failure arising from contagion if one bank fails. Boreo (2003), among others, has called for more attention to be paid to ‘‘macroprudential regulation’’ – preventing the banking system as whole from getting into trouble because they are exposed to the same collective risks – so an entire banking system can encounter problems simultaneously. For this reason, Boreo argues, equal attention should be paid to the aggregate exposures of banks.

To summarise:

• Financial fragility can provoke a loss of confidence in a bank/banks and provoke a bank run, preventing the bank/banks from offering an important product/service: liquidity.
• The banking system is vulnerable to contagion: contagion occurs when a lack of confidence associated with one bank (e.g. a bank that has just failed) causes a run on other banks as depositors, fearing the worst, withdraw their cash. The problem here is one of incomplete information – depositors do not have the information to distinguish between healthy and failing banks.
• The presence of contagion contributes to systemic risk: the risk that problems in one bank will spread throughout the entire sector, via contagion. Once the entire financial system collapses, there is no mechanism for money transmission and in the extreme, the absence of a payments system, the country reverts to a barter economy.
• Bank failures have obvious private costs, but there are social costs too.
• The issue of microprudential regulation shifts to macroprudential regulation if banks in one or more countries are collectively exposed to the same risks, a point which is taken up later.

Unfortunately, the special treatment of banks has a downside. Not only does it divert government resources away from other activities, it can create moral hazard problems. The concept of moral hazard was introduced earlier. In the regulation of the banking system, the traditional line is that moral hazard can arise for one of two reasons. First, if deposit insurance is offered to discourage runs on banks and second, if a bank is considered so important to the economy that they are deemed by regulators to be ‘‘too big to fail’’. The existence of one or both these conditions can alter the incentives of depositors and bank management. Most governments offer some degree of insurance. Customers with deposit insurance know their capital is safe, giving them little incentive to monitor the activities of their bank. It is even possible that bank managers’ behaviour will be affected – some may be inclined to undertake riskier activities, especially if the bank is encountering difficulties. Here, the manager may go for broke, hoping the gamble pays off and the bank survives. If not, at least depositors are protected. The same points apply if depositors or bank management know (or think it likely) their bank is considered too big to fail, making it probable the bank will be rescued by the state.

Or so the standard argument goes. However, the logic is somewhat flawed. Managers will worry about loss of jobs and status if a bank fails, but why should they have any special concern for depositors once the bank collapses? Any bank manager trying to undertake riskier activities because of deposit insurance and/or the attraction of ‘‘too big to fail’’ status will encounter objections from well-informed shareholders who stand to lose their capital. Even some depositors have an incentive to monitor managerial behaviour because insurance is normally capped at some deposit level, their type of deposit does not qualify for insurance, there is co-insurance, or all three.

A more likely scenario is the looting hypothesis, first described by Akerlof and Romer (1993). Consider the situation where a bank has, for whatever reason, got itself into serious problems, and senior management has enough inside information to know there is a good chance the bank could fail within a few years, at which time they will lose their jobs. They could respond by undertaking riskier activities6 to boost short-term profits, which enhance their status and salary, and boosts the bank’s share price, which they can take advantage of by cashing in stock options. Well-informed shareholders may also sell their shares when prices are high, turning a blind eye to the reasons for the sudden increase in short-term profits. There is a small chance the risky undertakings might restore the bank to economic health, in which case, all parties are better off. However, if the strategy is unsuccessful and the bank fails, then senior managers (and possibly, major shareholders) have used the breathing space to feather their nests. To make matters worse, managers have every reason to undertake sizeable gambles because the downside is truncated. It is someone else’s problem whether the bank collapses with losses of £1 or a million pounds.

Free Banking

An alternative school of thought advocates free banking. In the 19th century, free banking was unregulated by government authorities, they did not need a charter or licence to operate, and issued their own bank notes. There were periods of free banking in Scotland (1716–1844), Sweden (1831–1903), Switzerland (1826–1907) and Canada (1867–1914).

Cameron (1972) argued that Scottish free banking fostered economic growth because of the intense competition between the banks, which forced them to innovate. He credits the banks as being the first to introduce branch banking, interest paid on deposits, and overdraft facilities. Dowd (1993) argued the free banking episodes in Scotland, Sweden and Canada were highly successful.

Modern-day usage of the term ‘‘free banking’’ refers to a highly competitive system operating without a central bank or regulations. Proponents of free banking claim central banks have the potential to encourage collusive behaviour among banks, thereby increasing their monopoly power. In the absence of government regulation, private banks have a collective interest in devising a framework to prevent runs. It could take the form of private deposit insurance and/or a private clearing house, which acts as lender of last resort. See, among others, Dowd (1993), Friedman and Schwartz (1986), White (1986). However, a private clearing house could also encourage collusion among banks. Cruickshank (2000) claimed that the private settlements system in the UK has resulted in the big banks exercising monopoly power, resulting in higher settlement charges for banks and customers. Furthermore, private deposit insurance and/or lender of last resort institutions merely replicate what a central bank does, so the same monitoring problems exist, creating incentives to free-ride.

Free banking also raises macroeconomic issues, because banks issue their own notes. No bank should have an incentive to issue too many notes because they will be exchanged for specie at that bank, thus running down its reserves. However, Nelder (2003) argues the above is only true if holders of the notes have to return to the bank where they are issued. However, if the notes issued by the different banks are perfect substitutes (or perceived to be by the public), then smaller banks have an incentive to issue an excessive supply of notes because there is a greater chance they will be redeemed at the larger banks. He argues that in the Swiss case, this resulted in an over-issue of notes, causing the depreciation of the Swiss franc. As a result, the banks agreed to give up their right of issue, and approved the establishment of a central bank, controlled by the federal government.

Nelder argues Sweden and Scotland also experienced periods of excess issue, but Canada escaped it because there was little in the way of effective price competition between the banks.

Though the free banking idea is interesting in theory, it is very unlikely that the regulatory systems of western countries will be dismantled to allow an experiment. For this reason, the issue is not explored any further.