Institute for Research in Economic and Fiscal issues

IREF Europe - Institute for Research in Economic and Fiscal issues

Fiscal competition
and economic freedom

Bank regulation: Troubleshooter or Troublemaker?

A widespread understanding of the 2007-2008 crisis places the origins of the crisis in a capture of global economy by the finance industry. The “occupy Wall Street” group would surely agree, as well as most of those who get their economics from the general media. And President Sarkozy in his recent Toulon’s speech did confirm the thesis. If this understanding is correct then it is natural to call for further regulation of the finance industry. But not everyone agrees, and some economists favor another understanding.

According to Professors Pierre Garello and Antoine Gentier from the University of Aix-Marseille, excessive rather than insufficient regulation is part of the problem. Actually the absence of regulation, besides property and contract, does not necessarily mean that there is no market order and the truth lies at the opposite– excessive regulation often generates market disorder.

To understand their analysis it is necessary to follow them in their trip back to the origin of the banking industry and to see how it developed from there. We then first discover how important it is to distinguish between deposit banking and investment banking. Deposit banks came first, offering a safe for the money of the merchants. Only later came the ancestors of the investment bank: essentially individuals operating with their own money to discount bills of exchange. It is important to distinguish analytically these two functions—financial intermediation and money management, even if in the course of time they progressively merged into the same label: “banking” (which does not mean that the possibility for a same institution to run both activities should be necessarily ruled out).

Contract is what ruled banking at its starting point. The contract between the client and the bank makes clear what can be done with money deposited by the client. Meanwhile, the contract between the bank and its shareholders sets the degree of shareholders’ implication into the management of the bank and the extent of their responsibility (limited or unlimited). This information, in turns, impacts on the contract between depositors and the bank.

Because every contract generates obligations for each party, clearly the banking sector, like any other market activity, was regulated from the beginning, not by the government but by the law. And this regulation by contract worked fairly well as reported in many studies quoted in Garello and Gentier’s paper. Indeed, it is misleading to believe that without government intervention and numerous regulations the banking sector would unavoidably drift.

If contract brings with it the discipline of responsibility, it also leaves room for diversity. Banks are free to choose their level of risk, and their benefits will be growing or decreasing according to the pertinence of the risk management. It is not necessarily a bad thing that some banks take more risk: . If it were not the case, some worthy projects would not find funding. Here again, regulation aimed at controlling the banking sector might give the wrong incentives.

Although contracts are powerful tools to promote social cooperation and growth, they are not perfect and bankruptcies are always possible. As it turns out, however, bankruptcy tended to be rare between the 12th century to the mid of the 19th century. Moreover these bankruptcies had not the same effect on depositors because the structure of the banks balance sheet was different. For instance, a bank’s equity capital represented typically between 40% and 80% of its liabilities, while today that ratio is usually found between 5% and 12%. Depositors were less exposed to the consequences of bankruptcies because the bank equity capital was sufficient to endure severe losses. And this is not mysterious as the economists explain: when the banking sector was not regulated by government, much higher quality requirements were imposed on banks via competition (and reputation).

The history of banking took a sharp turn in the 20th century. Today, the State is intervening into the banking activity essentially through two channels: directly, by regulating the banks’ activities and indirectly by the money creation. Following Garello and Gentier’s opinion, this intervention has been—at first glance, paradoxically—initiating a sort of race to the bottom, each bank trying to get more profits without having to build a correct anticipation of the risk involved.

Of the two channels, probably the most damaging has been the progressive granting of a state monopoly on money creation. This profoundly modified the banking activity, allowing the bank to participate in the creation of money without serious constraints and totally changing the determinants of interest rates. This resulted in an unprecedented dilution of responsibility, a dilution that the various schemes of public deposit insurance contributed to amplify. A point was quickly reached where it was not longer clear if liquidity problems were due to the bad management of commercial banks or to a flawed monetary policy. Interestingly, the first central banks have been at the origins of the bankruptcy of many commercial banks (in England in 1797, in the USA in 1932-1933 or in France during the thirties), which pushed most of the governments to nationalize central banks and to develop their function of “lender of last resort”, which in turn further weakened the sense of responsibility among commercial banks.

Add to this that taxation on profits and dividends—another government “regulation”—promoted debt financing and contributed to the dramatic fall of bank’s capital-to-debt ratio. With so much debts, a bankruptcy will most likely affect depositors, which was usually not the case when the capital ratios were much higher.

You can read more about how regulation and monetary policy are destroying the bank activity in the article by Pierre Garello and Antoine Gentier*. In doing so you will discover that this point of view is more widely shared than you might think. But may be the lesson from history and from economics are too painful to hear for the promoter of regulation, central banking and floating currencies. Better go with the same policy trying to convince yourself and others that this time you will get it right.

*The article is in French

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