WE ARE SO INURED TO BANK regulation that we seldom stop to ask why we do it. Yet, when one looks deeply into the question, it is difficult to identify a sound policy reason for regulating banks. Most of the conventional explanations--inherent bank instability, deposit insurance, the Federal Reserve's role as lender of last resort, or the Fed's role in the large-dollar payment system--turn out on examination to be either unfounded or based on risks that the government need not take in order to foster the growth of the economy.
Regulation, of course, is not without significant costs. In recent decades, we have experienced the wholesale collapse of both the banking and savings-and-loan industries, with huge costs to taxpayers and the economy. The fact that this happened to heavily regulated industries, and never happens in the absence of regulation, should tell us something about whether regulation does more harm than good. Although there is clearly a political consensus that regulation is efficacious or necessary, thoughtful students of the financial system should consider whether that consensus will survive in the absence of a compelling policy rationale.
In modern financial history, there have been just two cases in which entire industries suffered wholesale collapse--and those involved the banking and S&L industries in the 1980s and early 1990s. In other words, two of the most heavily regulated industries turned out to be highly unstable when economic conditions were unfavorable. There is no mystery about why this happened, and the problem is not that regulators are incompetent. The reason is the absence or reduction in market discipline--the loss of the wariness and skepticism that investors should feel when they commit funds to an enterprise--because of government regulatory policies. In the case of regulated depository institutions, those policies communicated a general sense to investors that government regulation was seeing to the safety and soundness of the enterprises, and thus that the usual risks of investment and the usual need for monitoring were much reduced. For ordinary depositors, market discipline was essentially eliminated by deposit insurance and uninsured depositors and shareholders were lulled by previous actions of regulators into believing that even if the institution failed they would somehow be protected--and indeed many were. This condition--the lulling of investors--has a name: moral hazard.
The absence of market discipline explains the collapse of the banking and S&L industries. The resulting losses fell on the taxpayers, who were compelled to pay more than $150 billion to bail out insured depositors, and on the economy in general, which experienced a recession over several years because of the depressed real estate market that resulted. There was also a spectacular political effect, with a president turned out of office because of voter dissatisfaction over the weak economy and the tax increases that were thought necessary, in part, to pay for the depositor bailout.
With this record, one might suppose that the best course would have been to rethink the whole idea of regulating depository institutions, but this was not to be. In Washington, the preferred course is always to redouble the bet on government, and that is indeed what happened. The Federal Deposit Insurance Corporation Improvement Act of 1991 (FDICIA) added significant new regulations, including draconian penalties for violating the regulations or the orders of bank and S&L supervisors. Ironically, however, the most successful elements of FDICIA were rules governing the behavior of the regulators themselves. Those rules required regulators to take "prompt corrective action" if the capital of depository institutions began to weaken--action that became more stringent as the institutions' capital levels declined. Leaving aside the difficult question of determining capital levels, this stratagem was successful because it became difficult for regulators to forbear in closing failing institutions--a natural human tendency to push off into the future unpleasant duties that do not have to be performed today.
ARE BANKS INHERENTLY UNSTABLE?
Despite the fact that regulation has produced some disastrous results, it might still be possible to justify it on various supervening grounds. In this article, we will review these …