Why Do We Regulate Banks? Concerns That Are Used to Justify Government Intervention Can Be Addressed Privately

By Wallison, Peter J. | Regulation, Winter 2005 | Go to article overview

Why Do We Regulate Banks? Concerns That Are Used to Justify Government Intervention Can Be Addressed Privately


Wallison, Peter J., Regulation


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. …

The rest of this article is only available to active members of Questia

Sign up now for a free, 1-day trial and receive full access to:

  • Questia's entire collection
  • Automatic bibliography creation
  • More helpful research tools like notes, citations, and highlights
  • Ad-free environment

Already a member? Log in now.

Notes for this article

Add a new note
If you are trying to select text to create highlights or citations, remember that you must now click or tap on the first word, and then click or tap on the last word.
One moment ...
Default project is now your active project.
Project items

Items saved from this article

This article has been saved
Highlights (0)
Some of your highlights are legacy items.

Highlights saved before July 30, 2012 will not be displayed on their respective source pages.

You can easily re-create the highlights by opening the book page or article, selecting the text, and clicking “Highlight.”

Citations (0)
Some of your citations are legacy items.

Any citation created before July 30, 2012 will labeled as a “Cited page.” New citations will be saved as cited passages, pages or articles.

We also added the ability to view new citations from your projects or the book or article where you created them.

Notes (0)
Bookmarks (0)

You have no saved items from this article

Project items include:
  • Saved book/article
  • Highlights
  • Quotes/citations
  • Notes
  • Bookmarks
Notes
Cite this article

Cited article

Style
Citations are available only to our active members.
Sign up now to cite pages or passages in MLA, APA and Chicago citation styles.

(Einhorn, 1992, p. 25)

(Einhorn 25)

1

1. Lois J. Einhorn, Abraham Lincoln, the Orator: Penetrating the Lincoln Legend (Westport, CT: Greenwood Press, 1992), 25, http://www.questia.com/read/27419298.

Cited article

Why Do We Regulate Banks? Concerns That Are Used to Justify Government Intervention Can Be Addressed Privately
Settings

Settings

Typeface
Text size Smaller Larger Reset View mode
Search within

Search within this article

Look up

Look up a word

  • Dictionary
  • Thesaurus
Please submit a word or phrase above.
Print this page

Print this page

Why can't I print more than one page at a time?

Full screen

matching results for page

Cited passage

Style
Citations are available only to our active members.
Sign up now to cite pages or passages in MLA, APA and Chicago citation styles.

"Portraying himself as an honest, ordinary person helped Lincoln identify with his audiences." (Einhorn, 1992, p. 25).

"Portraying himself as an honest, ordinary person helped Lincoln identify with his audiences." (Einhorn 25)

"Portraying himself as an honest, ordinary person helped Lincoln identify with his audiences."1

1. Lois J. Einhorn, Abraham Lincoln, the Orator: Penetrating the Lincoln Legend (Westport, CT: Greenwood Press, 1992), 25, http://www.questia.com/read/27419298.

Cited passage

Thanks for trying Questia!

Please continue trying out our research tools, but please note, full functionality is available only to our active members.

Your work will be lost once you leave this Web page.

For full access in an ad-free environment, sign up now for a FREE, 1-day trial.

Already a member? Log in now.