A Market-Based Approach to Regulatory Reform

Article excerpt

Regulatory requirements and prohibitions impose significant, although sometimes unintended, taxes on the business of banking. As with all business taxes, the true burden is shared jointly by investors in the form of reduced market valuations of their investment, by employees in the form of lower real wages, and by customers-in this case, in the form of higher interest paid on loans and lower interest received on savings.

Whatever natural comparative advantage depository institutions have in delivering intermediary services is diminished under the weight of these taxes, and businesses and households suffer a reduced menu of financial services. Indeed, the entire economy is harmed to the extent that regulation reduces the efficiency of the financial system and therefore the real growth potential of the economy. Even when regulation is appropriate, its form may matter a great deal.

This Economic Commentary outlines a proposal to modify the current regulatory system, with little or no new legislation. This proposal represents an important move in the direction of supplanting and complementing official regulation with market-based regulatory discipline, thereby making greater use of market forces to achieve legitimate regulatory goals (such as the safety and soundness of the financial system) while reducing compliance costs. Harnessing market forces for regulatory purposes will reduce costs because markets are much more efficient than regulators in successfully modifying banks' behavior.

This modest program for regulatory reform can be readily implemented without any material changes to existing law. Like the more sweeping proposals for reform that have been offered of late, it provides incentives for every bank to become better managed and better capitalized.(1) It does so by creating a process for reducing the cost of complying with bank regulation both directly, because well-managed and well-capitalized banks would pay lower deposit insurance premiums and receive preferential regulatory treatment, and indirectly, because the need for regulation would be reduced by a decline in the risk to the Bank Insurance Fund and to taxpayers. Unlike other market-based reform proposals, the plan does not rely on statutory reductions in deposit insurance coverage to provide banks with incentives to increase their capital and to limit loss exposure. It is also not an alternative to fundamental reforms to the financial safety net and bank regulation. Instead, the plan represents an intermediate step toward the implementation of a true market-based system of bank regulation that might be set in force immediately.

Within that limited scope, this proposal will move the bank regulatory system closer to the Securities and Exchange Commission's (SEC) information and disclosure approach to supervision, which I believe is more efficient than the permission, denial, and directive approach to regulation that is now the norm in banking.


Complying with regulatory requirements and prohibitions entails both explicit and implicit costs. Explicit costs include the resources used to comply with the regulations, such as hiring additional employees to process associated paperwork. The implicit costs imposed by regulatory prohibitions include the forgone opportunities from diverting resources into less efficient activities. Both of these regulatory costs can be significant, but are often overlooked in the heat concern about bank safety. Indeed, it sometimes appears that there is now zero tolerance for losses to the Bank Insurance Fund, rather than a sense that the costs of incurring these losses should be weighed against those of avoiding them.

The costs of regulation are extremely difficult to estimate. Nevertheless, various studies have estimated that the explicit costs of regulatory requirements range from 6 to 14 percent of commercial banks' non-interest expense.(2) Banks' non-interest expense was $130. …