Regulation and Differences in Financial Institutions

By Chick, Victoria; Dow, Sheila C. | Journal of Economic Issues, June 1996 | Go to article overview

Regulation and Differences in Financial Institutions


Chick, Victoria, Dow, Sheila C., Journal of Economic Issues


Some regulation of financial markets is accepted even in these dirigiste times and even by those neoclassical economists who find it a struggle to explain why the market for money is different from the market for peanuts.

Monetary regulation as defined in this paper has three parts: the legal framework, monetary policy, and the supervision of banking and financial markets. Historically, these roles have developed alongside the systems they regulated, new measures being created by the monetary authorities - or even by large private banks - as specific problems presented themselves. Within this evolutionary framework, policies were tailored to the institutions as they existed at the time. Thus, when banks provided only a minor proportion of monetary instruments, prudential regulation was left to the banks themselves and caveat depositor. When bank-issued notes began to create what we would now describe as macroeconomic instability, the government/monetary authority took over the issue of notes. When bank credit and deposits became a force to reckon with, the authorities devised such instruments as reserve or liquid asset requirements and, where the development of securities markets allowed it, open market operations to keep the banks on a short lead. Each of these episodes marks a shift in the power to provide money, first away from the state to the private sector, then back again as the state regains control. The current situation, almost everywhere in the developed world, is that the power to create money lies almost entirely with the private sector.

The current situation in the European Union (EU) bears some similarities to the situation at the time of the institution of the Federal Reserve System, which, of course, came on the scene after a common currency was already in place but when communications were slow and there were distinct differences in the regional economies of the United States. These differences were the reason for the federal structure of the Federal Reserve System, with each Federal Reserve Bank having the power to operate interest rate policy according to local needs. The great diversity of state legal frameworks under which banks were chartered and regulated, and the diversity of banks in terms of their size, their branching, and their local situation, gave rise to differential reserve requirements and discretionary lending through the discount window, which could make allowances for these individual circumstances.

While the diversity in the EU is similar, the regulatory response is markedly different: a new legal framework, a centralized monetary policy, and supervisory mechanisms are being deliberately designed in the context of projected economic and monetary union (EMU) with a common currency. When common currencies were put in place in former times, the monetary institutions were few and simple. One would have thought that the architects of Europe's new system would confront the fact that well-elaborated institutions are in place in every member country, which vary very considerably in a number of important respects. Instead, the new grand design is informed by a powerful set of monetarist and neoclassical assumptions that give little recognition to the institutional structure of European banking and finance.

As seen by the governing bodies of the EU and by the European Monetary Institute, whose job it is to prepare the groundwork for stage three of monetary union, the legal framework defines institutions and provides certain safeguards, such as capital adequacy rules and deposit insurance, which will be uniform in application. The governing idea is that this uniformity will create a "level playing field" for competition, along the same lines as other areas of EU activity (i.e., money is being treated in the same way as peanuts in this respect), and that the competition among financial institutions that will ensue, and the results of that competition, are no business of the authorities. …

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