On the Political Possibility of Separating Banking and the State

By Calabria, Mark | Journal of Private Enterprise, Fall 2014 | Go to article overview

On the Political Possibility of Separating Banking and the State


Calabria, Mark, Journal of Private Enterprise


I. Introduction

Banking has long been one of the most highly regulated sectors of the American economy. It is also, perhaps surprisingly, more extensively regulated in the United States than in any other comparable developed country. This study examines the pattern of financial freedom across countries, with the objective of determining whether a free-market, or even a less-regulated, banking system is feasible within the United States. Also briefly examined is the political history of U.S. banking regulation, with an eye toward discerning any lessons regarding the future of U.S. banking regulation. In general, this paper is not about the economic feasibility or desirability of freemarket banking.

II. What Causes the Regulation of Banking?

Activities generally recognized as banking developed prior to the regulation of banking. Some aspects of banking created a demand for the regulation of those activities. Classical welfare economics, in the tradition of Pigou, suggests that regulation arises as the result of a market failure, such as the externalities imposed by financial panics or asymmetric information problems between borrowers and lenders. The modern structure of banking regulation, however, with its safety net that creates moral hazard and its restrictions on competition, suggests that correcting market failures has little relation to modern banking regulation. Empirical research on the link between banking regulation and market failure is at best mixed. In their cross-country study, Heinemann and Schuler (2004) "do not find support for a link between stability in the banking system and the supervisory stringency." Heinemann and Schuler do find, however, that more generous deposit insurance schemes are associated with more fiequent banking crises, results consistent with those of Barth, Caprio and Levine (2004) as well as Demirgüç-Kunt and Detragiache (2002). Alternative explanations for regulation include: ideology; redistribution of wealth among industry participants, consumers and competitors; and regulation as a source of governmental finance.

One hypothesis is that societies with relatively free banking systems are simply those that embrace free markets in general. That is, a general ideological support for free markets drives the support for less-regulated banking. Simple comparisons do show a high correlation between a measure of general business freedom and financial fieedom, as illustrated in Figure 1. Simple comparisons between more open societies (in terms of political freedoms) also display a positive association with financial fieedom, but the correlation is weaker.

A handful of countries display higher financial freedom than the United States, yet less business freedom (see Figure 2). Countries such as Ireland and Luxembourg experience significantly less business freedom than the United States does-though still more than most countries-yet have higher levels of financial freedom, suggesting that more is at play than a country's overall approach to business regulation. To some degree, banking does appear special, at least in terms of its relationship to government.

Most countries ranking higher than the United States on financial fieedom demonstrate a legal system of English origin, as does the United States. Many are also of Scandinavian legal origin. A small number of countries of German legal origin also rank high on financial fieedom, while few countries of the French civil law tradition rank high on financial freedom. These simple rankings support the importance of legal origin in explaining the organization of both law and finance (La Porta et al. 1998). There is the question of whether the various economic fieedom indexes, including the financial freedom index, are largely measuring legal origin. By construction, the financial freedom index mirrors a country's reliance on state administrative control versus a heavier reliance on common law.

The regulatory and deregulatory environment for banking in the United States proceeded along a number of dimensions. …

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