Regulating the Radically Unknown

[ed. A Spanish translation/version of this essay was presented at the V Conference of Austrian Economics, hosted by the Instituto Juan de Mariana, on 20 June 2012.]

History has recurrently shown that banking regulations do not succeed at providing financial stability.  The most recent crisis is another “natural experiment” that accentuates the frailty of a regulated banking system, despite the fact that modern governments have enacted some of the most complex and comprehensive webs of rules and policies designed to prevent exactly what they ultimately did not.  The policy response should not be “more regulation,” because “more regulation” does not address the fundamental obstacle of State-management of financial intermediation and monetary distribution: radical ignorance.  After a brief review of the history of modern financial regulation, it is opportune to revisit the theory of economic uncertainty and the role of the bank in mitigating the problems of dealing with the radically unknown.

While the history of banking regulation is a whole topic of its own and largely unique between the world’s nations, my intention is only to draw attention to the gradual intensification of government supervision that nearly uniformly characterizes it.  In the United States, for example, anti-branching laws and growing restrictions on note-issuing, such as taxes on certain banks’ notes, made it increasingly difficult to respond to information runs caused by inflationary episodes also stimulated by government intervention: namely, the circulation of greenbacks between 1862–71, issued to pay for the American Civil War and the resulting debt, and later fiduciary over-issue encouraged by allowing national banks to issue notes backed by government bonds and the manipulation of the exchange value of gold and silver.  Eventually, runs and consequent panics, especially that of 1907, led to the formation of the Federal Reserve System.  This did little to constrain banks and actually intensified fiduciary over-expansion, ultimately leading to the Great Depression and the creation of deposit insurance.

Deposit insurance takes the place of market processes that accomplish much of the same thing, but by externalizing the burden of failure to the taxpayer.  Deposit insurance, much like last resort lending without ex ante restrictions, causes problems of its own.  It eliminates the need for market discipline, or constraints placed upon banks by its clients and investors, because these people are essentially insured against the loss of their deposits.  Banks are given leeway to make what are perceived to be riskier investments, and regulators soon saw the need to step in to guard against excessive risk-taking by these regulated financial institutions.  After the Second World War, it became popular to enact deposit and savings rate ceilings, which accomplished the function of restraining competition in the industry.  This, according to regulators, serves two important functions: (a) it maintains profits, or franchise value, which is said to be an incentive to make safer investments and (b) it disallows banks from paying a higher premium on deposits, meant to compensate for the allegedly higher risk investments being made.

Also popular are capital controls, which are intended to force banks to hold a certain volume of their own capital against their investments.  This is what the three Basel frameworks are, in part, intended to do; in the United States, prior to the 2010 adoption of a framework based on Basel III, these efforts were mimicked by the recourse rule.  Different assets were rated against their perceived market risks and then organized into buckets and tranches.  Ideally, the riskier the asset the more capital banks have to hold against it.  In the event of the liquidation of an investment the bank can partially patch the loss with the reserve.

These regulations have not passed the test.  Rate ceilings on non-deposit accounts were lifted in the United States and elsewhere during the so-called “deregulation” of the 1970s and 1980s to allow banks a greater degree of flexibility in dealing with the economic stagnation of those times.  Some economists blame these deregulations for the crisis of the late 1980s and early 1990s, but the financial institutions which failed were already suffering insuperable losses when saving rate ceilings were in place.  Much of the alleged deregulation was in the form of phantom deregulation, since much of it did not actually take place.  For instance, ceilings on deposit rates remained intact.

The ongoing financial crisis is much more telling, because it was caused in large part by the capital controls designed to prevent it.  The prevailing myth is that banks made wild, overly risky investments by gambling other people’s money, certain that in the worst case scenario deposit insurance and bailouts would buttress them against failure.  The evidence suggests something different: the majority of assets held by American investment banks, for instance, were all low-risk and low-return.  No less, many banks held higher than required reserve requirements, suggesting an interpretation that is the polar opposite of the mainstream view.  These investments were guided by capital controls, designed by regulators using government-recognized risk-assessment agencies.  Ex post, when the true nature of these assets’ risks were revealed, regulators were quick to point and lay the blame elsewhere.  The real problem was in the inability to understand and forecast the distortions which credit expansion had induced during the previous decade.  It should be uncontroversial to recognize that Basel III, the post-recession regulatory framework, has not addressed the fundamental weakness in its approach.

The basic model — the Diamond–Dybvig model and its derivatives — recognizes two functions for banking: optimal quality-assessment and risk-sharing.  This model does not identify the even more essential role of financial institutions: safeguarding clients’ money against uncertainty.  From this stems more modern functions, including the task of intermediating savings between savers and entrepreneurs.  Banks, most importantly, are institutions designed to manage assets — especially money — against the winds of the radically uncertain.  Bankers are entrepreneurs who command a large part of the fate of the market; bad decision-making, as we well know by now, can lead to losses that require years to restore.  It is sensible to want to maximize efficiency by helping bankers better deal with the unknown, but regulators are neither magicians nor fortune-tellers.  Regulators are no better at predicting the future.

Financial entrepreneurs, however, enjoy a crucial advantage over regulators — they are constrained by the market process.  The world is replete with people looking to make a profit, as such there is no shortage of potential bankers.  Those who make bad decisions suffer losses and are forced off the market; profits, on the other hand, reward good results.  The phenomenon of profit and loss is an essential market process that continuously redistributes capital to those who best use it.  This is the “market discipline” that early interventions did so well to marginalize.

Regulators have gone to great lengths to inhibit competition — they do this openly, claiming that it maintains “franchise value” and helps guarantee less risk-taking.  The evidence implies the opposite!  Not only have larger banks made the same mistakes these regulations were meant to prevent, but they have gained the elite privilege of being “too big to fail” — profit and loss is no longer allowed to operate, since the government willingly expropriates society’s wealth to protect bad decision-makers.  Greater competition should not be feared; the less a bank can risk against the unknown future, the less the potential loss becomes.  Many economists claim that small franchise values are an incentive against making less risky investments, but this theory is an imagined one and is meant largely only to justify broad anti-market ideologies.  The incentive to make better investments is two-fold: (i) avoid going out of business and (ii) garner greater profits.

Competition has other positive side-effects.  Allow me to emphasize that entrepreneurial decision-making, like all human action, is a future oriented process.  The future is unknown; it is not so much about “searching” for information, but having it be revealed to you.  Good decision-making is guided by luck and chance as much as it is by knowledge.  Profitable techniques and plans are “discovered,” oftentimes unintentionally.  In this environment, heterogeneous planning and action is preferable over its homogenous ilk.  What this means is that the more variation there is in the individual plans of individual bankers, the higher the probability that good decisions will be made.  That is, the greater the opportunity for better techniques to be discovered.  This is a market process that affords society better use if its resources — what some might call greater, or relative, “efficiency.”

Regulations work to obstruct this process, or even relegate it to irrelevance.  Not only do they restrain competition, but they also tend to homogenize entrepreneurial action.  Choice-based interventions force bankers to make only pre-approved decisions; incentive-based interventions guide bankers to make these same decisions by rewarding them in some way.  The result is the same: variation is gradually eliminated.  If the regulators’ choices are bad, the whole industry follows and society pays the price.

All that the market — which is nothing but the individuals who make up society’s division of labor — provides to constrain the behavior of bankers, and entrepreneurs in general, is undone by government regulation.  Where the market process penalizes those who perform poorly, government rewards them by subsidizing their losses.  Where the market works to minimize social costs and improve social benefits, the government stabs at the dark and unnecessarily arrests economic progress.  In even broader terms, what this means is that the evolution of our financial industry has been needlessly hindered by government restraints.  Perhaps worse still is whatever evolution has been made in directions which take for granted government institutions and the protections they afford.  Oftentimes, the imperfections these bring with them are blamed on the “free market,” when in fact they would have never been made possible had “market discipline” been in effect.  This gives reason to new regulations, which in turn sow the seeds for more acute inefficiencies.

The long-term solution is free banking, or a financial industry that has evolved within the constraints of the market process.  This not only includes true deregulation, but also returning the task of issuing money to “the market.”  Competitive money supply, where customers choose that which provides the greatest satisfaction — for example, reliability —, is a safeguard against the inflationary tendencies of monopolized currency systems.  Faux competitive money and banking systems, like that of 19th century Australia, are insufficient.  Monetary institutions should have true freedom to enter the market, and customers true freedom of choice, otherwise the complete arsenal of benefits of “market discipline” are abandoned.  It is only a process of social evolution, guided by profit and loss, that will improve the relative efficiency of a division of labor that will forever be pitted against the radically unknown future.  Interventionism, which evolves within a completely different environment — characterized by coercion, allowing government to bypass market discipline by simply expropriating society’s wealth — serves to impede social progress.  This is because a process unconstrained by loss is one which finds the uncertain future irrelevant.  Such a process is incompatible with our world.

Suggested Reading:

Sudipto Bhattacharya, et. al., “The Economics of Bank Regulation,” Journal of Money, Credit and Banking 30, 4 (1998).

Critical Review 7, 2–3 (1993), pp. 237–370.

Douglas W. Diamond & Philip H. Dybvig, “Bank Runs, Deposit Insurance, and Liquidity,” Journal of Political Economy 91, 3 (1983).

Jeffrey Friedman & Wladimir Kraus, Engineering the Financial Crisis (Philadelphia: University of Pennsylvania Press, 2011).

Thomas F. Hellman, et. al., “Liberalization, Moral Hazard in Banking, and Prudential Regulation: Are Capital Requirements Enough,” American Economic Review 90, 1 (2000), pp. 147–165.

Ludwig M. Lachmann, The Market as an Economic Process (United Kingdom: Blackwell Publishing, 1986).

Ludwig von Mises, Human Action (Auburn: Ludwig von Mises Institute, 1998), pp. 431–445.

George A. Selgin, The Theory of Free Banking (Lanham: Rowman & Littlefield, 1988).

Eugene N. White, “The Political Economy of Banking Regulation,” The Journal of Economic History 42, 1 (1982), pp. 33–40.

12 thoughts on “Regulating the Radically Unknown

  1. Lord Keynes

    The idea the “most recent crisis is another “natural experiment” that accentuates the frailty of a regulated banking system, despite the fact that modern governments have enacted some of the most complex and comprehensive webs of rules and policies designed to prevent exactly what they ultimately did not” does not convince.

    Nobody claims that there was zero regulation: the point is that the system that existed was a deeply dysfunctional neoclassical version of what had existed from 1940s-1970s.

    As for the financial deregulation that occurred 1980-2000s, the acts that changed the Post-WWII system are easy to list:

    Depository Institutions Deregulation and Monetary Control Act (1980)

    Garn–St. Germain Depository Institutions Act (1982)
    These two acts were major contributors to the Savings and Loan crisis.

    Riegle-Neal Interstate Banking and Branching Efficiency Act (1994)

    Financial Services Modernization Act of (1999), also called the Gramm-Leach-Bliley Act

    Commodity Futures Modernization Act (2000).

    The SEC’s Voluntary Regulation Regime for Investment Banks (2004).

    Where were the huge asset bubbles 1940s-1970s when the system was regulated in a much better way?

    1. Jonathan Finegold Catalán Post author

      Nobody claims that there was zero regulation…

      I didn’t claim that anybody claimed there was zero regulation, so I don’t see how this is relevant.

      And, I mean, you can list a bunch of laws which were passed to re-organize banking regulation, but this doesn’t really say anything useful (especially including the Gramm-Leach-Bliley Act, which I think every serious economist recognizes did not contribute to our most recent crisis).

    2. Earmonn Eli

      Wow, you amazingly whitewash everything the keynesians every did “lord keynes”.

      1. The Savings and Loan Banks were created by the government.

      2. All these “deregulations” happened in periods with huge increases in regulations at the same time.

      3. Noone is talking about having the system of 1980-2000, one is talking about a system where banks are actually responsible for their deposits. All these periods are periods where the government is the guarantor of deposit and the federal reserve is the guarantor of cheap credit.
      You and your keynesian buddies simply want to direct the cheap credit completely through the government, you are not interested in it fundamentally not arising in the first place.

      4. The 1940s-1980s must be your period, because it is in the awful 80s that all these deregulations that you attribute the crisis to were passed. In all those years one saw a huge stock market bubble, They became HUGE after leaving the GOLD standard, which is another shot at your primitive paper money scheme. The lacking of gold is the most obvious of all events statistically, but the post-keynesians simply carry on that fiat money or world government fiat money is the best.

      You should face the fact that keynesian policy has failed, and the policies deriving from the works of post-keynesians are basically keynesianism extreme or socialism.

      You should understand the difference between regulating away certain behaviour and certain outcomes, you frequently want to regulate certain behaviour and outcomes without even considering other causes for the undesireable outcomes.

  2. Lord Keynes

    I add that I see no reason why Australia had a “Faux competitive money and banking system ” in the 19th century.

    By the 1860s, the Australian banking system had these characteristics:

    (1) a gold standard (usually dated from 1852 [Bordo 1999: 327] with a branch of the British mint established in Sydney in 1855);
    (2) no central bank;
    (3) no capital controls;
    (4) few legal barriers to entry;
    (5) no branching restrictions;
    (6) no credible restrictions on assets, liabilities or bank capital;
    (7) no legally established price controls;
    (8) no government-provided deposit guarantees.

    In what way was this a false “free banking system”?

    1. Jonathan Finegold Catalán Post author

      I’ve written a bit on Austrialia before: here. Australian banks were not without restrictions, including restrictions on being able to issue notes. This makes it much more difficult to deal with information runs, such as those which resulted from the realization that much of these banks’ assets were illiquid. Also, it casts shadows on whether or not there was a truly competitive monetary system in Australia. Yes, Australia may have had the freest banking system of all real world banking systems, but this does not make it a true free banking system. The real reason why I mention Australia out of all possible examples, is precisely because of this fact.

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