Financial Regulation: Market or Government?

Remarks at the University of Minnesota School of Law, February 13, 2013

Let me start off with an important clarification. I will not be making the case for self-regulation. That’s a straw-man, at best. No individual, whether a bank CEO, regulator or the President is capable of serving as a judge of their own actions. Unconstrained power generally ends badly.

What I will be making the case for is the regulation of financial companies by other market participants, as opposed to regulation by government bureaucrats. I will also address why the mixed option of both government and market regulation is actually worse than relying on either exclusively government or market-based regulation.

Before we move to the real world, let us begin with a simplified version. In free-market for banking services, the leverage and risk-taking of any one bank is limited by its cost of funds. The more highly leveraged, the mismanaged, or even the more fraudulently managed a bank, the higher the rate at which creditors charge to lend to said bank.

Keep in mind that cost of funding is the most crucial element of finance. The difference of even a few basis points can drive market structure, determining which firms survive and which fail.

For those misbehaving firms that face a higher cost of funds, their growth and activities will be limited by this higher cost of funds.

Of course a higher cost of funds is only one element of market discipline. When creditors have substantial funds at risk in any one institution, they face a strong incentive to monitor and intervene in the management of said institution. Quite simply in a world where creditors have their own money on the line, they impose discipline; that is they regulate bank behavior.

This is not simply a theoretical curiosity. One of the most robust empirical findings in financial research is the existence of market discipline when creditors are at risk.

Another empirical regularity is the lack of market discipline where creditors are protected by government. This is the moral hazard created by government guarantees.

Let me say, as an aside, of course creditors, as well as management, misjudge or make mistakes. Markets are not perfect. But then neither are governments.

What makes the market superior at error correction is much stronger incentives facing market participants, as opposed to regulators. Creditors who have lent a bank millions, or billions, have a lot on the line. Regulators, who rarely lose their job because of a financial crisis, have little on the line.

In fact the problem facing regulators is not only weak incentives, but also perverse incentives.

As an asset bubble builds, for instance, the broader public and their elected representatives, will pressure regulators not to interfere with the instant wealth creating machine that bubbles appear to be.

My own experience, as staff on Senate Banking, during the growing housing bubble was a chorus of groups and individuals lauding the great wealth creation machine of homeownership. Democracy loves a bubble and whoa the regulator to dares to stand in front of one.

Regulators may also feel that speaking out against a bubble would undermine the confidence pushing said bubble. If confidence did evaporate, and the bubble burst, the regulator would be blamed. This was certainly the lesson the Fed took away from trying to pop the 1920s equities bubble.

It is far easier to simply let the bubble build and move in afterwards to clean up the mess. This continues to be the policy of the Fed. Sadly this also reinforces bad behavior. Not all banks behavior the same, even in the face of over-whelming regulatory pressure to do so.

When regulators come in during a crisis and protect failing firms they stop the market process of eliminating bad behavior. As you are aware, Citibank has, for instance, been rescued four times now. Those rescues have guaranteed that its broken corporate culture will continue to infect our financial markets. Just as nature evolves, so do markets, in the absence of government keeping failed firms in existence.

This again speaks to the incentives facing regulators. While they will not lose their jobs because of a bank failure, they do suffer embarrassment and may even be over-looked for promotion. They incentive facing regulators is to either allow those firms to grow their way out of their problems or else to use taxpayer funds for a rescue of said bank.

Recent studies have found, for instance, that short-sellers, in the aggregate, identify more corporate fraud than does the SEC. Recall that such failed firms as Enron, Fannie Mae, Countrywide, WorldCom and others, were all identified as engaging in misbehavior first by market participants, not regulators.

If anything regulators have been repeatedly rewarded in the aftermath of financial crises by even more power. Probably no institution failed more in responsibilities than the Fed, yet Dodd-Frank extended the power of the Fed. If anything, the incentives facing banking regulators are to reward them after a crisis rather than punish them.

Regulators quest for stability and avoiding firm failure has lead regulators to repeatedly restrict competition, protecting incumbent firms and allowing such firms to retain monopoly profits. Today for a new bank to open, it must receive approval from regulators and one of the factors which regulators use to approve or disapproval new charters is the competitive impact on incumbents.

The logic is that giving banks some monopoly power encourages them to be more risk-averse and to protect their franchise value. This logic is not without some basis in reality. However the cost of this protection is both higher costs for consumers and the protection of bad business practices that would otherwise be eliminated by competition.

Even when regulators aren’t intentionally trying to reduce competition, regulatory barriers can have that impact, often causing tremendous harm.

Take for instance the regulation of mortgage brokers, one group associated the financial crisis. Professor Morris Kleiner, who teaches here at the Humphrey School of Public Affairs, has found that leading up the mortgage crisis, the more stringent was a state’s regulation of mortgage brokers, the higher was the rate of mortgage defaults.

The lesson here is that regulation, rather than protecting the public good, creates market power, which reduces the effort of incumbent firms. We have witnessed similar results in the federal regulation of credit rating agencies.

Financial regulation is often justified because it is claimed that banks are inherently unstable. Nothing could be further from the truth. The foundation of our federal system of banking regulation, created in the progressive and New Deal periods was a reaction to widespread failures among small banks. The reason for such failures was the restrictions imposed on bank branching by states.

Such restrictions reduced both geographic and scale diversification by banks. As recently as the 1990s some states continue to restrict banks to a single location. Obviously that makes said bank highly vulnerable to local economic conditions.

Countries without such restrictions have faired better during times of economic distress. For instance Canada, which suffer a similar decline in GDP during the Great Depression, did not witness one bank failure during that time, and that is despite not having a central bank or deposit insurance at that time. What it did have was a geographically diversified banking system.

This is not result is not limited to Canada. Empirical studies of the period support these results across countries. More recent studies from both the IMF and World Bank also find that the more extensive a country’s bank safety net, the more frequent and severe are its financial crises.

What we have essentially created in the US is a system of local monopolies, insulated from competition. That would be bad enough if it were not also impossible for politicians to resist redistributing those monopoly profits to favor constituencies, ultimately resulting in financial failures driven by politics, not economics.

This is one reason why a mixed system is more unstable. Government cannot resist the temptation to redistribute the monopoly rents created by the barriers to entry it imposes.

Another reason is, as I’ve mentioned, the regulators incentive to cover up their own mistakes via bailouts reduces market discipline. If creditors know regulators will not allow Citibank to fail, then creditors will reduce their monitoring and disciplining of Citibank. This also creates the perverse incentive for banks to become larger and more complex in order to be perceived as TBTF.

The last hundred years of banking regulation has been a continued trend of replacing market discipline with regulation. The result has been more bank failures, not less. This year marks the 100th anniversary of the Fed. We have had over twice as many bank failures in the last 100 years than we did in the 100 before the creation of the Fed. This result holds even once you control for number of banks.

Even President Obama’s first CEA director, Christina Romer, has found that the economy since the Fed has been no more stable than before its founding. We also witnessed those states with their own deposit insurance schemes having higher bank failures during the Great Depression.

In the absences of government provided safety nets, banks and their creditors would take off-setting precautions. We witness similar behavior in the hedge fund industry, where the typical hedge fund is leveraged two to one, whereas the typical bank is leveraged ten to one. Of course bank leverage was not so high before the creation of the federal bank safety net.

In fact the closer you are to politics, the more highly leveraged an institution becomes. Freddie Mac’s credit guarantee business was leveraged over 200 to 1 during the crisis. In the absence of an implied government guarantee, no company would be allowed by creditors to become so highly leveraged.

One of the rationales given for bank regulation is the possibility of contagion. That is having troubles at one bank spread to another. Let me be crystal clear. There is not one example in US banking history of a healthy, solvent bank failing due to a run. Contagion failures are the unicorns of finance. It’s badly managed & insolvent banks that fail and they do not bring others down with them.

Bad policy and macroeconomic disturbances can also create bank failures. The highest year ever for bank failures, 1933 where over 4,000 banks failed, was a direct result of FDR’s move to take the US off the gold standard. Like depositors in Greece today, depositors in 1933 did not wish to see their currency devalued. Recall the FDIC was created under the Banking Act of 1933, signed in June. Bank failures continued throughout that year.

The FDIC was created to keep poorly run and undiversified small banks in business. As FDR, who opposed creation of the FDIC, recognized, this would create more failures not less.

Given the time limitations, there are a number of issues I’ve left unaddressed, focusing mostly on the differing incentives facing regulators relative to market participants. Let me wrap up with a brief mention of other critical issues.

I’ve mentioned that banks can fail in mass due to a common shock, such as currency devaluation or bursting real estate bubble. One characteristic of a stable financial system is one where the probably of failure across institutions is not highly correlated. Quite simply you want a diversity of balance sheets and business models. Regulation has generally pushed for uniformity.

Regulating all the banks, or financial institutions, the same will increase the likelihood they all fail in mass, as they will respond similarly to the same shocks, such as real estate bubbles. Given the appropriate due process and rule of law considerations, I believe US banking regulation will always push for a high degree of uniformity, ultimately turning what would be small shocks into systemic ones.

I’ve also set aside the question of whether regulators or politicians even know the correct regulatory scheme to implement. Of course no one knows this ex ante. One of the great advantages of markets is their superior ability to create knowledge, because they can coordinate the thinking and opinions of millions of individuals. Given the slowness of regulators to even recognize problems in the housing market, regulators clearly face severe knowledge problems, even assuming they faced appropriate incentives.

Let me close with a reminder. Yes our analysis must be based upon the actual imperfect workings of real world markets. However our analysis must also be grounded upon the actual imperfect workings of government. Identifying market failures is the beginning of analysis, not the end.
Mark A. Calabria is director of financial regulation studies at the Cato Institute.