The Appropriate Role of Bank Regulation

Abstract

The appropriate role of bank regulation, or whether banks should be regulated at all, has long been a matter of controversy. Banks are the oldest and largest financial institution. Their liabilities serve as money, which distinguishes them from non-financial firms, for which government regulation is generally less pervasive and more limited. We believe that most of the arguments that are frequently used to support special regulation for banks are not supported by either theory or empirical evidence. We also argue that banks should be regulated prudentially only to reduce the negative externalities resulting from government-imposed deposit insurance. Banks are believed to be inherently unstable because they are structurally fragile. The perceived fragility stems from their maintaining low ratios of cash reserves to assets (fractional reserves) and capital to assets (high leverage) relative to their high short-term debt. But such fragility does not imply instability if depositors and bankers are aware of it and act appropriately. This appears to have been the case in most countries. In the United States, the bank failure rate was lower than that for non-banks from I 865 until the establishment in I9I3 of the Federal Reserve System. This occurred despite restrictions that prevented banks from diversifying geographically through branching. Ironically, the failure rate increased only after the establishment of a central bank that was intended to reduce the severity of bank crises. Before the United States had a central bank, banks themselves established private clearing houses, resembling the private central banks in other countries, to provide both prudential supervision and prevent abrupt local declines in the assets that served as bank reserves and money. Nevertheless, we take as given not only a government central bank, but also government-operated deposit insurance. Thus, we do not disagree greatly with Dowd's defence of free or laissez faire banking, but focus instead on how banks should be regulated in an existing non-laissez faire structure to achieve the best of both worlds.