Why Regulate Banks?

Why do we regulate banks? As George Benston and George Kaufman point out in an article in the May 1996 issue of the Economic Journal, they don''t serve food that might sicken unsuspecting customers and they don''t deal in dangerous materials that might explode or cause plagues. Rather, they provide checking accounts and investment services, make loans, and facilitate financial transactions. Why should we be concerned about what they do any more than we are about what any ordinary business does?

Most economists agree that unregulated businesses generally serve consumers and the economy best if markets are competitive. But banking in most countries tends to be regulated. Professors Benston and Kaufman examine a variety of valid and less valid reasons why:

  • One reason might be that banks produce the nation''s money supply – cheques. To protect our money, banks should not be allowed to take great risks that might cause them to fail. But today, the central bank controls the money supply. If people are concerned about a bank's failing, they simply transfer their funds to another bank. Of course a bank failure is costly to some people; but so is the failure of any firm of comparable size.
  • Another possible reason is maintenance of the public's confidence in the banking system. Unless people are confident, the argument goes, they might all try to withdraw their funds at once. If so, the bank will fail because it is likely to suffer losses on hurried disposal of assets to meet the withdrawals. This argument has some serious flaws: first, there is very little evidence that there were ''runs'' on banks that were not insolvent. Runs on insolvent banks are beneficial, as they both force the regulators to deal with the bank and keep bad bankers from making more mistakes in a bid to make it solvent again. Second, if bankers are afraid of runs, they will be encouraged to manage their banks more carefully and prudently.
  • A third reason is that deposit insurance is provided by law or practice by governments of most countries. If depositors are protected from loss, they have little reason for concern. This may save them some trouble, but it also frees some banks to take greater risks. The cost of these risks is borne first by well run banks that have to bail out the depositors of banks that fail by paying insurance premiums or assessments; and second by taxpayers when the insurance agency''s funds are exhausted and the government pays the bill. But it is not necessary or desirable for government officials to restrict what banks do. All that is necessary is for the banks to hold sufficient capital so that the owners bear the cost of losses and mistakes. The government''s job is to make sure that banks actually do hold enough capital.
  • Prior to deposit insurance, the most important reason that banks have been regulated in the past is political: to benefit government officials, their friends, bankers or their competitors. Early bank regulation took the form of restricting entry into banking to produce monopoly banks. Governments, officials, and their friends either owned these banks or got loans at favourable interest rates. Banks'' activities were generally restricted to benefit their competitors. Consumers were and still are the losers.

Benston and Kaufman conclude that if there were no deposit insurance, there would be no appropriate role for bank regulation for economic reasons, assuming that the goal is to benefit consumers. Given deposit insurance, the appropriate role for government regulators is to ascertain that banks have sufficient capital to absorb most losses and, when they do not, oversee them closely until they repair the shortfall or cease operations with minimum, if any, loss to depositors, the insurance agency, or taxpayers.

'The Appropriate Role of Bank Regulation'' by George Benston and George
Kaufman is published in the May 1996 issue of the Economic Journal in the Controversy section:
''Should We Regulate the Financial System?'. Benston is at Emory University; Kaufman is at the
Loyola University of Chicago.