Wednesday, December 16, 2009

The House’s proposed bank regulation fails to address adverse incentives,

and even reinforces some.

Government regulations tend to ignore the private incentives that elicit quality products. This is perhaps best seen in the product-specific subsidies of official health care that discourage consumers from acquiring information about costs and qualities, and suppliers from developing reputations. But it is also seen in banking regulation, such as deposit insurance. What do we care about our bank’s safety if our deposits are insured against loss and even inconvenience? The FDIC insures that the availability of our deposits is not interrupted as the new bank takes them over (usually with a subsidy) from our old failed bank. What do we care about the costs of our medical services if someone else is paying?

The reduced concern for risk due to deposit insurance has been limited by ceilings on the amounts insured ($5,000 in 1934, $10,000 in 1950, $100,000 in 1980, and $250,000 in 2008, at first “temporarily” until the end of 2009, then extended to January 1, 2014; although coverage is increased by multiple accounts), which means that large depositors (such as firms with payrolls and other large bills) might have had incentives to monitor their banks. But even this positive residue is eliminated by the regulators’ philosophy – underwritten by Congress – of too big to fail.

House Democrats have promised to end this problem in a “sweeping financial regulation bill designed to prevent another financial crisis.” “The bailouts of AIG and Bear Sterns would not be possible – made illegal – under this bill,” Barney Frank , chairman of the House Financial Services Committee, said last week. “If a company fails, it’ll be put to death.”

Experience tells us of the vacuousness of this resolution. Frank was a leader in the bailouts arranged by panic-stricken Congresses and administrations in 2008 and 2009. His successful lobbying for TARP funds for a local bank that had received a cease and desist order from the FDIC for unsound lending practices and excessive executive pay and perks is well known.

The Federal Deposit Insurance Corporation Improvement Act of 1991 that followed the bank failures of the 1980s was intended to reduce the TBTF doctrine. “A two-thirds majority of both the Board of Governors and the directors of the FDIC, as well as the approval of the Secretary of the Treasury, are required” to agree that a bank’s failure would “have serious adverse effects on economic conditions or financial stability” (Mishkin, p. 279). The Fed was directed to stop lending to insolvent institutions.

The futility of these resolutions, no matter how often thay are repeated, will continue until the incentives of government officials, elected and appointed, have changed.

Other components of the current bill according to news reports are “more oversight and higher capital requirements,” and a new Consumer Financial Protection Agency to oversee consumer financial products lie credit cards and mortgages.”

We have seen the ineffectiveness – and worse -- of capital requirements. They are easily evaded and used as cover against serious regulatory oversight, and contributed to the recent financial crisis. They induced banks to reduce risk (so the regulators believed) through credit default swaps issued by AIG, which allowed them to make riskier loans. Banks should have known that these bets on the state of the economy violated a basic requirement of insurance, which is independence of risks, but they succumbed to the regulatory incentive to buy them (Carrey March 2, 2009).

The new “protection” agency will be seen, like other agencies in the past (such as the Interstate Commerce Commission and the Securities and Exchange Commission) to reduce competition and consumer choice. Those who will enjoy the most protection will be large firms at the expense of consumers. Nothing fundamental has changed

As a rule, regulation is acquired by the industry [despite its pretended protests for the public’s benefit] and is designed and operated for its benefit.

George Stigler

A few hundred billion dollars extra won’t hurt, either.


John Carney. 2009. “How bank regulation helped destroy AIG,” The Business Insider, March 2.

Fredric Mishkin. 2006. The Economics of Money, Banking, and Financial Markets, 7th ed. Pearson Addison Wesley.

George Stigler. 1971. “The theory of economic regulation,” Bell Journal of Economics and Management Science, Spring.