Why the Banking System Should be Regulated
Author(s): Sheila C. Dow
Source: The Economic Journal, Vol. 106, No. 436 (May, 1996), pp. 698-707
Published by: Wiley on behalf of the Royal Economic Society
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The EconomicJournal, io6 (May), 698-707. ? Royal Economic Society I996. Published by Blackwell
Publishers, Io8 Cowley Road, Oxford OX4 iJF, UK and 238 Main Street, Cambridge, MA 02I42, USA.
WHY THE BANKING SYSTEM SHOULD BE
REGULATED*
SheilaC.Dow
It has long been taken for granted that the financial system should be
regulated. That this should now be open to question is to be welcomed. It is
important in general to question assumptions,but it is particularlyimportant
to do so in the case of a sector which has undergone such major change over
the last few decades. It is necessarythereforeto go back to firstprinciplesand
examine the implications of these principles in the current environment. The
outcome outlined here is a renewed case for regulation, but one which takes
account of the changing nature and role of banks. Historical evidence aids our
understandingof thesechanges, but historicalevidence must be usedwith care;
the advocates of free banking misinterpretand misusethis evidence to support
their position.
The case for regulation restson the very special economic role of money and
the uncertainty associated with it. This uncertainty in turn renders free
banking unworkablesince the proposalrequiresthe non-bank public to assess
the expected value of the portfolios of the issuers of money. Adequate
knowledge could only be generated if money-issuing were concentrated in a
dominant institution, or set of institutions,which operated like a central bank.
This outcomewould only occur, and be sociallyacceptable, given a high degree
of social cohesion. Rather than eradicatingregulation on the grounds that it is
flawed, and risking financial chaos, the more appropriate response is to
consider how to improve regulation.
I. BANKS AS PRODUCERS OF MONEY
Because banks' liabilities are used as money, their redeposit ratios are
sufficiently high to allow them to hold longer-term assets without fear of
illiquidity. The primary purpose of prudential regulation has been to ensure
that banks'assetsretain sufficientliquidity to meet any reductionin redeposits,
and to discourage such a reduction in the firstplace. Regulation is warranted
because the moneyness of bank liabilities is a public good: moneyness (rather
than any particular money asset) satisfies the conditions of non-rivalry-inconsumption
and non-excludability-in-exchange. The state produces moneyness
by inspiring confidence in money's capacity to retain value. This
confidence underpins the performanceof money's role as means of payment
and store of value. But most of all it underpinsmoney's role as unit of account
and thus denominator of contracts, which are central to the functioning of
modern economies (see Davidson, I978; Heinsohn and Steiger, I989).
The context of this latter argument is that the functioning of economies is
fundamentally conditioned by uncertainty. The term uncertainty is not used
[ 698 ]
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[I996] WHY THE BANKING SYSTEM SHOULD BE REGULATED 699
here in the sense of a learning gap which in principle can be closed. Rather it
refers to unquantifiable risk - a learning gap which can never, even in
principle, be closed. Uncertainty in this sense pervades the economic process,
colouring the decisions to consume, invest, supply labour and allocate wealth.
In order for the economic process to proceed in spite of uncertainty, society
adopts conventions as a basis for expectation formation, and, supported by the
state, creates elements of stability to aid decision-making (see Hodgson, I988).
The legal system supports the establishment of contracts, while the provision of
outside money and bank regulation and supervision supports the evolution of
a banking system which produces money as an asset to hold in times of
particular uncertainty. Just as money's role is integral to the economic process,
so the state's role is integral to the evolution of private sector institutions and
conventions. While it is conceivable that the private sector could evolve such
institutions and conventions without state support, and indeed can be said to
have done so in particular historical instances, there is no guarantee that it
would do so.
Money is the ultimate object of liquidity preference. Understood in flow as
well as stock terms (see Dow, I993, pp. I65-8), liquidity preference operates
simultaneously on both sides of the banks' balance sheet. In addition to
influencing the demand for bank deposits, liquidity preference also influences
the expenditure and borrowing plans of the non-bank sector, as well as the
willingness of banks to extend credit. A generalised increase in liquidity
preference thus creates a paradox of liquidity (see Dow, I993, pp. I46-52) just
when the demand for bank deposits rises because of increased uncertainty
about asset values, their supply may be curtailed by a credit crumble. The
financial system thus exacerbates the downturn phase of the business cycle.
Similarly, the reverse process exacerbates the expansion in output in upturns:
banks are most willing to expand credit just when demand for holding liquid
assets is at its lowest.
The reserve ratio in many countries no longer acts as an effective constraint
on credit, due largely to the priority given to promoting confidence in the
financial system through the lender-of-last-resort facility. Central banks can
use this facility to prevent an undue credit crumble when bank expectations
turn out to have been over-optimistic. The UK banking system has probably
gone furthest down the road of reducing required cash ratios: it is now almost
entirely an inside money system. The outsideness underpinning the banking
system is no longer a tangible metal, or even tangible liabilities of the public
sector, but the experience of bank regulation and supervision. The public's
concern, insofar as it exists, is that deposits might not be accepted as a means
of payment because of concerns over the banks' actual or perceived solvency;
a problem only of illiquidity, and perceived as such, can always be resolved by
interbank lending, or lending by the central bank. That the UK public is not
in general concerned about retail banks' insolvency, is a product of a long
history of bank regulation and supervision and the absence in recent history of
retail bank failures.
Regulation and confidence in supervision have acted as elements of stability
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700 THE ECONOMIC JOURNAL [MAY
in a system which provides the vehicle, money, for the economic process, in a
sector where expectations of asset prices are crucial and yet not covered by
quantifiable risk. The structure of the financial system has been undergoing
major change, which certainly invites a major rethink about regulation. But
moneyness itself is a convention, the product of centuries of experience. To
propose to remove these elements of stability and introduce a new convention
is bold to say the least; the confidence arising from many years' experience is
not to be dismissed lightly, nor can the behavioural effects of changing
conventions be predicted easily.
II. CRITIQUE OF FREE BANKING PROPOSALS
The proposal to free the banking system from regulation rests on a very
different view of money from that outlined above (see Smithin, I994, chapter
2; Dow and Smithin, I994): one which presumes that uncertainty is eliminable.
It follows first that there is no need for a perfectly liquid asset as a means of
payment; bank liabilities of diversely varying value will do. Secondly, it follows
that financial assets can be valued in the same way as goods, so that there is no
reason for banks to be regulated differently from other producers. Third, there
is no connection in their view between credit creation and the demand for
money (other than the increase in transactions demand which may follow from
a credit-financed increase in expenditure), with no consequent risk of
instability. Instability is therefore seen in micro terms as the result of unwise
portfolio decisions taken by individual banks, or imperfect information about
individual banks. While the law of reflux does not protect against a generalised
expansion, Dowd (I993, pp. 2I2-7) argues that the risk of adverse clearing
without a lender-of-last-resort would be enough to encourage individual banks
to buck the trend. But it is the presumed absence of uncertainty which allows
Dowd (I996) to argue that banks can actually detect overvaluation of assets
(implying, for example, that banks in recent years knowingly entered into the
situation which generated bad debts).
Ignoring true uncertainty has pervasive importance, not just for the nature
of the demand for money and the propensity for systemic instability, but also
for the operational feasibility of a free banking system. Free banking proposals
rest crucially on the market's capacity to value bank assets. In the absence of
state regulation and supervision, it is the market which is to discipline banks
into adopting prudent portfolios. Yet free bankers have not demonstrated that
the market can actually generate the knowledge by which to assess bank risk;
the word 'knowledge' is used advisedly- it is not a matter of complete or
incomplete information, but rather a matter of the ability or otherwise to
predict market values correctly, even within a probability distribution, and
even in principle. Free banking would certainly provide the incentive to
depositors to acquire more information about banks, but the question is
whether even complete information is adequate for correctly assessing risk with
respect to asset values.
The contrary argument is not that asset values can never be predicted, but
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I996] WHY THE BANKING SYSTEM SHOULD BE REGULATED 70I
that these valuations are contingent on a range of unknowns. There is
accordingly no sense in which one can talk in general of the 'true' value of a
bank's assets. Keynes (I937) outlined the conventions employed in practice
under uncertainty: giving undue weight to current trends, and relying on
conventional judgements and on the judgements of experts. A conventional
view might emerge, through the pronouncements of pundits for example, that
a bank's portfolio is unbalanced, with the effect of encouraging a run on the
bank. But, as Davis (I992) points out, it is extraordinarily difficult even for
central bank supervisors of banks (whose raisond'etreit is) to determine whether
a bank has-a liquidity problem or a solvency problem. That is why prudential
regulation needs to be backed up by the lender-of-last-resort facility. Goodhart
(I993) argues in similar vein that private sector deposit insurers would face
insurmountable difficulties in gathering adequate knowledge. It would be even
more difficult for small deposit holders, and it is for this reason (without
considering its wider implications) that Kaufman (i99i) advocates deposit
insurance to reassure small depositors.
Recognising that unwarranted runs might occur, Dowd (i989, pp. 27-3I)
proposes, in the absence of an insolvency problem, that option clauses be
invoked when bank reserves are reduced. Banks would retain the option not to
redeem their liabilities, with some compensation if the option were taken up.
Dowd (I995) takes convertibility as an institutional given, necessary for
stability at the level of individual banks and as a source of general price
stability. This would certainly be a reversal of recent banking history, in which
the notion of an outside medium of redemption has become progressively less
important. But if he is right that such a reversal is required, and if the public
are not assured of redemption on demand, it is not clear how much confidence
would be generated by the expectation that redemption would only normallybe
forthcoming. The use of the option clause, or even the possibility of its use,
reduces the liquidity of bank liabilities and thus their moneyness. If redemption
is as crucial for bank stability as Dowd argues, then option clauses would
threaten that stability.
In order to satisfy the need for a safe asset, deposits would be attracted to the
liabilities of those banks inspiring most confidence. While technical economies
of scale in banking are not sufficient to induce concentration, there are
significant economies of scale in generating confidence. The conventional
judgement on confidence-inspiring portfolios would tend to favour large, wellestablished
banks. This judgement would be reinforced continually by its
consequence of high redeposit ratios for these banks. The liabilities of these
banks would then dominate as media of exchange, and would tend to be held
as reserves by the smaller banks. The stability of the smaller banks would then
depend on the stability of the large banks, and the capacity of the large banks
to assess the credit-worthiness of the small banks and to discipline imprudence.
The stability of the system in other words would depend on the capacity and
willingness of the large banks to act like a central bank.
The Benston-Kaufman proposal for a modified free banking scheme,
whereby there would still be a central bank whose purpose would be to supply
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702 THE ECONOMIC JOURNAL [MAY
the banking sector with adequate liquidity, would address the issue of systemwide
instability up to a point. But there would be no direct lending of last resort
to individual banks, and no supervision; supervision is seen as being superseded
by risk-assessment by (competing) federal insurance agencies. It would be up
to the interbank market, then, to decide on the terms on which reserves might
be borrowed. But it has not been demonstrated that the allocation of reserves
by the market would be based on better knowledge than that available to a
central bank with a supervisory apparatus.
Already the banking system has moved in the direction of free banking by
having capital adequacy ratios as the centrepiece of regulation. If banks want
to expand credit, then they must convince the market that it is warranted. But
the market has shown itself to-make judgements which, in aggregate, are at
odds even with available, concrete information. The market was remarkably
sluggish in absorbing even the most obvious implications of the debt crisis. Free
banking enthusiasts might argue that this myopia with respect to fundamentals
is induced by the sense of security provided by the state, i.e. by moral hazard.
But the onus is on them to prove that, without that sense of security, the market
would have anticipated correctly the consequences of the increase in sovereign
debt in the I970s, for example.
Moral hazard is in any case far from pervasive in a regulated system. Banks
faced increased uncertainty in the I970S and 198os, first with increased
exchange instability, then with crumbling asset values, and finally with
increased competition due to deregulation. Even with deposit insurance and
lender-of-last-resort facilities, banks expressed increased liquidity preference by
shortening the term of assets, securitisation and so on (see Strange, I986;
Gardener, I988). If such tactics were applied successfully (and that is a big
'if'), they could protect banks from failure in a free banking system, but this is
a far cry from Dowd's image of the prudent banking system meeting the
economy's needs.
Finally, free bankers argue that the risk of contagion does not justify
regulation. It is argued that deposits would simply be transferred from the
banks with unsound portfolios to banks with sounder portfolios, thereby
encouraging sound portfolio management. But this argument ignores the
potential for systemic instability. As Minsky's (i 982) theory elucidates, fragility
increases for the financial system in general as the economy proceeds through
an expansionary phase. Thus unrealistic expectations of asset values on the part
of one bank are highly likely to be mirrored by unrealistic expectations on the
part of other banks. Any resulting contagion would not be unreasonable; it
would be the result of a change in conventional judgement about banks' asset
values. This is where the Benston-Kaufman proposal is superior to the other
free banking proposals: in the situation of a reversal in expectations about asset
values, an increased supply of liquidity into the system (by the central bank)
is the best policy for limiting the potential for instability.
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1996] WHY THE BANKING SYSTEM SHOULD BE REGULATED 703
III. THE HISTORICAL EVIDENCE
The historical evidence both of regulated and unregulated banking systems
lends support to these arguments, contrary to the claims of the free bankers.
However, historical evidence should only be addressed with great care to
thought experiments designed for modern application. Chick (I992; I993)
argues convincingly that banking systems proceed through an evolutionary
process,duringwhich the natureof causalforceschanges.The need to generate
confidence in banking systemshas encouraged the state to evolve a regulatory
presence, but the outcome has been an ever-increasingcapacity in the private
sector to determine the volume and allocation of credit. This capacity is
compounded by the massivefinancial superstructurebuilt on the foundation of
bank deposits as ultimate liquidity. The scope for systemic instability in the
absenceof countervailing action by the state is accordinglyincreased.Further,
the notion of commodities, or commodity-linked assets, as bank reserveshas
been replaced by a combination of governmentliabilitiesand confidencein the
state's capacity to encourage prudent bank behaviour. The free banking
supporters are thus proposing to jump back from Chick's seventh stage of
banking development to stage three.
Few would deny that there have been periods of significant financial
instability when bankshave been regulated (see Minsky, I982; Kindleberger,
I978; Davis, I992). The case is easiest to make with respect to the United
States, where the regulatory system has been conditioned by a dual statefederal
structureand strongly conflicting interests.Yet it does not follow at all
that the only reasonablealternativeis no regulation. Many episodesoffinancial
instability can be traced to misguided attempts to use regulatory power to
control the money supply; since such a project is unworkable (see Goodhart,
I994), it is not surprisingthat it should produce instability. Yet, free bankers
share the monetarist view (applicable if at all only to early stages of banking
development) that inflation is determined by the money supply which in turn
is determined by bank reserves. Money supply regulation is accordingly the
focus of their attention (see Benston, I99 I, and Kaufman, I99 I). The import
of the argument presentedhere is that more attention needs to be paid instead
to prudential regulation.
Benston and Kaufman (I995, I996) conclude from the US evidence that
financial fragility is not the result of bank behaviour since it has tended to
follow rather than precede failuresin the real economy. But their evidence of
financial instability accentuating instability in the real sector, far from
contradicting Minsky's theory, actually supports it. It is in the nature of
systemic fragility that the real and financial cycles are closely interrelated.
Credit expansion to finance productive activity is diverted to unproductive
activity when the real cycle turns around; financial euphoria takeson a life of
its own which is eventually curtailed because high leverage makes borrowers
particularlyvulnerable to any normal shock. This pattern has been reinforced
by the increasingparticipation of industrial companies in financial marketsas
lenders as well as borrowers.Thus, while the bursting of a euphoric financial
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704 THE ECONOMIC JOURNAL [MAY
bubble can be identified with the failure of individual financial institutions, it
is systemic fragility which accounts for the systemic consequences of such micro
failures.
The evidence of historical episodes of free banking is perhaps most pertinent
to the debate. There has been some dispute in the literature as to what actually
constitutes an episode of free banking. For example, the experience of Scotland
in I695-I845 cannot be isolated from the presence of the Bank of England.
The Canadian free banking experience of I820-I935 was coloured by the fact
the Bank of Upper Canada and the Bank of Montreal were owned to a
significant extent by politicians in Upper Canada and Lower Canada
respectively.
At issue here is not just the question of how to interpret evidence, but the
deeper question of whether the purist version of free banking as free competition
is actually meaningful. Conventions and regulation exist along a continuum,
with the only ultimate distinction being that it is the state which enacts
regulation; but then the state and centres of power in the private sector also
exist along a continuum. It is not legitimate to focus, as Dowd (i 996) does, on
a dual of regulation/laissez-faire. Given the central historical role of the State
and of long-established conventions in the financial sector, the onus is on free
bankers to demonstrate the merits of overturning history, not the reverse.
Indeed the successful episodes of free banking were those which evolved
conventions which closely mirrored state regulation. There has been a wide
range of free banking episodes, but the two to receive most attention until
recently are the United States case and the Scottish case. There is dispute as to
whether the United States experience constituted a success (see for example
Gorton, I985; Dowd, i989, chapter 5), but the Scottish experience has been
widely used to support influential arguments for free banking (see for example
White, I984; Dowd, I989; Hayek, I990).
While the Scottish case can indeed be interpreted as successful, it can also be
seen to illustrate the arguments made above about the unworkability of the
type of free banking scenario put forward by Dowd (I996). (See Dow and
Smithin, I992.) First, the banking system evolved its own form of central
banking. The two 'old banks', the Bank of Scotland and the Royal Bank of
Scotland, set up a note exchange and an exchange equalisation system,
accepted the notes of other banks to curtaii runs (most notably in the case of
the Ayr Bank), disciplined banks whose credit creation was judged excessive
(by refusing access to clearing) and made representations to Westminster on
behalf of the banking system as a whole. The other banks in turn held their
reserves with the old banks, which adopted an authoritative role, based on
market power, which does not square with Dowd's (i 996) 'club' interpretation.
While this system succeeded because central banking evolved naturally in
the private sector, it cannot be presumed that such would necessarily always be
the case. Scotland was a small, cohesive community, with strong and stronglyperceived
interdependencies. Indeed it would be unduly cynical, and a
misunderstanding of history, to argue that the activities of the two old banks
were motivated purely by narrow self-interest. Any self-interest was tempered
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I996] WHY THE BANKING SYSTEM SHOULD BE REGULATED 705
by a profound sense of community and the potential for strong social sanctions.
But it would be hard to argue that this would be a good general description of
the context of free banking were it to be introduced now. Without an element
of public-spiritedness among leading banks, it would be quite possible for moral
hazard to dominate, so that central banking and thus scope for financial
stability would not naturally emerge.
The Scottish experience also illustrates two further points. First, Dowd
(1989) lays much stress on the use of option clauses to preempt bank runs. The
clauses was used widely in Scotland in the early I76os by private banks which
were expanding credit rapidly. The I765 legislation forbidding use of option
clauses was enacted because representations were made to the old banks,
following public meetings, to lobby Westminster; the uncertainty attached to
the notes' value made them unacceptable to the general public. Indeed even
after I 765 public meetings resulted in boycotts of notes other than those of the
Bank of Scotland and the Royal Bank of Scotland because of continuing
uncertainty as to their value. Option clauses and uncertain value had removed
the moneyness of the private banks' notes.
Secondly, the consequence of the old banks' notes being the standard of
value encouraged concentration of the banking system. Certainly there were
periods of competition, but each wave of entry was followed by a process of
concentration. Such concentration is the natural consequence of the need to
satisfy the demand for a stable money asset. It is evident in a wide range of
banking histories, and is currently evident in the United States and in Europe
following the first flush of competition encouraged by deregulation. There is no
reason to doubt that a free banking experiment would also end up in
concentration in the banking system.
Finally, in more recent times, the debt crisis illustrates further the need for
central banking functions which naturally arises in a deregulated environment.
Sovereign debt expanded in the I970S on a flimsy knowledge base. When
banks' asset values collapsed, they were faced with the dilemma of whether to
write debts off or to reschedule, and concerns were voiced about the stability
of the international financial system. The solution was found by making
recourse to the IMF, whose knowledge base is much more extensive than that
of individual banks, which can take a system-wide view, and which has a wellestablished
supervisory apparatus. Faced with a systemic problem, the market
demonstrated its need for a world central bank which even goes beyond the
remit of national central banks.
Thus, at best, a totally deregulated market would throw up its own version
of a central bank, with its provision of a standard of value and its supervisoryregulatory
presence. But the long struggle in the United States to establish the
Federal Reserve System provides just one example of impediments in the way
of the emergence of central banking.
IV. THE FUTURE OF BANK REGULATION
What has been presented here is an argument against complete deregulation of
banking, or a restriction of regulation to deposit insurance and the generalised
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706 THE ECONOMIC JOURNAL [MAY
provision of lender-of-last-resort facilities to the system as a whole. It is an
argument for regulation on the grounds that the moneyness which is necessary
to the working of the monetary system is a public good. However it is not an
argument for complacency about bank regulation; regulation by its nature is
problematic and certainly involves costs (see Gowland, I990). But economists
should feel comfortable with addressing trade-offs between costs and benefits,
and suspicious of any proposal which is presented as a cost-less solution.
The regulatory issues facing us now arise from market structural diffusion
(see Gardener, I988), itself the product partly of deregulation. This diffusion
has altered the place of banks in the financial system and changed the
knowledge requirements of the market and of bank regulators. Experience with
attempts to promote European integration in banking demonstrates amply the
significance of different national market conventions, which in turn are
complicated by different regulatory traditions. What generates confidence in
one tradition is not necessarily what generates confidence in another tradition.
There is the additional question regarding the institutional separation of bank
supervision and attendant regulation from efforts to control monetary
aggregates.
Urgent regulatory issues are therefore posed by the potential for financial
instability which has arisen with a partial dismantling of regulation and from
the changing role and behaviour of banks themselves. To suggest a complete
removal of regulation as the solution to these issues is both to admit defeat and
to court disaster.
Universityof Stirling
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