Who Will Regulate the Bank Regulators?

by Robert P. Murphy
Mar. 16, 2015

A fascinating report by Finn Poschmann from the C.D. Howe Institute discusses the history of bank regulation in the U.S., Canada, and U.K. It explains the movement away from shareholder liability in banks, towards the current system where taxpayers are ultimately on the hook for a bank’s solvency. This leads to a situation of “moral hazard” where bank managers do not have the correct incentives for prudence, and where bank depositors and shareholders do not have the correct incentives to monitor them.

An excerpt from the study:
[U]ntil the mid-20th Century, banking regulation in the United States, Canada, the UK and elsewhere relied mostly on monitoring by shareholders and depositors. Central banks did not necessarily exist, and where they did, they did not necessarily have a modern lender-of-last-resort function. There were financial regulators, but depositors were expected to pay attention to the behaviour of the banks that held their savings. Senior bank managers often were exposed to liability for net losses incurred in the event that their financial institutions failed, as were other shareholders.

The limited-liability corporate form, while it existed, did not apply to deposit-taking financial institutions. The reason was that owner-managers of banks often had incentives, and the capacity, to use for their own benefit the funds they held on behalf of others. Nonetheless, while bank runs, failures and crises occurred, bank depositors were nearly always made whole, and financial crises tended to be sharp, brief, and localized.

Over the course of the 20th Century, shareholder liability, or double liability as it is often called, disappeared from the regulatory framework, to be displaced by deposit insurance, which has the political and economic attraction of reducing the incidence of bank runs and limiting their impact on depositors.
For the full history, I encourage interested readers to read the study itself. Let me motivate the discussion by some thoughts on the United States’ program of deposit insurance, called FDIC (the Federal Deposit Insurance Corporation).

The FDIC was established in 1933 in one of the first Acts in the new Roosevelt Administration. The way most people think of it, FDIC is an “obviously” beneficial institution that greatly reduces the scourge of bank runs (which had been a huge problem in the U.S. during the early 1930s, though not in Canada–a fact that already casts doubt on the standard narrative).

By federally insuring depositors’ funds in a commercial bank (up to a certain threshold), FDIC would remove the temptation for depositors to “run” on a bank when news surfaced of its troubled investments. Confidence is vital in modern banking, since the practice relies on “fractional reserve” practices. By their very nature, modern banks are illiquid, engaging in maturity mismatch. They take in deposits that are callable upon demand, and yet invest those funds in longer term assets.

The problem with FDIC (and similar programs) is that they reduce the incentive for depositors to monitor the banks. People open up checking accounts based on the convenience of a bank’s branch and ATM locations; they don’t do research on the bank’s investment portfolio. Thus the system as a whole is more vulnerable to the very problems that would cause bank runs in the first place.

As in so many other areas, State intervention to fix an alleged problem with the free market only makes things worse.
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Robert P. Murphy is the author of The Politically Incorrect Guide to Capitalism, and has written for Mises.org, LewRockwell.com, and EconLib. He has taught at Hillsdale College and is currently a Senior Economist for the Institute for Energy Research. He lives in Nashville.













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