Government Intervention in the Regulation of Financial Markets

Introduction

Regulation may, in fact, not be necessary in financial markets. Discussed here are some issues pertaining to why we may feel it necessary to heavily regulate our financial system and the problems it attempts to overcome. Following this is a discussion on financial markets without regulation. With a vast amount of criticism currently being directed at regulation and its effectiveness at preventing crises such as the one we are currently in, we look at how left to free trade all the problems regulation seeks to overcome could be solved naturally.

Advantages of Financial Regulation

Problem of Grid Lock

Without a regulator in the system there are instances when a grid lock, Llewellyn (1999), can occur. This happens when, despite knowing how they should act in relation to their customers, banks take on risky policies in order to increase short term profits. It is made more likely by them having no assurance that other banks are not following similar policies. These policies may only come to light in the long run. This can result in two problems, adverse selection and moral hazard.

With adverse selection good firms may be forced out of business by the bad as their more risk adverse policies produce smaller profits. With the moral hazard problem there is the risk that the good banks will be persuaded to follow suit and take more hazardous approaches to their deposits. This could be because they see others taking these routes and the profits that are resulting, or that they have no confidence in the other bank not undertaking these policies.

Herd behaviour is another problem here. Banks will be far more likely to follow each other if there is safety nets in place. If management adopts the riskier policies of the bad banks then should it pay off and deliver high profits they will be rewarded and congratulated, however should it pay off and they had not themselves adopted those policies they will be held responsible for that. Should the policy fail all those that had adopted it will fail also, so the problem will not be solely with that bank but with all. A role for regulation here is to set a minimum standard that must be followed by all banks. It can break the grid lock by providing a guarantee that all banks under a specific regulator have to abide by these rules.

Moral Hazard

A further issue of moral hazard arises with the safety net that regulation provides; deposit assurance and lender-of-last-resort. With a lender-of-last-resort in place in can lead banks to undertake higher risk policies. Depositor insurance can then result in depositors being less careful as to where they put their money, and may actively seek higher risk banks on the basis that with those higher risks comes a higher reward and should the bank fail their money is safely backed by the government. In general terms, with the presence of a safety net firms in the financial system are able to a degree to pass their risk onto others and this can affect their behaviour negatively. Regulation must be set in place here so as to ensure that these problems never arise. In any form of insurance contract there is moral hazard, the insurers usually attempt to minimise the potential for the insured to be able to take advantage of it.

Disadvantages of Financial Regulation – The Alternative

A Laissez-Faire System

Arguments for no financial regulation, for financial laissez-faire Dowd (1996), are in fact rather straightforward. In the wider economy it is generally taken that free trade is best for markets. If this is the case then all forms of intervention by the government is unnecessary and should be brought to an end. On the most part economists are pro free trade, however they state that in the case of financial services it is not applicable. Despite a general consensus of this opinion there is no rational justification of it.

In order to discuss this Dowd (1996) states three general points which we must take into account. Firstly, if - as is generally agreed – free trade is a positive in markets there must be at least a basic argument for no regulation. Unless proof showing that it could not work in a particular scenario is given, the assumption is that it would apply to that scenario. Secondly, a great deal of the opposition to free banking is based on habituated thinking. We have been made to think that regulation of the financial markets is necessary. Lastly, there is a vast amount of evidence in support of free banking; it shows that a financial sector with no regulation can be stable.

The free banking economy would evolve itself. The economy itself is not without fault; asymmetric information, moral hazard, agent-principle problems, and so on. As a result of its imperfections intermediaries are created. These intermediaries filter out these problems, achieving better outcomes collectively including reduced costs.

Those defending regulation may say that this would create an unstable system; there is no lender-of-last-resort or deposit insurance. Depositors would want assurance that their money is safe should something happen. The banks would be aware of this and that for the bank to continue they would have to be able to instil confidence in their customers. To get this confidence the banks would ensure a reduced risk lending policy and they would open themselves more to the outside to show their stability. Capital is another key to ensuring the banks remain stable. The higher their capital the greater losses they can absorb while still having the funds to pay their depositors. There is significant evidence to support that banks would maintain high capital ratios under no regulation Kaufman (1992). There are also case studies in Dowd (1992) showing evidence of minimal failures and losses of other systems which remained mostly unregulated.

Competitive Pressure and Contagion

Competitive pressure and contagion between weak and strong banks need not be a factor either. There would be no pressure for good banks to follow policies of bad banks in order to match their short term growth. The bad banks can only generate larger growth through riskier policies which would be detrimental to their long term growth. The good banks can maintain risk adverse policies, strengthen themselves financially and subsequently be better placed to gain customers when the bad banks suffer losses and a reduction in depositor confidence. The good banks would therefore maintain normal short term profits to be better in the long run. Similarly good banks will want to distance themselves from the bad banks, and if they felt that there was a possibility of contagion they would strengthen themselves and reduce their interaction with the weak banks. They would be able to place themselves as a refuge for depositors leaving the weak banks. Evidence stating bank runs are contagious is weak Benston, et al., (1986) so those making a run on the weaker banks will then look for quality and move to the good banks who have a stronger position.

Moral Hazard

The issue of moral hazard comes into effect as a result of government intervention in the form of a central bank and its role as lender-of-last-resort and also deposit insurance backed by the government. A lender-of-last-resort is there to protect bad banks from failing, those banks which are good and strong have no problem getting loans and ensuring their liquidity. This facility therefore pushes banks to undertake greater risk policies and to feel less obliged to hold higher capital ratios as they will always be bailed out should something go wrong. This will encourage the good banks to follow suit and take on greater risk rather than sacrificing short term growth to gain over in the long run, as even if the bad banks fail they will be supported by the central bank allowing them to continue.  Deposit insurance gives the depositors assurance that their money is safe even if their bank fails. This results in depositors taking less interest in the policies of the bank and of its management. Management therefore will find it easier to engage in risky policies to ensure a greater return. The deposit insurance can also make depositors more likely to go with banks that are riskier; if the risk pays off they get rewarded and if the bank fails they will simply recover their money through the insurance scheme.

Conclusion

Efficient and adequate regulation can have some key benefits. If done correctly regulation can overcome problems of transaction costs, it can solve the discussed problem of grid lock, enhance customer confidence in the market, help remove the issue of moral hazard and through required disclosure can improve customer knowledge – reducing asymmetric information problems – and allows them to better understand any contracts which they enter into. Although in principle regulation seems the only course of action in order to ensure the financial system operates properly, it has been shown that regulation may not always be the answer and an unregulated market can be superior to a regulated one – which itself can cause some of the problems it seeks to overcome. Through free trade the market would correct itself and remove these problems naturally.

References

Benston, et al., 1986. Perspectives on Safe and Sound Banking: Past, Present and Future. Cambridge, MA: MIT Press.

Dowd, K. ed., 1992. The Experience of Free Banking. London: Routledge.

Dowd, K. 1996. The Case for Financial Laissez-Faire. The Economics Journal, 106(May), pp.679-687.

Kaufman, G.G. 1992. Capital in Banking: Past, Present and Future. Journal of Financial Services Research, 5(4), pp.385-402.

Llewellyn, D. 1999. The Economic Rationale for Financial Regulation. Occasional Paper Series; The Financial Services Authority April.