Rethinking Bank Regulation: Till Angels Govern (Book review)

Contrary to the common view that banking regulations improve the security of bank deposits and reduce risky and careless behavior by bankers, the actual evidence is to the contrary: regulation and government supervision actually reduces the stability of the banking system. We can make conjectures as to the reasons for this: government supervision lulls the public into a false sense of security and allows bankers to behave recklessly. Or the regulatory agencies eventually become overly influenced by self-interested political powers. Or even the proponents of regulation actually have sinister motivations (certainly true in some countries). Regardless of the reason, the fact remains: regulations don't work.

In their pioneering and comprehensive study of 150 banking systems around the world, internationally known banking experts James Barth, Gerard Caprio and Ross Levine contradict the conventional wisdom and show that regulations actually have adverse consequences on the banking industry, and probably always will, at least "till angels govern" (quoting from the political philosophy of James Madison).

Across the different statistical approaches, we find that empowering direct official supervision of banks and strengthening capital standards do not boost bank development, improve bank efficiency, reduce corruption in lending, or lower banking system fragility. Indeed, the evidence suggests that fortifying official supervisory oversight and disciplinary powers actually impedes the efficient operation of banks, increases corruption in lending, and therefore hurts the effectiveness of capital allocation without any corresponding improvement in bank stability.

What they are saying is the primary tools of banking regulation in the US (such as capital requirements and ability to shut down a bank), are not effective in other countries, and are in fact harmful.  Deposit insurance in particular, doesn't work:

Also, although a state objective of government sponsored deposit insurance is to stabilize the banking systems, we find the opposite: the generosity of the deposit insurance regime is associated with greater banking system fragility, not enhanced stability.

This conclusion is quite scary, because in the 2008 financial crisis the Treasury and Fed greatly increased the level of government insurance: up to $250,000 per account.  Although their conclusions regard foreign banks, the lessons are still relevant for us.

However, there is something that actually improves banking performance: Education and market scrutiny.

One mechanism for fostering private monitoring of banks is by requiring the disclosure of reliable, comprehensive, and timely information. Countries that enact and implement these pro-private monitoring regulations enjoy more efficient banks and suffer from less corruption in lending. Furthermore, laws that strengthen the rights of private investors enhance the corporate governance of banks.

The authors only state the correlation. However, we can speculate on various reasons.  The 'moral hazard' argument is that insurance induces recklessness and carelessness on both the consumer and the banker: since the consumer doesn't have to worry about the safety of their deposit, they don't enforce any discipline on their bank, and the bankers take greater risks because they have reduced downside liability (government safety net). This is true of the S&L debacle of the 80's, when investors continued to put money in insolvent banks for years, because they knew they were insured.  Furthermore, bank managers may mistake regulation for good practice, and believe that any action they take, as long as it conforms to regulation, is appropriate.

Clearly we, the public, must take responsibility ourselves for monitoring the banks. Government's role primarily is to ensure a strong legal system.  Beyond that, it can require transparency and disclosure of information from banks, as it does with stocks and bonds. But it should not regulate them. If we take responsible for the safety of our money, we will do a much better job than the government in protecting it and avoiding financial catastrophe. If we allow government to do the job, we are almost guaranteeing another calamity.