Is Bank Deregulation Dangerous?

banking regulation, deregulation, Scottish Free Banking, misunderstanding financial crises, Dodd-Frank Act
"The National Pop-Shop in Threadneedle Street 1826," The British Museum, CC BY-NC-SA 4.0
banking regulation, deregulation, Scottish Free Banking, misunderstanding financial crises, Dodd-Frank Act
Courtesy of The British Museum, CC BY-NC-SA 4.0

Among last week's news items that had colleagues asking me, "What's your answer to this?," was a piece by Quartz's John Detrixhe, telling its readers that, according to "300 years of financial history," rolling back bank regulations is a good way to trigger a financial meltdown.

Though you may be surprised to hear me say it, there's some truth to Mr. Detrixhe's thesis. While government intervention in banking typically does more harm than good, it's also true that, unless it's done carefully, deregulation can itself lead to trouble. As I put it some years ago in a Cato Journal article (reprinted recently in Money: Free and Unfree), "Dismantling bad bank regulations is like cutting wires in a time bomb: the job is risky and has to be done in carefully ordered steps, but it beats letting the thing go on ticking."

Back in the 1980s, for example, when U.S. bank regulators phased-out depression-era regulation-Q type restrictions on the interest rates depository institutions could pay to their depositors, they unwittingly freed a moral hazard genie that those regulations had kept bottled-up for several decades.

Did that make deregulating interest rates a bad idea? It didn't, first of all because had those rates not been deregulated banks and S&Ls would have taken a licking from new Money Market funds, and also because regulators might have avoided the moral hazard problem by allowing banks to offer competitive interest rates on uninsured deposits only. The phasing-out of reg Q and its S&L counterparts would then have proceeded only to the extent that it went hand-in-hand with deregulation of another sort, namely, more limited deposit insurance, which would have gone a long way toward avoiding the S&L crisis later that decade. (And if you think banking stability depends on deposit insurance you really do need to review some non-U.S. banking history.)

However, as the last example suggests, the fact that careless deregulation sometimes sets the stage for financial crises doesn't mean that deregulation isn't desirable, or that a deregulated banking system can't be safe. On this point the three centuries of experience to which Mr. Detrixhe's article refers speak eloquently, provided one bothers to consult the relevant case studies. Compare, for example, Canada's banking system, especially between 1867 and 1935, to the system or systems of the U.S. Will anyone deny that Canada's system was both far less heavily (and less heedlessly) regulated, and far more stable? The same conclusion holds for a comparison of the Scottish and English banking systems between 1772 (the year of the Ayr Bank's failure, in which unwise regulation also played a part) and 1845 (when Scottish banks were compelled, for no good reason, to abide by Peel's Bank Charter Act). Showing that misguided bank regulations were also an important cause of crises elsewhere than in the U.S. and England is also child's play, provided one bothers to try. (Have a look for starters, at Charles Calomiris and Stephen Haber's Fragile by Design.)

Not trying, especially by not even considering the performance of the world's least-regulated banking systems, is the main reason why so many economists learn the wrong lessons from history. I made that point several years ago in reviewing Gary Gorton's book, Misunderstanding Financial Crises; and I fear that what goes for Gary Gorton may go for Mr. Detrixhe as well.

Consider Detrixhe's discussion of the Financial Crisis of 1825. In the years leading up to it, he notes, the prices of securities trading on the London Stock Exchange "were soaring, and members of parliament sat on the boards of some of the firms quoted on the exchange." Quite true. But lax regulation of British banks had nothing to do with it. To the extent that England's "country" banks (meaning all those apart from the privileged Bank of England) contributed to the boom, they did so, as I explained in my 1992 article "Bank Lending 'Manias' in Theory and History," only by following the Bank of England's lead:

The ratio of country note circulation to Bank of England issues remained within the narrow range of .64 to .663 for most of the years 1818 to 1825. The sole exceptions were 1823 and 1824 — the two years preceding the crisis — when the ratios were .572 and .588, respectively. These figures suggest that, insofar as country banks behaved unusually in the years just prior to the crisis, they did so by becoming more conservative than usual, resisting any impulse to extend their liabilities beyond levels consistent with available, liquid reserves of Bank of England notes.

The Bank of England, on the other hand, had been engaged since 1822 in what Elmer Wood (English Theories of Central Banking Control, p. 82) refers to as "a general plan for cheap money and credit expansion," involving a reduction in its discount rate to 4 percent from its traditional value of 5 percent and an increase in the maximum maturity of bills eligible for discounting from 65 to 95 days. The country banks, and London discount houses, I observed in the above-mentioned article, having long been accustomed to treating Bank of England deposits and notes as so much cash, "could hardly be expected to do other than respond positively to the increased abundance of their own reserves, by reducing their own discount and deposit rates" (ibid.).

As for the Bank of England's own capacity to fuel a bubble, that stemmed entirely from the Bank's monopoly privileges, including its unique enjoyment of joint-stock status, and its monopoly of note issue within London and its surroundings.

As the Bank's liabilities grew, its stock of bullion, which was just shy of £14 million in May 1824, declined continuously and rapidly. By the the end of 1825, it had fallen to just £1.26 million. When at last the Bank of England took steps to conserve its dwindling reserves, in part by once again raising its discount rate to 5%, the country banks, having been "kept in the dark about the status of the Bank's bullion reserves" (ibid.), were among the firms and persons that bore the brunt of its policy reversal. "By the end of 1825," Mr. Detrixhe observes, "markets were in a 'full blown panic'…leading to bank runs and failures." "A year later," he continues, "nearly 10% of England's banks had collapsed, sparking the first major global banking crisis."

But did the 1825 Panic really trigger a global banking crisis? Not unless Scotland had somehow taken leave from planet earth, for as far as the British Isles were concerned, the banking crisis was an English and Welsh episode only; it left nary a trace in Scotland, whose bankers emerged from it unscathed. To a contemporary English cartoonist, the difference looked like this:

banking regulation, deregulation, Scottish Free Banking, misunderstanding financial crises, Dodd-Frank Act
"The State of the Money Market," University of Glasgow Library, Special Collections

The different experiences of England and Wales on one hand and Scotland on the other reflected, not more heavy-handed regulation of the Scottish banks, but just the opposite. Most importantly, Scottish banks were, unlike their English and Welsh brethren, not subject to hampering restrictions on bank ownership, including the notorious six-partner rule. As Kevin Dowd explains (Laissez-Faire Banking, p. 35), Parliament had imposed that rule, limiting all English and Welsh banks apart from the Bank of England to six partners or less, back in 1709, as a means for reinforcing the Bank's privileges in return for its having granted Parliament a subsidized loan. The measure

effectively prohibited reliable (that is, large) aggregations of capital in banking, as those partnerships that were allowed to enter the industry were too small to withstand any substantial shock. People knew how vulnerable the banks were and, whenever there was any disturbance, rushed to withdraw their gold (ibid.).

As Robert Jenkinson, the 2nd Lord Liverpool, told Parliament the year after the crisis, under the six-partner rule,

a cobbler or a cheesemonger, without any proof of his ability to meet them, might issue his notes, unrestricted by any check whatever; while, on the other hand, more than six persons, however respectable, were not permitted to become partners in a bank, with whose notes the whole business of a country might be transacted. Altogether, this system was one so absurd, both in theory and practice, that it would not appear to deserve the slightest support, if it was attentively considered, even for a single moment (ibid., pp. 47-8).

Thanks in part to Liverpool's efforts, the absurd rule, enacted in the first place to gratify the Bank of England's shareholders, was finally scrapped. In the ensuing decades, 138 English joint-stock banks were established, of which only 19 either failed or went into voluntary liquidation prior to the passage of Peel's Act in 1844 (Newton n.d., p. 4). I hope I'm right in thinking that Mr. Detrixhe, had he also been an MP in 1826, would not have been tempted to plead for sticking to the six-partner rule on the grounds that getting rid of it would increase the risk of another financial meltdown.

Certainly Mr. Detrixhe can't be accused of favoring any sort of government regulation. He recognizes, for example, that U.S. government housing policies contributed to the recent panic. On the other hand he seems to believe that the Dodd-Frank Act's many provisions are capable of preventing another crisis, if only Republicans will let them stand, whereas in truth those provisions hardly address any of that crisis's root causes.

And although Mr. Detrixhe never actually claims that the subprime meltdown itself illustrates the supposedly general tendency for panics to follow deregulation, one suspects that he, like many others, believes this to be the case. But while many have blamed the crisis on deregulation, and especially on the partial 1999 rollback of Glass-Steagall, such claims seem to be based on little more than their authors' preconceived notions. A close look at the evidence suggests, on the contrary, that although the crisis had many causes, deregulation wasn't one of them.

So let's by all means learn as much as we can from 300 years of financial history. But let's also remember that to do so one must delve deep into that history, and not just skim the surface.

  • Ray Lopez

    Good Selgin article that discusses how initially deregulation of finance can be destabilizing (I recall an Economist article from the late 1980s saying the same thing about New Zealand's deregulation), and how contagion between countries is not automatic, pace C. Kindleberger's writings on this about Austria and the Great Depression. I would add my hypothesis that free banking would not stop panics necessarily, which have no rhyme or reason. If bank runs can occur even with state funded insurance programs (like in the State of Maryland a generation ago) they can certainly occur with private schemes. That said, I'm in favor of free banking, breaking the 1.00 buck barrier on price/share for money market funds, and eliminating FDIC insurance (or scaling it back). Too much debt is not good for society IMO.

    • Ray, Re "breaking the 1.00 buck barrier", if you're saying that where deposits fund loans banks should not be allowed to promise depositors they'll get $X back for every $X deposited, then I agree with you. Money market mutual funds have of course switched to that system.

      In that scenario, so called "deposits" are not really deposits at all: they are effectively equity. Plus that system is what advocates of full reserve banking (like me) advocate.

      • George Selgin

        I believe that Ray was arguing that Money Market Mutual Fund shares should be treated according to the rules that apply to other equity shares, not that bank deposits (or notes) should be treated like equity. A bank that offers not to "break the buck" on its deposits is merely doing what any debtor is obliged to do.

      • Ray Lopez

        Thanks Ralph Musgrave and George Selgin. I was not aware until Ralph mentioned it that the 'break the buck' rule has been in effect since Oct. 2016; I thought it was still pending. As for full reserve banking, that's a bit too extreme for me, as it implies to me (from what I understand) that the government would providing the backing funds for every loan, with no fractional reserve lending. Not to get too far off-topic, but it seems full reserve banking might end up, during business expansions, in rationing credit and/or forcing businesses that wish to leverage to resort to non-cash equivalents like Bitcoin, foreign currency or some non-dollar 'money'. I believe in money neutrality so this is not a big deal (and recall in colonial days they circulated 'Pieces O Eight') but even I concede this might create needless friction in the economy.

        • No: under full reserve, government does not provide any sort of back up for loans. What government DOES DO is to back deposits which are GENUINELY safe because the money is NOT loaned on: the money is simply lodged at the central bank for example. As to people who want a bank to lend on their money, they're on their own, and quite right: why should someone who wants their money loaned out have taxpayers help when the money is loaned to a corporation via a bank, when there is no such help when the same person buys a corporations bonds direct? That's a blatant inconsistency in the existing system.

          • Ray Lopez

            @Ralph47:disqus Thanks Ralph for that clarification. So given that most lending these days is for real estate, full reserve narrow banking is simply the retail lender (that would be you) having a first mortgage (primary lien) on any money from the retail lender used to finance the buying of a house? Instead of the bank having the first mortgage, the bank's customer does? Is that it? Big deal (NYC raspberry sound here) Notwithstanding, I think most people would opt to just lend their money to the bank to do as the bank pleases, in consideration for receiving an interest rate, i.e., exactly as done today. But I concede I could be wrong and it could be that there's a huge interest in the public being primary lien holders.

          • No: those wanting their money loaned out by a bank buy a stake in a mutual fund. Banks can set up mutual funds specializing in anything they want: e.g. NINJA mortgages and/or very safe mortgages where home owners have say a 30% equity stake. The chance of investors not getting their money back in the latter case would be near zero. If a bank wants to set up a "as bank pleases" fund (to quote you) there'd be nothing to stop that.

            There is a fundamental principle here: a bank should not promise anyone they are 100% sure to get their money back when that money is loaned out: loaned out money is NEVER totally safe.

    • W. Ferrell

      "I would add my hypothesis that free banking would not stop panics necessarily, which have no rhyme or reason." Free market banking has natural incentives to police against credit bubbles. A bank expanding credit recklessly will have it's notes called by other banks. Without credit bubbles, panics are not generally likely.

      • Ray Lopez

        @W. Ferrell – "without credit bubbles, panics are not generally likely" – I agree, except this presupposes the conclusion, unless you believe in such nonsense that the Fed creates bubbles. People create bubbles, and the Fed has little power to stop them. BTW, you feeling anxious about the stock market? According to Tobin's Q, it's getting close to year 2000 levels. But probably you don't feel anxious, which underscores my point: people create bubbles, and a bubble is only apparent after it bursts.

        • W. Ferrell

          So the Fed creating 4 trillion in monetary base out of thin air and buying bonds with it does not enable a credit bubble? You are just joking, right?

          • Ray Lopez

            @W. Ferrell – not joking. Google "money is neutral". And the 4 trillion created since 2007 did not cause inflation or any kind of asset bubble; stocks in fact are slightly under the trajectory they were before 2007. The markets do not "follow the Fed", this is an urban legend. Fed has very little influence over the stock market and nearly every other market. Even Greenspan's 1994 surprise rate hike did not roil the markets that much (about a month as I recall, and I lost money on that rate hike but it was not such a big deal that monetarists make it out to be).

    • You would be revered by the cashless society folks. No FDIC insurance and yet you have to keep your money in the bank. Just another case of liberation becoming totalitarianism, Ray.

      • Ray Lopez

        You can always buy gold, unless a new-FDR bans it…

  • Bravo!

  • Walker F Todd

    George is right as usual, but one thing (the Regulation Q reference) needs to be clarified. Reg. Q indeed was introduced in 1933 to stop payment of interest on demand deposits. That restriction ended in 2011. A separate and, we thought, potentially more credit-distorting feature of Reg. Q in the Old Days was that, after 1966, until around 1986, savings and loans were allowed to pay 1/4 pct. more interest on savings deposits than commercial banks. Essentially, this was another way of propping up/subsidizing the housing/mortgage market. Bank reformers in the 1970s and 1980s had to do heavy lifting to get rid of the Reg. Q interest rate differential before they could move on to dismantling the prohibition against the payment of interest on demand deposits. That looked like a big breakthrough at first, but say, how much interest have you received on your checking account lately? — Walker Todd, Middle Tennessee State University

    • Ray Lopez

      Thanks for that bit of history, but it seems NOW accounts ( were a work-around to Reg. Q. After five minutes of searching I still don't know the difference between NOW accounts and demand deposits, but it's OK. Another example of the market circumventing laws.

      • George Selgin

        They were. But they had limitations.

    • George Selgin

      Thanks for these details, Walker. I knew I was skimming over them; hence my hand-waving reference to reg Q "type" restrictions! Anyway, it all goes to show just how complicated deregulation can get, and how easily it can go awry.

  • The entire wealth system is shared between banks and Gov.'s therefore it becomes quite obvious that each one works for a quite narrow market when compared to its populations at large. Why banks do not change to digitized currency and make complete changes that will ensure that no person or Gov would ever be in debt. What does it take to make it happen?

  • For instance by allowing lower capital requirements for banks when financing “safe” houses than when financing “riskier” entrepreneurs, which means banks earn higher risk adjusted returns on equity financing houses than financing entrepreneurs we end up with way to highly priced houses and way little job creation.

    And yes, absolutely, the last thing you need is to have those who armed the regulatory bomb that has dangerously been exploding for decades, and still do not understand what it does, now trying to dismantle it