Banking system needs regulation

In banking industry, there are problems happen all the time. Free banking truly benefited market before, but when problems appear, we still need to correct them and make problems in control, and can we say the process of correcting would not be a process of regulating? Just like those examples in the previous posts, we see free banking result in crisis and reborn in a regulated banking system which has removed the previous risks away.

Some people say that financial crisis is still happening even in the regulated banking system, but let us go back to the original point. In the book of “financial regulation why, how and where now?”, Goodhart, etc. said  that “one rule can never fit all, regulations inevitably distort the economic outcome, possibly so much that the end result is worse than the unregulated starting point”. But problems still coming up and regulations have been required by people, not all risks are taken into account but the purpose of regulation is just removing all risk away. As a result, we need regulation and regulation must be keep upgrading to form a more healthy banking system.

More ideas againest free banking

In the first post, Chu's test showed in a certain period, the amount of bank failures in free banking is less than that in regulated banking and drew the conclusion of regulation is noneccesary. But can bank failures indicate the banking stability? It is not, in fact, banks failure is normal and it is a process of pushing regulation updating. So Chu's test also cannot support free banking.

Otherwise from that, in 2004, Hickson and Turner analyzed the deficiencies of free banking from other directions, which further defences the necessary of banking regulation.

First of all, they mentioned time-inconsistency problem. Since there is competitive market in free banking, banks are more difficult to regulate, therefore, depositors would never really know the value of loan portfolio and finally, the time-inconsistency problem was generated. Moreover, this asymmetric information problem also gives incentive of banks to over-issue liabilities. Even though, there was a limited liability system during free banking time, but that failed to reduce over-issue problem and cause more risky investment.

Another idea of Hickson and Turner, at the time of free banking, the liability ownership was limited, which helped to prevent banking stability. But in this case, it seems that banks are under regulated instead of free banking.

Can free banking argument successfully stand on past examples?

From the ideas which are supporting the free banking, it is easy to see that all the arguments stated base on the past examples. We also know those examples truly succeed during a certain period. But what happened after the glory days?

Scotland

From White (1984), for the whole 18^th and early 19^th centuries, free banking system in Scotland was stable. There are no central banks, openly entry the market and little restriction on money-issuing. Also through the comparison between the performance of Scottish banks and England banks, it stated that “banks would spring up if government had let banking alone”.

However, Sechrest and Larry (1991) found several deficiencies of White’s idea. First of all, it is true that from 1809 to 1830, less bank failures in Scotland than that in England. But in the later part of this period, banks failures in Scotland increased dramatically and finally have the same failure rate with banks in England. Secondly, better convertibility in Scotland is not true. In the later time of free banking period, it became hard to transfer notes to gold. What is more, the law of no issuing money less than one pound was actually made market result in inflation. Moreover, it set a maximum interest rate in Scotland that not only restricted bank competition, but also always be lower than market interest rate. Finally, White doesn’t like central bank and advocates free competition in banking, but there were actually there banks with special power at that time, made the competition unfair.

As a conclusion, banking in Scotland, as the best free banking example, had many aspects need to be corrected and is not that free.

Australia

What happened in Australia before 1893 could surly support free banking, unfortunately, it fell in crisis in 1893.

Before the crisis, there was a fast price increasing of real estate, this finally formed a bubble and led many banks fail. Some of them survived because of the fund supply from Britain and elsewhere. Then the crisis came.

Three points were concluded for Australia’s failure:

1, less liquidity reserves for more depositors

2, banks over expansion

3, Government influence the market negatively (lately engage banks to take over risk).

Regard to the problem, it argued that if the note issue was limited and a credit system was provided, etc. the crisis could be avoided.(more information in Hickson and Turner in 2002).

Therefore, in the case of Australia, we can say the crisis is mainly because of the lack of government support and regulating.

Free banking ideas are stand on past examples, however, with the information provided above, it is reasonable to say that the supporting ideas of free banking are not solid and regulation might be necessary for banking syatem! 

Why free banking? part 2

At the time of more financial problems occur due to the instability caused by central banks, some people like Dowd start to argue the benefits of free banking. In his book of “the experience of free banking”, he was concentrating on the advantages of free banking and against the banking system with central bank by the introducing the successful example of free banking in the history.

In Dowd’s book, all the basic supporting ideas of free banking are more or less similar as those mentioned in the last post. More important thing in here is the illustration of free banking’s performance in different aspects.

1. The growth rate of economic. With the successful of Scottish free banking system been proved by Rondo Cameron, free banking can benefit economy on this point.
2. Improve efficiency of intermediation. For example, it argued that the loan interest rate is lower in free banking than that in system with central banks.
3. The stability of price. As in the free banking, it is easier for people to convert notes to gold. The price would be more stable in free banking than that with central banks in long-term.
4. Fraud. This point was not well supported, it just said that the fraud happened, but not spread too much.
5. The lender of last resort. As we know, one important function of central bank is that it can help banks in trouble. But this also potentially allows banks to take more risk. Dowd said that this situation would not happen in free banking because banks would be much more carefully on handling this problem.
6. Panics. It is no doubt that deposit insurance must be useful to avoid panics, but Dowd seemed to say that the history of free banking did not show the deposit insurance is necessaries.

Obviously, most of those points are defenced by the successfull past free banking example. Is it convincing?

Why free banking? part 1

Banking industry has made great contribution to decades of economic development. Nowadays, banks’ performance can strongly influence economy stability.

The question of “Should banks be regulated or just let them develop freely?” has been discussed widely by people. In this blog, I would try to find out the answer to this problem. In this part, I would concentrate on the reasons of why some people support free banking system. In White's book in 1995, free banking is generally described as 1, no central bank. 2, unlimited issue currency and deposite.

Another literature written by Chu in 1996, which collected many ideas supporting both aspects. Later on with a comparison among three countries, a result which explained the free banking is not the reason of banking instability was drawn.

Generally, people argue free banking could result in bank instability, because with externalities, natural monopolies and asymmetric information, more fraud would appear, banknotes would be over issued and banks would have no restrict on expanding. On the other hand, if banks are regulated, there are plenty of benefits such as depositors can be protected, payments are guaranteed, etc. Therefore, a stable banking system can be formed.

However, people like Hayek believes that in free banking system, banks would compete in supply of money, also by considering their brand, over issued money would less likely happen. There are some other ideas shows that banks’ diversification can be limited by regulation, more moral hazard problems and higher taxes also reduce banks’ profit.

In the test of Chu’s article, by considering the number of banks’ failure, from 1935 to 1964, both Hongkong banks that are unregulated and Canadian banks which are regulated have no bank failures appear, but in the US which only regulated its deposit insurance has bank failures in every year. Therefore, it shows that the banking regulation is not necessary.