Banking deregulation

December 4, 2002

Free Market Foundation

Bank deregulation in America in the 1980s and 1990s went a long way toward eliminating the many inefficiencies of the state-regulated banking system of the late 1800s. But important regulatory impediments still exist, such as the distinction between finance and commerce, the moral hazard created by deposit insurance, and the special status of the government-sponsored enterprises (GSEs).

Some suggested reforms:

New laws allow financial activities to be done within financial holding companies, but it does not clearly define what a “financial activity” is.

Such regulatory roulette results in banks facing unnecessary risk as they plot their strategic direction in customer and product development and it politicises the regulatory process.

The fuzzy definition of permissible activities is the result of the government’s desire to prevent an unfettered mixing of “finance” and “commerce” yet there is no convincing economic argument for that separation, economists say.

The final area of bank deregulation is reforming GSEs that control housing finance in the United States (Fannie Mae, Freddie Mac and the twelve Federal Home Loan Banks), which have outlived their usefulness and create significant distortions and risk.

They do not contribute significantly to Americans’ ability to own homes.

The government guarantee of their debts wastes taxpayers’ money ($10 billion a year) and poses a risk of catastrophic loss to taxpayers.

Their role as privately owned firms with public benefits enables them to compete inappropriately with U.S. Treasury securities, thus raising government borrowing costs.

They attempt to monopolise mortgage origination and use that monopoly status to expand into retail operations.

Analysts recommend a two-step process: immediate prudential regulation of their financial structure and risk management, followed by full privatisation.

Source: Charles W. Calomiris, Banking Approaches the Modern Era, Regulation, Summer, 2002; Vol. 25, No. 2, The Cato Review of Business and Government.

For more information: http://www.cato.org/
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FMF Policy Bulletin\26 November 2002