– February 23, 2015

What role does banking play in a theory of sound money? Banks in the United States are regulated by several agencies, especially the Fed. But should the Fed really regulate the banking system? Can the Fed effectively regulate the banking system?

Regulators claim central banks have always run the banking system. Ben Bernanke, for example, has cited Walter Bagehot as an early proponent of central bank involvement in the banking system since Bagehot recommended the central bank act as a lender of last resort.

In truth, however, Bagehot opposed central banking. He believed the central bank should make loans to illiquid banks because illiquidity in the banking system is often caused by the central bank itself!

For example, the Fed played a major role in creating the Great Depression. It created a shortage of money in the economy and then, when banks became illiquid, the Fed refused to bail them out.

To protect consumers against the Fed’s policy failures, depositors are forced to purchase insurance from the FDIC. Since 1933, the U.S. government has required all deposits (now up to $250,000) be insured so that depositors will not lose money in case of a bank failure. So the Fed atones for its policy failures by forcing consumer to buy a product they may not want. Make sense?

Unfortunately, deposit insurance leads to another problem known as moral hazard. With fewer people monitoring the bank, deposit insurance gives the bank an incentive to take more risk, which leads to more bank failures.

Today the financial sector is among the most heavily regulated industries in the nation, and most banking regulation is intended to prevent, or at least mitigate, the problem of moral hazard. Despite the fact that a few misguided regulations were lifted in the 1990s, the number and types of banking regulations have been growing for decades.

How have these regulations fared? Ill-conceived banking regulations were the major cause of the savings and loan crisis of the 1980s. To remedy these errors, the Fed adopted a stricter set of “risk-based capital” regulations in the 1990s, which unintentionally encouraged banks to hold more mortgage-backed securities, a major cause of the 2008 financial crisis. After the crisis, the Fed’s policy of paying interest on bank reserves prevented monetary policy from being effective and inhibited economic growth. So the record is… not so good.

Because the Fed has proven itself incapable of regulating the banking system in a way that improves stability or monetary policy, many economists such as Scott Sumner argue the people in charge of banking regulation should not also be in charge of the Fed’s monetary policy.

Ending the Fed’s control of the banking system may be an important step toward sound monetary policy. As Bagehot described:

Nothing can be truer in theory than the economical principle that banking is a trade and only a trade, and nothing can be more surely established by a larger experience than that a Government which interferes with any trade injures that trade. The best thing undeniably that a Government can do with the Money Market is to let it take care of itself.

Thomas L. Hogan

Thomas L. Hogan

Thomas L. Hogan, Ph.D., is a senior resident fellow at AIER. He was formerly the chief economist for the U.S. Senate Committee on Banking, Housing and Urban Affairs. His primary research interests include banking regulation and monetary policy.

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