March 29, 2011 Reading Time: 3 minutes

Financial industry regulation has been a hot topic in the wake of the Panic of 2008 and ensuing recession. Many pundits blamed the crisis on a vaguely-defined concept of “deregulation.” Over the years, they argue, governmental oversight of financial institutions was reduced, allowing banks—especially large ones—to build up too much risk. This allows bankers’ greed and short-sightedness to go unchecked, the story goes, and poises the entire economy on the brink of financial collapse. From the “deregulation” perspective, the proper preventative against future crises is of course more and better regulation. This has led to vast and complex new layers of regulation such as the Dodd-Frank Bill.

But all this “deregulation” talk is bogus—a scapegoat for a more fundamental regulatory problem. What we really need to address is not what specific regulations, or specific regulators, are required so that “it never happens again.” The real question is what general economic rules will be most conducive for each entrepreneur in each industry discovering and applying those “regulations” which are most appropriate and effective for his individual business circumstances. 

And Economics has a simple answer: COMPETITION. And I mean genuine competition, where there’s neither coercive limitation (“legal barriers to entry”) on anyone entering any industry nor taxpayer-funded bailouts for the losers. Economists since Adam Smith have understood well that such wide-open, radical, unrestricted competition is the greatest source of effective regulation.

In competitive markets there are two great motivators: desire for gain (greed), and fear of loss (prudence). Every business is continually tested, and every entrepreneur must find the right mix of greed and prudence required for long-term survival. Fred, an entrepreneur, will fail if he doesn’t satisfy his customers and investors. Why? Because Ted, a competitor, promises “I can do better!” If the Freds of the world do not shape up, they lose their customers and financing to the Teds. Ask any small business owner what drives customer service and cost efficiency—the dictates of a far-removed official regulatory bureaucrat, or the immediate demands of customers and investors? 

This “regulation by competition” would be especially applicable to the banking business in a truly competitive environment. In banking, customers (i.e. depositors) are also investors, with deposits supplying more than two-thirds of banks’ investment funds. Hence the banking entrepreneur must really take care of the customer/investor, primarily by not wasting the funds on unsound investments. If a banker can’t provide a consistent return (or consistent liquidity), his depositors will flee. Thus a banker who can’t provide his customer-investors with some level of confidence won’t last. Another respected, reputable bank will come along advertising “safety and soundness” and woo away the customers and the funds. The “weak” bank will die a competitive death—a very healthy and essential aspect of the market economy.

But aren’t banks competitive? Not so much. They only look that way because there are so many of them. The problem is that banks don’t really stand good for their main source of funds, i.e. customer deposits. Instead, a government “Regulator”—the FDIC—promises to bail out the depositor-investors should the bank screw up and lose the funds on a bad investment. This is true for all banks, so as a banker, it doesn’t make much sense to advertise (much less achieve) “safety and soundness”. Thus the normal effects of competition for funds—i.e. recognizable prudence in the use of funds—are drastically curtailed in the banking industry.

And the FDIC is merely one of many competition-stifling official “Regulators.” The bailout promises for Fannie Mae, Freddy Mac, Wall Street banks and hedge funds, and inducements to ramp up certain high-risk investments, all come at the hands of, um… let’s see—oh yeah, the official “Regulators” themselves. Thus we have a strange Orwellian situation where the official “Regulators” are actively undermining effective regulation by stunting true competition in the industry. To call this “deregulation” is an absurd myth, a red herring, a total sham. A much better label would be “political regulation aimed at shutting off competition for the sake of protecting the big players.”

This is an old pattern. Most acts of official “regulation,” from the National Banking System in the 1860s, to the Fed in 1913, to Glass-Steagall in 1933 (which created the FDIC), have had the effect of reducing competition and thereby weakening the most vigorous source of genuine regulation. Moreover, the much-ballyhooed “deregulation” of the 80’s and 90’s, and newer official regulations such as the Basel Accords, basically amount to replacing one arbitrary set of standards with another. None of these gives effective incentives for local entrepreneurs to engage in the “right” level of prudence, because as we’ve seen, in bailout nation, without true competition for funds, prudence becomes pointless.

The lesson from economics is almost embarrassingly simple: if you want good regulation, get rid of the official “regulators.” Real competition is all you’ll ever need.

Tyler Watts is an assistant professor of economics at Ball State University.

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