The Rationale for Regulation

Bank regulation is concerned primarily with ensuring that banks are financially sound and well managed. In the United States, this concept is referred to as safety and soundness regulation and in most of the rest of the world as prudential regulation. Although banks are subject to many other forms of regulation, including consumer and investor protection requirements, these regulations receive only our passing attention. The focus of this book is on prudential regulation, and we therefore begin with an explanation of why governments subject banks to prudential regulation.

Governments intervene in the operation of a market economy, whether through taxation or through regulation, for two primary reasons: either to ensure that markets work efficiently or to alter market outcomes to achieve social objectives. With only a few exceptions,2 tax policy is most often used to achieve social objectives. For example, a tax on the wealthy can be used to redistribute wealth to those less fortunate through welfare programs. On the other hand, the general objective of regulation is market efficiency. Since economists usually refer to market inefficiencies as market failures, regulation is often described as an attempt to correct a market failure.

Conventional economic theory recognizes three market failures that generally form the basis for regulatory intervention. The first is the existence of monopoly power. If one or a few firms have the power to restrict competition, they are likely to raise prices, restrict supply, offer poorer service, and restrict innovation. The distortion of the market through the exercise of monopoly power supports anti-monopoly and anti-cartel legislation as far back as the United States’ Sherman Antitrust Act (1890) and as recent as the United Kingdom’s Competition Act 1998.

The second way in which markets can fail is through the existence of externalities or what are sometimes referred to as spillover costs.3 These arise when the economic activities of some participants in a market indirectly affect, positively or negatively, the well-being of others. Positive externalities arise in a wide variety of contexts. For example, a popular restaurant that brings customers to nearby businesses is not compensated for the value of the positive externality it generates. Regulation, however, is typically employed to correct negative, rather than positive, externalities. A negative externality exists when the price of a good does not reflect the true cost to society of producing that good. In the classic example, if a steam train emits sparks that occasionally burn the crops of nearby farmers, the cost of the destroyed crops is a spillover cost (externality) imposed on the farmers by those who use the train. To account for this externality, either the users of the train could be taxed to compensate the farmers or the emission of sparks from a railway locomotive could be regulated, for example, by setting standards for the construction of locomotive chimneys.

The third justification for regulation arises from the existence of information imbalances (“asymmetries”).4 In a well-functioning market, buyers and sellers possess all the information needed to evaluate competing products or services. Buyers and sellers must be able to identify the alternatives available and understand the characteristics of the goods or services offered. Yet, information is a commodity like any other, and markets for information can fail like any other. For example, one of the parties to a transaction may deliberately seek to mislead the other, by conveying false information or failing to disclose key facts. Failures in the market for information justify regulation of various types—for example, food labeling or disclosures in securities offerings.

The Regulation of Financial Institutions and Markets

Regulation over the past three decades has rested on the notion that markets are essentially rational and highly efficient at allocating resources and that markets are generally self-policing and self-correcting. Given these assumptions, regulatory intervention could be justified only to the extent necessary to correct the comparatively rare instances in which markets may fail. In the context of banking, these market failures take two main forms: information asymmetry and systemic risk (a negative externality). Most of the regulations examined in this book represent attempts to correct these two types of market failure.