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Bank Regulation, Private Central banks would way the costs of regulation and the costs of default

by on February 22, 2012

Thank you Colin for writing an interesting and though provoking post: “Real banking innovation requires a separation of basic banking from the rest of the financial services”. Whilst  agree with most of the post I do not see why a separation is a requirement. I agree that this will give consumers a choice, but do not see why the system should be limited to just the one option. In this post I have outlined a way in which I believe regulation could develop, so that consumers have a more flexible choice and more effective regulation. We all agree that a 100%  cash reserve ratio would not have much risk, yet this would make banking services extremely expensive.  Competition in regulation has been the norm throughout history and my belief is that this makes regulation more effective and less intrusive.

Bank regulation

In the current fractional reserve banking arrangement, it makes sense to have a private central bank (or central banks), who is (are) responsible for a group of banks that are directly connected to the payment system. They are in effect banker of the banking system. Private central banks could act as regulators, deposit insurers and lenders-of-last resort. In this system regulation would not need to be imposed by a government. Regulation would be determined by the central banks trading-off the costs of regulation to its banks (and the subsequent costs to banking services)  and the benefits of regulation that decreases the probability of  insurance and lender-of-last resort costs. In such a system regulation will no longer be bureaucratic and misdirected, but design to protect what we need protecting: the payment system.

Complex companies

I can already hear people saying that I have only focussed on bank regulation. What about the “complex financial companies”? The case has been made that the collapse of AIG may have take investment banks and the whole financial system down with it. This seems at the heart of EU and US regulation on hedge funds. Yet creating wider and wider regulation only makes regulation more complicated and increases the incentive to make the financial companies themselves complex and inefficient. It would make more sense to increase the insurance premium paid to central banks higher for those banks lending to these riskier counter-parties (or are part of the same company). Thus if a bank has exposure to an investment bank, which in turn has exposure to a hedge-fund, one would expect the a higher insurance premium and more regulation from its central bank. The higher premiums will mean that commercial banks will demand higher fees from hedge-funds and investment banks, who themselves may want to be more transparent to get a better deal.

The Volker Rule/ Glass-Steagall

In this system described, I believe that the Volcker Rule may well apply in many cases without it needing to be prescribed. Different banks will have different insurance schemes (some may protect all the depositors money, others a proportion, yet other a fixed amount). They will all have to pay premiums for their cover.  Depositors are free to choose the bank that offers the scheme that best fits them.  This may be a bank which is essentially a utility bank, which probably pays a low premium for 100% coverage of deposits, but need not (It could well be the case that a $30.000 cover at more complex institution is sufficient for most depositors as long as the banking fees are low).

Here again competition amongst central banks who both want a cheap lending system and safe deposits will lead to a “Race to the Top”. I do not see the logic in deciding the “best” option for everybody ex-ante at our desk. It would be more efficient to let the individual depositors and banks decide the best option when they put their own money on the line and need to pay for the costs of the banking system.

An excellent reference on this topic is “Central Banking in a Free Society” by Prof. Tim Congdon. In this covers  Prof. Congdon the Northern Rock affair among other things. An somewhat dry presentation followed by an highly interesting discussion can be seen in the youtube clip.

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From → Extended Society

One Comment
  1. Indeed, this gets into the mechanics of insurance, and I agree with all of this because it will produce the right result. The central element that you mention here that resonates for me is assurance of the payment system. I am not tied to the specific mechanics of the Volker Rule for example, especially after I noted the piece in todays FT from Osborne/ Azumi in which they note the Volker rule specifically allows trades in US dollar securities but excludes other countrys securities.

    This kind of self-interested detail flies in the face of the supposed target which is to provide for a system that at least reduces the ability of risky banking to extract cheap funding from the utility bank side of things and place that money at undue risk, thus placing widows, orphans and savers money at risk where no risk is desired.

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