(Reprinted from HKCER Letters, Vol. 4, September 1990) 


Regulations to be Blamed for Financial Crises

George Selgin


The subject of Dr. Selgin's forbiddingly-titled seminar was the role of regulation in financial and especially banking crises. The question was: To what extent were banking crises really a free market phenomenon as opposed to a phenomenon explained by regulations?

The conventional wisdom of financial crises is that free market financial systems are inherently unstable and prone to crises. Banks, being fractional reserve institutions, cannot possibly meet all their obligations if there are runs on them. The money supply dries up and a terrible economic depression ensues. Central banks can play a crucial role in acting as lenders of last resort, providing new base money to the banking system to meet the outstanding demand of depositors. In addition, schemes like deposit insurance and reserve requirements are also supposed to provide some kind of safeguard to the financial system.

Dr. Selgin, however, finds that the above view is deficient since it does not explain why financial crises should emerge in a free system. In fact, according to him, these crises occur because of certain unwise regulatory restrictions. Regulations are seen as a cause of rather than a cure for financial crises.

To elaborate on his somewhat heretical view, Dr. Selgin drew on examples from the banking history of various countries. In the United States, as a result of restrictions on branch banking on a nationwide basis, there are over 14,000 banks. A consequence of having so many banks is that they are all relatively undiversified and under-capitalized. Moreover, bank investments will tend to concentrate geographically and in particular kinds of industries. These conditions lead to higher risks than otherwise. As for the large number of bank failures in Oklahoma and Texas, where there are unit banking laws -- most of those banks had invested heavily in oil and real estate, the value of which has depended on the prosperity of the oil industry.

Another kind of restriction that has been important in the United States is bank activity restrictions. The Glass-Steagall Act of 1933, for example, prohibits commercial banks from engaging in investment banking. Here again the result is that banks have taken more, not less, risk because of the limitation on diversification.

A third example is the restrictions on deposit interest rates, known as Regulation Q in the United States. In times of rising inflation, as in the 1960s, depositors were earning negative rates of interest and began to take their money out of the banks and invest it elsewhere. Eventually a suitable alternative emerged in the form of money market mutual funds. A disintermediation crisis occurred in the banking system.

There is also the deposit insurance scheme, which most people see as a force stabilizing banking systems. In fact, it has done quite the opposite in the United States where the premiums charged to individual banks are not tied to the riskiness of their assets. This creates a very serious problem of moral hazard, as the safe banks pay the risky banks for theirrisk-taking. This regulation makes banks more prone to taking risks.

In times of financial or banking crises, people usually look to the central banks for help. To Dr. Selgin, however, central banks are again a cause rather than a cure of such crises. He sees the monopolized issue of currency by central banks as a very crucial destabilizing factor in banking systems. One reason is that central banks have a tremendous capacity to generate changes in the monetary base to make the entire system expand or contract.

A second reason is that cyclical changes in the currency-deposit ratio would alter the total money supply, whereas this would not happen if each bank can issue its own redeemable bearer notes, convertible into some outside independent base money.

Though Dr. Selgin does not wish to claim that a free market banking system is necessarily crisis-proof, he thinks it would be very close to crisis-proof, and it could be made so, provided that certain special arrangements are adopted which are consistent with the free market.

Turning to Hong Kong, Dr. Selgin mentioned the widespread sentiment in favor of adopting things like a deposit insurance scheme or a central bank. His advice was simply ,"Don't do either of these things," because the net effect of such reforms would be to make the Hong Kong banking system weaker and more vulnerable to crises. On the other hand, he suggested the abolition of the unwarranted legal restrictions to make the Hong Kong banking system more stable. These restrictions included the Interest Rate Agreement, as well as the three-tiered system, which limited bank activities and diversification and caused banks to take more risk than they need to.

Dr. George Selgin, a former lecturer in the Department of Economics at the University of Hong Kong, visited the Hong Kong Centre for Economic Research and presented a lunch seminar entitled "Legal Restrictions, Financial Weakening, and the Lender of Last Resort." Dr. Selgin specializes in monetary economics and is an expert in the increasingly influential field of free banking. He is currently affiliated with the University of Georgia.


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