Is regulation a better solution in today’s environment?

The biggest concern associated with the question “what works best?”, is which system would be more stable and able to avoid great crises.  But is it possible at all? Let’s look at the corporate governance as an example. 

It is commonly known that stock prices cannot grow forever, no matter how the growth trend looks like. The Wall Street Crash of 1929 is the best example of naïve investors believing in everlasting growth. Even more, the expected change in price, and the long term average change in value of stock is ZERO.

BUT, Shleifer and Vishny, and many others, describe corporate governance as the agents who are working in the interest of shareholders, and are supposed to keep increasing shareholders wealth. So the paradox is that the main concept of corporate governance is doing something, which is, in principle, NOT POSSIBLE. So isn’t trying to avoid financial crises the same?

We all learn from our own, or someone else’s mistakes. Thus experiencing crises and taking important lessons could be considered as process of learning and improving. Maybe the fact the free banking no longer exists means that lessons have been taken?

In today’s interconnected markets, free banking cannot exit in one single country, as this will lead business to move into that country, and a possibility of WTO intervention. So even those who believe in free banking, can see that it is hardly possible to achieve it.

How do alternative (or Free Banking) systems work?

Free banking has been introduced by the Austrian School. Austrian economics have been promoted by the Austrian economists, such as: Carl Menger, Ludwig von Mises and Frederick Hayek. The question is: are Austrians right that we should have free banking? Or should we rather have “right” banking regulation?

Free banking has number of historical examples, both successful and disastrous. Such banking system in Australia seems to be an example of the most unsuccessful experiment. Hickson and Turner suggest that the success of free banking largely depends on whether bank shareholder have limited or unlimited liability (where systems with unlimited liabilities tend to be more stable). However, no matter if the Free Banking experiment was successful or not, by now, all the countries have converged to regulated banking.

Banking regulation is the intervention of government into banking system, and generating money with the help of central bank. As we know, government is “taxes”, and “taxes” is money, therefore it is hard to imagine a stable and powerful government without the control of money.

Monetary policy plays an important role in economy.  Poor monetary policy of the US president Hoover, in the beginning of 1930’s, has deepened the recession. Hoover’s administration had simply “locked the gold in a cell” without supplying adequate amount of cash. Roosevelt, on the other hand, did the opposite. He abandoned the gold standard and used quantitative easing to boost the economic recovery. The above example shows how powerful monetary policy is, and how crucial are the right decisions.


In today's "mostly democratic" world, governments act (or at least are supposed to act) in the interest of country citizens. Whereby giving the monetary control to the private banks, it is hard to imagine bankers beings interested in the public good.

Basel Accords - Something somewhere went terribly wrong!

“German regulators seized the ailing Herstatt and forced it to liquidate on June 26, 1974. The same day, other banks had released Deutsch Mark payments to Herstatt, which was supposed to exchange those payments for US dollars that would then be sent to New York. Regulators seized the bank after it received its DM payments, but before the US dollars could be delivered. The time zone difference meant that the banks sending the money never received their US dollars.”

Business Pundit, May 7, 2009

This failure has special place in the history of banking regulation, as the following debates led to introduction of new international regulation. This included well known Basel Capital Accords introduced in 1988, which has mainly focused on banks’ credit risk management, by setting risk-weighted minimum capital requirements. Unfortunately, bank regulators seem to have failed to discipline banks.

OECD analysis shows a significant decline in risk-weighted assets to total assets ratio over time. Historical development of the ratio of 15 largest banks has declined from nearly 70% in 1990 to 35% just before the financial crisis. Systemically important banks started moving to unconventional business practices, which suggests that risk-weighted system of calculation encourages banks to design instruments for bypassing the regulatory regime.

“Commerzbank is to swap junior debt for shares to boost core capital by €1bn and take the German bank closer to meeting European regulators’ demands to shore up its balance sheet.”

Financial Times, February 23, 2012

By engaging in shadow-banking and other unconventional banking activities, banks seem to forget about their core function, which is prudential lending to credit-worthy enterprises and households. The following table shows the percentage ratio of selected banks' loans to their total assets.

Since Basel accords were implemented in 1992, the percentage ratio of bank loans to the total assets in decline gradually throughout past 20 years, causing negative consequences for economic output.

As banks main profit margin is derived from securitisation of loans, they failed to devote adequate attention to prudential underwriting (credit risk assessments) of individual loans. It looks like capital requirements, which are based on risk-weighted assets could contribute to further incentives for financial engineers to bypass the regulatory requirements.

Back to the Stable Point or Transition into a New System?

“Complex dynamical systems, ranging from ecosystems to financial markets and the climate, can have tipping points at which a sudden shift to a contrasting dynamical regime may occur.”

This is a quote from Marten Scheffer’s research paper on the early-warning signals for critical transition.

Even though financial regulation is not that dynamic, but rather slow to react to the changes in the financial world, it still reflects (and sometimes forces) the dynamics in the financial sector. Could we then historically compare financial regulation to an unstable swinging boat, which sometimes comes to a tipping point and (with a minor disturbance like wave) can easily turn over?

In this case waves would be the financial and economic crises that seem to occur every decade and swing the boat of financial regulation.

The crisis in 1980 seemed to have pushed the boat to its tipping point, and the disturbance of Reagan and Thatcher (driven by Chicago Business School economists), has turned the regulatory system by 180 degrees.

“In the present crisis, government is not the solution to our problem, government is the problem.”

This was in Reagan’s inauguration speech in 1981.

The following system of liberal economy was quite resilient, now however, it seems to be it its tipping point where it could either go back to its stable point, or transit into a new system with a new point of stability.

Which came first, the chicken or the egg?

"Which comes first, the chicken or the egg?" is the commonly known question that would confuse not only a kid, but even an adult. This causality dilemma could be applied in financial market by asking the question: whether financial innovations cause the increase in regulation or are the result of the restrictions imposed by the increased regulation?

One of the most popular topics in the financial news these days is the regulation of the financial (particular banking) sector. The regulation often involves applying restrictions on use of different types of financial innovations (as these are often blamed for causing the recent financial crisis). However, could these restrictions cause further increase in innovations in the financial sector?

According to Edward J. Kane, innovation “…is the act of putting an invention into practice”. In an unregulated sector the use of invention is usually justified by its technical productivity. However, in the regulated sector, implementation of technical invention can be justified by its ­productivity in regulatory avoidance. One of the greatest examples is the electronic funds transfer system (EFT). Beside its productivity gains of substituting (or replacing) cash and cheques, this was mainly driven by avoidance of heavy regulation of cheques.

There is some controversion in the academic literature about the role of circumventive innovation, which makes it harder to answer the initial question of this financial dilemma. However, no matter what comes first, the process of regulation→ regulatee avoidance→ and the following re-regulation is a constant battle between political and market forces, which is hardly ever going to achieve any stationary equilibrium (Kane 1981).