The Importance of Free-Market Banking Reforms

Published December 21, 2016

Progressive critics of deregulation wrongly assume the contemporary banking environment is one of freewheeling laissez faire, in which major banks are permitted to exploit consumers and engage in the kinds of risky investment practices that led to the crisis of 2008. This often-repeated account is belied by the proliferation of new regulations in the years leading up to the crash and the by Byzantine complexity of the legal and regulatory environment in the finance sector in general. Layers of government intervention at the state and federal levels blinkered the market, preventing the price system from doing one of its most important jobs: managing and assessing risk.

Just how overregulated are America’s banks? Banks are regulated by several federal agencies, the Federal Deposit Insurance Corporation (FDIC), and the Federal Reserve, among other organizations, all of which promulgate thousands of their own regulations. The Dodd-Frank Act alone has spawned almost 30,000 new restrictions, making it one of the largest pieces of legislation in American history. That Act, a 2,300-page monstrosity passed in the wake of the crisis, has advantaged large banks and consolidated market power, forcing many small banks out of business. According to data published by George Mason University’s Mercatus Center, the United States’ community banking sector contracted by 14 percent in just the four years immediately following the passage of Dodd-Frank.

An assumption of the Dodd-Frank law is in implementing its rules, regulators will go easy on smaller banks, reducing their compliance costs relative to national giants such as Bank of America and JPMorgan Chase. But this principle is too often difficult to put into practice, and it is notoriously difficult to accurately quantify the weight of the regulatory burden—both because doing so adds yet another cost for banks and because, as a recent FDIC Community Banking Study notes, compliance “is so interwoven into their operations.” As a practical matter, neatly separating out compliance costs is impossible. With sophisticated legal and compliance departments and large economies of scale, Wall Street’s giants are able to absorb new regulatory demands.


Attention to the economic way of thinking—in particular the school known as public choice theory—suggests regulated industries often seek out regulation precisely for these anti-competitive effects. “[A]s a rule,” argued Nobel laureate George Stigler, “regulation is acquired by the industry and is designed and operated primarily for its benefit.” Lawmakers and regulators are people too, no less motivated by self-serving and potential partiality toward the most influential players in U.S. banking (or any other industry).

Public choice theory is the idea policymakers should take this insight seriously rather than treating policy ideas as if they exist in a vacuum, apart from the human beings charged with their implementation. Still, this economic way of thinking does not demand of its practitioners an all-consuming cynicism about politicians and bureaucrats, only a practiced consistency; it simply proposes what Duke University political economist Michael Munger terms a “methodological demand for behavioral symmetry.” Here, behavioral symmetry entails an assumption that is actually much more modest than the claim that all politicians are necessarily engaged in nefarious plots against the common good. Instead of imputing evil motives, public choice suggests only that, in Munger’s words, people “are self-interested to the same extent in markets and in politics,” that the neat bifurcation of public and private sector actors is entirely unfounded. Any theory impliedly based on the neglect of this basic truth will be a weak one, incapable of advancing the process of tailoring public policy means to ends.

Public choice theory thus enables observers of events to parse two of the narratives that inform the conversation whenever the subject of regulating Wall Street arises. The first looks at the relationship between the political and corporate elite with a jaundiced eye; it treats elected officials and bureaucrats as mere puppets, captured by powerful corporate interest groups and working through shady backroom deals to advance their greedy agenda. In the second narrative, elected officials and experts are public-minded do-gooders who have dedicated their lives to promoting a justice through necessary reforms.

Neither one of these accounts is completely true to life. Real-life policies are the messy product of both well-intentioned reform efforts and the concentrated pressure of well-organized and mobilized interests. But as the case of Dodd-Frank demonstrates, within such a complex process of policy creation, good intentions are by themselves never sufficient to guarantee good laws. Advocates of ever more regulation believe a relatively very small group of bureaucrats is smarter than the billions of voluntary agreements and decisions that we call “the market.” They are overconfident in their ability to predict the future, to anticipate the consequences of their eager interventions. When the shortsighted remedies of positive law fail, the invariable response is a chorus of calls for new laws and regulations, but prudent investing and the adoption of appropriate consumer protection measures are not engendered by arbitrary government decrees, which raise consumer prices and have a negative impact on market competitiveness. The desired objectives are instead best served by comprehensive deregulation of financial services, by lowering barrier-to-market entry and removing laws and regulations that privilege the largest and most powerful Wall Street banks.

Free banking, at least to the extent that it existed in various markets, is history’s most effectively regulated financial system. The scholarship of economists Lawrence H. White and George A. Selgin has pointed to historical evidence from Canada, Scotland, and Sweden to show that free banking presented significant stability advantages over central banking systems. Far from resulting in monopolies or price-fixing cartels, free banking offered robust competition that protected against panics and crashes. Scotland enjoyed an extremely stable system of free banking for well over 100 years, before mid-19th century English statutes effectively abolished that system and brought Scottish finance under the Bank of England.

Politics and ideology aside, the shared goals of strong consumer protection, long-term stability, and meaningful competition are best served by a system of free banking in which no bank is considered “too big to fail.” Overregulation and rampant Federal Reserve meddling have had their time. Banking reform should focus on fostering competition, with rules that are few in number and unambiguous in their scope and application.

[Originally Published at Townhall]