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Regulators Should Treat Banks Like Businesses

Over the past four decades, banks have expended considerable resources attempting to circumvent outmoded regulations, while regulators have responded by scrambling to outlaw banking innovations. This cat-and-mouse game has been costly to banks and regulators, and, by extension, to bank customers and taxpayers. A recent article published by the Federal Reserve Bank of Cleveland suggests that current efforts to reform the regulatory framework for the U.S. banking industry should consider the incentives of its players and allow the industry to evolve with the needs of its markets.

Writing in the Bank’s Economic Commentary, Economist João Cabral dos Santos says that commercial banks, like other companies, are in business to earn profits by supplying the products their customers demand. However, because of their central role in creating money and credit, banks have been considerably more regulated than firms in the nonfinancial sector. While these regulations may contribute to the banking system's efficiency and stability, they also may harbor hidden costs and foster perverse outcomes if they fail to factor in bank’s incentives due to innovations and changing market conditions.

For example, Santos notes that banks circumvented deposit-rate ceilings — designed to restrict banks’ competition for deposits — by offering gifts to depositors when rates for competing investments moved above the ceilings.

Santos also cites the 1927 McFadden Act, which effectively prevented interstate branching by U.S. banks. By the 1950s, changing market conditions encouraged banks to find ways around the branching prohibition. Successive rounds of innovations by banks to operate across state lines and new laws prohibiting them ensued, until the early 1980s, when regulatory barriers to interstate banking began to be dismantled.

The Glass-Steagall Act (1933) forced the separation of commercial and investment banking in the wake of massive bank failures following the 1929 stock market crash. Three decades later, developments like the growing outflow of deposits from commercial banks and the rapid increase in investments in mutual funds gave banks a strong incentive to explore new investment activities. Banks developed financial innovations aimed at exploiting the gray areas of the law (such as joint-venture-type agreements with investment companies); regulators responded by closing loopholes, before finally beginning a certain amount of deregulation in the 1980s.

Santos says that continuous increases in financial market competition and constant progress in information technology are making banking innovation easier and more attractive. He concludes that lawmakers should take these incentives into account as they consider reforms in banking regulations. They should also evaluate whether the benefits from certain proposed regulations are worth yet another round of costly cat-and-mouse games between regulators and bankers.

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