Government intervention in the banking sector was motivated by an unwillingness to let banks fail due to ‘systemic importance’. Meanwhile, there was no efficient market for risk because banks expected to be bailed out in their hour of need, even though diversity in this area is extraordinarily beneficial. The solution is smart regulation to eliminate the need for massive government intervention.
Any efficient banking system requires different degrees of risk. Savers generate a higher return on their savings by placing it in a bank that lends to riskier borrowers for a premium. The optimal ratio of risk-to-return for each saver should be determined in conjunction with a free market to maximise liberty, under ideal circumstances.
Thus, diversity makes sense. The problem with the current system, is that the government reliably bails out these banks by guaranteeing the loans when disaster strikes.This creates moral hazard amongst savers, who don’t need to take responsibility for where they put their money.
This can be motivated by political pressure, apparent culpability of government for improperly regulating or justified on grounds that the banks are of ‘systemic importance’. Unfortunately, the reasoning is irrelevant.
Freedom of government to intervene is the problem, but this option has to be maintained as long as there are legitimate reasons to do so. If banks of systemic importance didn’t exist, or didn’t fail, there wouldn’t be a problem.
Then the hands of government could be tied by legislation, insulating them from political pressure or populism, and savers would be forced to think about where they saved their money.
The problem of systemically important banks failing could be eliminated by making capital requirements progressive, id est larger banks would have higher capital requirements. This would simultaneously allow the creation of the ‘risky’ banks, smaller banks with lower capital requirements.
But, these risky banks would be limited by legislation. If they were large, they would be forced to have vast amounts of capital to balance the risk on their portfolio. If they are small, their failure has limited impact on the market but provides diversity of choice for consumers.
Similarly, large banks of ‘systemic importance’ would be incredibly unlikely to fail because of the huge capital requirements at such size. More likely, such banks wouldn’t exist, being in competition with medium-sized banks that have less strenuous capital requirements – but who aren’t individually of ‘systemic importance’.
Then, the government could believably declare unwillingness to ever bail out banks, even resorting to legislation. The competitive market forces then determine optimum capital requirements of banks.
The banking system will also be highly competitive and efficient, with either no banks of ‘systemic importance’ at all or any capable of failing. There will also be risky banks for risk-takers amongst us, but no moral hazard. We can eat our risk, and have it too.
© The Free Marketeer 2009