On the political possibility of separating banking and the state.

Author:Calabria, Mark
  1. Introduction

    Banking has long been one of the most highly regulated sectors of the American economy. It is also, perhaps surprisingly, more extensively regulated in the United States than in any other comparable developed country. This study examines the pattern of financial freedom across countries, with the objective of determining whether a free-market, or even a less-regulated, banking system is feasible within the United States. Also briefly examined is the political history of U.S. banking regulation, with an eye toward discerning any lessons regarding the future of U.S. banking regulation. In general, this paper is not about the economic feasibility or desirability of free-market banking.

  2. What Causes the Regulation of Banking?

    Activities generally recognized as banking developed prior to the regulation of banking. Some aspects of banking created a demand for the regulation of those activities. Classical welfare economics, in the tradition of Pigou, suggests that regulation arises as the result of a market failure, such as the externalities imposed by financial panics or asymmetric information problems between borrowers and lenders. The modern structure of banking regulation, however, with its safety net that creates moral hazard and its restrictions on competition, suggests that correcting market failures has little relation to modern banking regulation. Empirical research on the link between banking regulation and market failure is at best mixed. In their cross-country study, Heinemann and Schuler (2004) "do not find support for a link between stability in the banking system and the supervisory stringency." Heinemann and Schuler do find, however, that more generous deposit insurance schemes are associated with more frequent banking crises, results consistent with those of Barth, Caprio and Levine (2004) as well as Demirguy-IKunt and Detragiache (2002). Alternative explanations for regulation include: ideology; redistribution of wealth among industry participants, consumers and competitors; and regulation as a source of governmental finance.

    One hypothesis is that societies with relatively free banking systems are simply those that embrace free markets in general. That is, a general ideological support for free markets drives the support for less-regulated banking. Simple comparisons do show a high correlation between a measure of general business freedom and financial freedom, as illustrated in Figure 1. Simple comparisons between more open societies (in terms of political freedoms) also display a positive association with financial freedom, but the correlation is weaker.


    A handful of countries display higher financial freedom than the United States, yet less business freedom (see Figure 2). Countries such as Ireland and Luxembourg experience significantly less business freedom than the United States does-though still more than most countries-yet have higher levels of financial freedom, suggesting that more is at play than a country's overall approach to business regulation. To some degree, banking does appear special, at least in terms of its relationship to government.

    Most countries ranking higher than the United States on financial freedom demonstrate a legal system of English origin, as does the United States. Many are also of Scandinavian legal origin. A small number of countries of German legal origin also rank high on financial freedom, while few countries of the French civil law tradition rank high on financial freedom. These simple rankings support the importance of legal origin in explaining the organization of both law and finance (La Porta et al. 1998). There is the question of whether the various economic freedom indexes, including the financial freedom index, are largely measuring legal origin. By construction, the financial freedom index mirrors a country's reliance on state administrative control versus a heavier reliance on common law.

    The regulatory and deregulatory environment for banking in the United States proceeded along a number of dimensions. (1) Perhaps most significant are the thresholds to market entry. Initially, entry into American banking generally required a special charter from a state legislature (White 1982). The "free banking" movement of the early 1800s represented a move to charters being generally available to anyone who could meet the entry qualifications, one of which was often a large purchase of state government debt. Sylla, Legler, and Wallis (1987) document the extensive reliance by state governments on banks as a source of government revenue and deficit financing.

    The most common type of entry restriction was state branching restrictions. The eventual removal of these barriers is perhaps the most frequently studied example of banking deregulation (Beck, Levine, and Levkov 2010; Economides, Hubbard, and Palia 1996; Kroszner and Strahan 1999). These studies largely take a private-interest approach to examining reasons for states' deregulating branching when they did. The findings of these studies inform the selection of variables examined here.

    American banking deregulation also occurred in relation to the terms of credit. Foremost among these was the removal of price ceilings on credit. These began with the elimination of state-level usury laws and ended most recently with the removal of caps on the allowable rate of interest to be paid on insured deposits, although the FDIC occasionally takes regulatory action against depositories that it believes are paying "excessive" rates. Benmelech and Moskowitz (2010) document the nature of state-level usury laws in nineteenth century America. Their findings suggest that the relative political power of wealthy elites drove these laws. As land holdings largely determined wealth at the time, Benmelech and Moskowitz's results are consistent with the findings of Rajan and Ramcharan (2011) that state-level financial regulations attempted to protect the wealth and position of the landed elite. This paper attempts to add to these findings by looking at the relationship between inequality, both in terms of income and land, and financial regulation. These findings suggest that greater inequality should reduce the level of financial freedom as elites demand increased regulation to protect their status. Alternatively, Peltzman (1980) has argued that greater equality increases the demand for redistribution. To the degree that financial regulation is used to redistribute income, then greater equality (defined by a lower Gini coefficient) would increase the demand for financial regulation in the model of Peltzman.

    A critical question regarding deregulation is timing. This study focuses on cross-country differences at one point in time. Financial regulatory changes, however, often exhibit dramatic...

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