How Free Market Forces Would Regulate Banks

One of my numerous smart and interested students at Towson University (yes, I’m fortunate), a non-economics major named Kristin, has sent me the following question in response to my recent post, “One Reason Governments Should Not Regulate Banks“:

How would you rely on free market forces to better regulate banks?

Here is my reply:

Kristin, it’s good to hear from you. I have part of a chapter on this in my book. Here are the main points:

Because all banks would want to be part of clearinghouse associations to keep down the costs of clearing checks and notes, all banks would have a strong incentive to join clearinghouses. The members of these clearinghouse associations would want some assurance that the OTHER members are creditworthy and sound. Therefore the members would agree to standards of soundness and to periodic inspections by agreed-upon bank examiners. Banks that let their capital or cash reserves drift too low would run the risk of penalties or even expulsion from the clearinghouse association. That whole process is strong regulation.

Deposit insurance, which people would want, would be private, of course, not taxpayer funded. Those who insure deposits with their own money, of course—and these might be insurance companies, bank shareholders (through double, triple, or even unlimited personal liability for their bank’s obligations)—would have a strong incentive to make sure the deposits the insure are reasonably safe. Thus deposit insurers would in effect regulate bank practices by refusing to insure deposits at banks they deemed too risky.

Lastly there is good old profit and loss. Bank shareholders don’t like losses; neither do depositors. In the absence of Federal (read taxpayer-backed) Deposit Insurance and bank bailouts with taxpayers’ money, bank depositors would monitor the practices of their banks (or pay someone to do so). If they started to worry about the soundness of their current bank, they would have a strong incentive to move their money elsewhere. The losses and gains of deposits experienced by different banks with different practices and standards would effectively select in sound practices and select out unsound ones. In the extreme (which has been very rare in actual periods of nearly-free banking), bad banks would rupture—go bankrupt. Loss aversion is a strong regulator, fear of bankruptcy a very strong regulator.

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