How Should Bank Lending Be Regulated?

Are regulators being too permissive about banks’ lending to businesses?

The Wall Street Journal reports yesterday, in “Regulators Question Banks on Business Lending Risks,” that U.S. regulators “from the Office of the Comptroller of the Currency, the Federal Deposit Insurance Corp. and the Federal Reserve Board”

are grilling banks over lending standards and warning them about mounting risks in business loans. …

“While some loosening of underwriting standards is generally appropriate given the strong tightening and pullback that occurred in the aftermath of the financial crisis, we do not want to see the lax practices re-emerge that led to the crisis,” said Stephanie Collins, a spokeswoman for the OCC.

How does Ms. Collins know how much “loosening of underwriting standards” is … appropriate? Which lending practices are “lax,” and which strike a sensible balance between riskiness and caution? How do the regulators know that difference? It would seem to be the essence of good banking to judge correctly how tight the bank’s underwriting standards should be; can the regulators make that judgment better than can the bankers who do it for a living?

And what about the time, effort, and expense this “grilling” costs the banks?

Bank examiners are pulling out more loans for inspection, questioning loan officers more thoroughly about credit standards and studying other underwriting functions more closely than they have in years ….

The time that loan officers spend answering regulators’ questions is time they cannot spend considering new loan applications. The time banks’ clerks spend producing the documentation the regulators need on the additional loans they are inspecting and other underwriting functions they are studying is time they cannot spend addressing bank clients’ needs. Is the distraction worth it? If so, how would regulators know?

Or are regulators being not too permissive, but too strict?

Some congressmen and the Obama administration have said in recent years that banks need to lend more to help jump-start the economy…

That’s a reasonable concern: We need banks to lend businesses the money they need to buy new equipment and hire new workers to get output and employment growing. But should the regulators should push banks should lend more? If so, how much more? Again, how would the regulators know how much more banks should lend, if any?

The fact is that regulators can’t know how much particular banks should lend to particular businesses at particular points in the business cycle, in order to strike an ideal balance of caution and risk in their lending.

Nobody can know this, not for sure, not ahead of time.

Top-down bank regulation by the OCC, the FDIC, the FED, and all the other government regulators is a kind of central economic planning that faces what my mentor Don Lavoie called the knowledge problem of central planning: The central planners—here the bank regulators—cannot possibly know all they need to know to plan effectively. It can’t be done. Not well, not top-down.

Bank lending must be regulated, of course, in the sense that it must be made regular, predictable, and neither excessive nor insufficient.  But it need not be regulated by government.

How tight or loose bank lending should be—and of course that will vary for different banks in different markets at different times, depending on the characteristics of loans they have already made and a host of other factors—is something that has to be discovered by the competitive experimentation of the banks. The feedback they receive via profit or loss helps them discover if their underwriting standards are too tight, too loose, or just right, for now.

Market forces should regulate the tightness or looseness of bank lending to businesses, not bureaucrats.

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One Response to How Should Bank Lending Be Regulated?

  1. Frank Sanger the lender says:

    In general, this simple analysis is dead on. Regulation is tampering insofar as it imposes surrogate authority over the due diligence of the lender whose business is made or broken in putting assets to work. The picture is complicated by a couple of factors though. We have seen that in certain circumstances, the lender may have different motivation than simply getting a fair return on investment when a) dealing with other peoples’ money and b) even making side bets in the expectation that a risky loan will fail! In 2008 we saw that even MIT physicists were not able to best high school probability and statistics when they attempted to architect elaborate financial houses of cards. Sensible regulation protects public asset classes and ensures that truly nefarious and destructive activities can be prosecuted. The worst regulation has the purpose of protecting anti-social economic activity and obfuscating outright stealing.

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