Bank Regulation—More Harm than Good

For years there has been growth in the regulation of the financial market, especially of banks. The last big push came after the bankruptcy of the Lehmann Brothers bank in 2008. A flood of new global regulations was issued (summarized under the name “Basel III”), which were refined and supplemented by national regulations that varied from country to country. It is often forgotten that many of the spectacular crises of individual banks would have happened even if Basel III had already existed at the time, because these banks were so heavily in debt that even stricter capital adequacy regulations would have been far from sufficient. Moreover, the banks ultimately had the central bank behind them as the lender of last resort.

The Origin and Role of Central Banks

The central bank is always situated at the beginning of the regulatory chain. The central banks are not the result of a free evolution of the market but were instituted by national governments for various motives. The first central banks were created in the 17th and 18th centuries. Their most important task was to finance the national debt: in plain language, the states, mostly the monarchs, needed money for warfare. In the 19th century, the number of banks increased considerably, and financial crises also occurred, which led to the desire that only one central bank be allowed to issue banknotes and coins. This also led to the role of central banks as the lender of last resort for private banks.

Central banks were also used in the 20th century to finance the two world wars. With rampant inflation in Germany and growing unemployment, the tasks of the central banks expanded in the direction of stabilizing the currency and controlling unemployment. In the 21st century, the tasks of the individual European central banks were transferred to the European Central Bank (ECB).

Fractional Reserve Banking, Credit Expansion, and the Reaction of the State: Increasing Regulation

The banks ran into problems because they were not careful enough, especially in the lending business, and customers’ demand deposits only had to be partially backed by liquid funds. However, customers can reclaim their money at any time. Since in “normal times” it can be assumed that only a fraction of the deposits that actually belong to the customers are withdrawn at any given time, these customer deposits are only backed by liquid assets to the tune of about 10-20%. The greater portion of the funds by far is in loans granted by the banks. Today, such partial backing of demand deposits is the standard around the world. The government’s reaction to this has been to create a central bank as a lender of last resort and, to protect the central bank, a banking supervisory authority that requires a minimum quota of capital resources. Today, under Basel III, this minimum level of capital backing amounts to around 10% of risk-weighted assets, depending on the type of bank.

There are also a significant number of other operational requirements, the most important of which are:

A guarantee of proper management of the Executive board, the administrative or supervisory board, and of the relevant shareholders

• A minimum liquidity
• No concentration risk
• A special reserve fund
• Deposit insurance
• Accounting rules.

In addition, there are the new institutions that must be approved, and these must meet a number of conditions, such as, that of determining the functional and geographical scope of their operations, the minimum number of employees relative to the scope of business, conditions regarding capital stock, etc. These regulations officially serve to protect bank clients and, tacitly, to protect the central bank from costly bailouts. If at all possible, due to these regulations, banks should be able to avoid needing the central bank’s assistance.

In order to draw up and monitor compliance with these regulations, the governments of the individual countries considered a banking supervisory authority necessary. The staffing levels of these authorities have simply exploded in recent years. In Switzerland, for example, banking supervision had a good 60 employees at the end of the 1980s, compared with 480 today, while in Liechtenstein it was two employees in 1995, and today it is around 80! To be fair, it must be added that part of this growth is due to the expansion of the scope of responsibilities, which now includes the supervision of insurance companies and financial service providers that are not banks.

The Keynesian Logic: Credit Expansion, Monetary Flooding, and Increasing Regulation

With the still predominant Keynesian economic theory the abundant provision of credit is seen as necessary to promote growth and overcome unemployment. Accordingly, an expansion of the credit volume of the banks is desirable. It is argued that 100% backing of demand deposits jeopardizes an adequate provision of credit. From the standpoint of the Austrian School of Economics this is not true. The problem is an oversupply of loans, resulting in unprofitable malinvestments and a distortion of the production structure, which causes the typical business cycles and their periodic crises.

The ECB is fully committed to Keynesian logic and is responsible for the huge flood of money in Europe that is the seed of largescale inflation. This has already happened in the case of assets.

Now it is precisely this unhealthy credit expansion that is ultimately triggering further regulations for the banks. Many banks are on the verge of bankruptcy because, due to low interest rates, they have been too careless in granting loans to entrepreneurs who, because of their lack of profitability, would have been out of business long ago if interest rates had been determined by the market. The most recent spectacular example is Italy’s oldest bank, “Monte dei Paschi di Siena,” which has only survived due to the help of a state that is also nearly bankrupt. The conundrum of the regulations is that they are intended to prevent undesirable outcomes in the future, but it is not clear whether this future will be the same as the past.

A High Regulatory Burden Is Ill-Suited for the Complex Nature of Reality

The economy and its banks form a highly complex self-organizing system that constantly generates new business models and innovations. It is impossible to attempt to steer this system with the help of a framework of rules that is complicated but in no way appropriate to the inscrutable complexity of reality. Although it is certainly not wrong to impose a higher capital adequacy ratio on banks, that is only a drop in a very large bucket.

Historically speaking, the amount of capital funds available to banks has steadily decreased since the 19th century. However, in Switzerland a regulation in a banking law of 1936 set a ratio that was far exceeded by most banks. As a result, the capital adequacy ratio of the banks continued to decline despite the progressive tightening of the requirements. The banks thus came closer to meeting the legal requirements! A reversal only began with the crisis of 2007. The largest cushion of equity capital is held by those banks that are not, or not primarily, active in the lending business, but mainly in asset management, and this actually involves comparatively low risks. One reason for this is undoubtedly that these banks are often not joint-stock companies but have a legal structure in which a small circle of owners is also liable for their private assets. By contrast, the lowest capital funds are held by banks that are mainly engaged in the much riskier lending business, mainly banks owned by the state and with a corresponding state guarantee: in Germany and Austria the Landesbanken, and in Switzerland the cantonal banks. They know that the state would rescue them if necessary.

This is what happened in Germany, where the number of Landesbanken shrank from eleven to six, resulting in immense costs for the public sector and thus for the taxpayer. In Austria, the liquidation of Hypo Alpe Adria Bank almost ruined the province of Carinthia, and in Switzerland, dozens of small regional banks disappeared because of the real estate bubble at the beginning of the 1990s. Four of the 28 cantonal banks were merged or taken over, and others had to be restructured at the expense of the taxpayer.

In the End, the Taxpayer Pays the Bill

Thus, it seems obvious: a state that rescues ailing banks in emergencies, either directly or through a central bank, is the most harmful to the healthy development of the banking system. In the 18th century, when the banks had a much larger cushion of capital funds, the main task of the central banks was to create a national currency and issue coins and notes. Their role as “lender of last resort” was secondary. More recently, deposit insurance has been added as a further element promoting risk appetite. In the worst case, the taxpayer pays the bill. But this does not give investors any reason to think carefully about which bank they want to entrust their money to.

However, it should not be forgotten that the procedure of only partially backing demand deposits also allows for an unhealthy credit expansion by the banks, which promotes malinvestment. The economist Jesús Huerta de Soto, who teaches at the Madrid University Rey Juan Carlos, pleads in his book Money, Bank Credit and Economic Cycles—published in its original version before the credit expansion of the ECB—for 100% backing of demand deposits. In such a scenario, the banks would have to finance a credit expansion beyond the level of existing deposits through the issuing of bonds, which would then transfer risk to the buyer of the bond. According to Huerta de Soto, as a first step towards a solution, the central bank should no longer be allowed to act as “lender of last resort.”

An Entrepreneurially Oriented Banking Sector Is Needed

In any case, the current system of regulations is not able to achieve its alleged goal—the protection of bank customers and to protect the central bank from costly bailouts. Within this framework, the banker can only be compared in a limited way with a private entrepreneur in other industries. The latter has traditionally tended to adopt a defensive stance towards the state—one need only think, for example, of labor law regulations in the 19th century, and today, above all, of regulations concerning the broad area of environmental protection and spatial planning. The banks, on the other hand, are now dependent on the central bank, and to some extent also on regulation.

The banker’s entrepreneurial activity is therefore limited, because he is not allowed to change the regulated scope of operations without a license from the supervisory authority. In order to circumvent this procedure, he will fatally take higher risks in the course of his usual activities. The history of Scotland in the 18th and 19th centuries shows that with only partially backed deposits, but no central bank, relatively stable development is possible. Moreover, Scottish banks were structured in a spirit of partnership; that is, the owners were liable not only for the company capital but also for their private assets, which naturally curbed their willingness to take risks.

In short, the banking system of the future should again be increasingly governed by a genuine market, but at the same time it should be based more on the bankers’ own responsibility and their willingness to take risks. More regulation is therefore a step in the wrong direction.

Translation from German by Thomas and Kira Howes