Paved With Good Intentions Part II. Regulatory Zeal Does It

Another important bias built into the regulatory mission is what we might call Damage Dominance. If there is a very small probability of a great material damage or intangible harm, and the risk can be averted at a cost of some regulation, always choose the regulation and never conjecture that the trade-off might be far from obvious and that the cost might be unreasonably high. The regulator suffers little or not at all by imposing a high regulatory cost on society, and may indeed earn respect for his prudence. If on the other hand he does not regulate away the risk and the damage occurs, he is sure to be blamed and his career may be over.

The elementary form of regulation the beginner finds in his textbook is a two-person game where a monopolist is made to loose and his customer to gain by a regulator who directs the game from above. In reality, the game is a maze of complications with an uncertain solution. Initially the monopolist (or perhaps the little band under his price leadership) is earning a return on capital of 10%. Considering it excessive, the regulator cuts it to 5%. As a consequence, economies of scale, brand reliability, or proprietary technology cease to be rewarded. Potential competitors willing to try to climb the barriers to entry that protect the monopolist, may no longer see much point in investing in economies of scale, building a reliable brand, or developing alternative technology. The regulator, in reality a participant in the game, has his gain. His good intention of enforcing a merely decent return on capital is fulfilled. Every body else loses, including one further player, namely the economy as a whole. It is pushed a bit further down the road to low rewards to investment, stable business, and the menace of stagnation.

Further complications may arise when the regulator and its supposed victims form a tacit and perhaps quite unintended alliance. George Stigler who earned a Nobel Prize for this and related insights thought that such alliances were a matter of course. Suppose that there is in the town a prosperous industry of dog dressing salons where dog beauticians wash and trim dogs to please their mistresses. Now and again accidents happen, the shampooing is done with scalding water, or the scissors prick the dog and it suffers a psychic trauma. Complaints are heard and the regulator must step in to protect the customers, for safety must be maintained. In short order he will subject the operation of dog beauty salons to the need to have a licence which can only be got by having a diploma from the animal care faculty of the local university. Under the regulator’s patronage there will be an Association of Dog Beauticians with powers to filter who will or who will not be admitted to this trade. Entry to the business will become very difficult, regulation will continue to protect profits, and should it fail to do so, entry can always be made more difficult still by requiring a Ph.D. to get in. Stability and security for all insiders will have triumphed.

This is perhaps a caricature, but like all caricatures, there is some reality behind it. Regulation of big business targets the putative abuses, like monopoly pricing or restrictive practices, that come naturally to small groups. The small business sector of the economy, being made up of large numbers of firms, finds it notoriously difficult to act cohesively. The intervention of the regulator helps it to overcome the large number handicap and enables small tradesmen to adopt restriction of output and maintenance of prices almost as if they were a monopoly. Entry to the trade is restricted by the regulator and by the tradesmen themselves by declaring on-the-job training as inadequate and all sorts of diplomas and examinations a requirement.

A wholly different field where regulation is a power for ill rather than for good is banking, supposedly the main culprit in the troubles that beset the economies of the West since 2008 and is still keeping most of Europe in a semi-comatose state. Banking is highly vulnerable because customers are entitled to withdraw their deposits at a moment’s notice, but also highly stable because normally few customers want to withdraw their deposits at the same time. When a bank is losing deposits and is short of money during the day a small number of other banks automatically find themselves with surplus money of the same amount and the deposit-losing bank can borrow the money back from them before the close of business by paying a few basis points of extra interest. This safe mechanism can of course be disturbed if too many depositors at the same time get spooked by some true or false rumour. In the limiting case, the bank will be unable to borrow back the money that is flowing to the other banks because smooth interbank lending depends on panicky rumour being disbelieved. This, however, is difficult to do if the rumour comes from such an august source as the Director General of the International Monetary Fund. Several times since 2007 the Director General has declared that the European banking industry was fragile and must be urgently recapitalised. Regulators followed this cue and set successively higher solvency ratios the bank had to meet within a matter of months. Any bank wanting to project an image of rocklike solidity would aim at a risk-weighed average solvency ratio of 12% when the regulators imposed 10% and the bank’s actual ratio was only 9. All were urged by the authorities to raise more capital. All could not do it—only a few could. The sole remaining means for the other banks was to shrink their entire balance sheet, reducing their holdings of corporate securities and squeezing their loan book. The same capital in a reduced balance sheet would, of course, raise the solvency ratio towards the desired level.

The result is that European small and medium-sized enterprises continue to be starved of credit at a time when a credit squeeze is the last thing the economy needs.

In strict logic the object of bank regulation ought to be to make sure that depositors can withdraw their money when they wish or, in the case of time deposits, at the promised date. This was to be assured by imposing on the banks a reasonably high liquidity ratio. Gradually, however, the target of the regulators shifted from liquidity (securing the depositors) to solvency (securing all creditors, and protecting the share holders as well). Believing that the solvency ratio can really look after both depositors and the other creditors is a gross error. When there is a run on a bank, having a solvency ratio of 12% instead of 10 makes not the slightest difference to the likelihood of the bank crashing or surviving. What a higher solvency ratio can do is to perform what the liquidity ratio should do, and in addition make it less likely that the bank’s own share holders will lose their money in the crash.

This, however, is not the supposed aim of bank regulation. The supposed aim of the regulation is to protect the depositors and only incidentally, if at all, its share holders. It is far from clear that it can achieve either aim in the face of some improbable catastrophe. What is clear is that in getting mixed up about the aim, the good intention of the bank regulators is achieving only one and very unwanted aim, the emasculation of banking and the starving of credit of an entire economy.