Abstract
We analyse costs and benefits of banking regulation and supervision to determine whether more supervision is always better for the functioning and stability of the banking sector. Whilst the motives for additional regulation are well understood, their social costs are not and hence net social benefits of additional regulation remain unclear. We emphasize that also in regulatory terms there is no free lunch; regulation—much like taxation—creates social costs and these may exceed the benefits so that society is actually worse off with than without (additional) regulation. And our argument is more intricate than that, suggesting that if the layers of regulation in place before the crisis have given poor incentives to those in the financial industry and their clients a revision or even reduction of regulation might generate a more stable financial system that is more friendly towards its customers. Financial regulation proposals should ultimately align the behaviour of financial institutions with social preferences. That strongly implies that the political discussion on regulatory proposals should reflect a full overview of relevant benefits and costs. The current situation is far from this theoretical optimum in our opinion. Politicians voice the public outrage over financial institutions that are supposedly at the root of the global financial crisis and often seem most intent to increase consumer protection and reduce taxpayer exposure.
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- 1.
Kerbl (2011) demonstrates precisely this point, applying an experimental setting to the various crisis measures that have been applied or suggested to reduce volatility in financial markets (e.g. the ban on short-selling, the Tobin tax on financial transactions and a maximum raw leverage ratio on market participants).
- 2.
These transformations functions, together with the operation of the payments infrastructure, are the core business of retail (or commercial) banks. Besides retail banks, there are numerous banking institutions with different orientations. It goes beyond the scope of this chapter to discuss them all in full. For a more extensive discussion, see for example Mishkin (2009).
- 3.
For an extensive overview of risks and quantitative risk management, see for example McNeil et al. (2005).
- 4.
Counterparty risk is a form of credit risk that banks run on their exposure on other financial institutions. In case of derivative products, where parties swap obligations against each other, counterparty risk is also involved.
- 5.
Note that currency risk, originating from changes in exchange rates, is part of market risk.
- 6.
Note, however, that where the traditional Laffer curve has clearly defined costs (tax rates) and benefits (tax income), the regulatory Laffer curve is a more abstract concept. Both costs and benefits of regulation are difficult to measure in any objective way. And whereas it is highly improbable that net tax income becomes negative, it is very conceivable that in the case of banking the costs of regulation exceed the perceived benefits, the net effect being a destabilization of the banking system.
- 7.
Basel-III is the recently announced package of new supervisory measures for banks, to be gradually phased in from 2013 onwards. It will be discussed in the next paragraphs.
- 8.
Most financial systems have functioned well for centuries without a DGS. The first DGS was introduced in 1934 in the USA, most countries followed only decades later.
- 9.
At the time the level of the DGS guarantee was increased in most countries worldwide.
- 10.
Indeed, the envisaged system would seem experience rated, but based on very little experience.
- 11.
One might feel that banks pick up the regulatory adjustment costs and one might feel that this is right. However, the financial sector is essentially no more than an intermediary for bringing surplus and deficit households together. If the costs of doing so increase for whatever reason, the impact will be borne by society as a whole.
- 12.
The expected annual cost of financial crisis is reduced from 0.95% of GDP (5% × 19% of GDP) to 0.76% of GDP (4% × 19% of GDP).
- 13.
Although society’s risk aversion may be sufficiently strong for it to be willing to accept a net cost of additional regulation if that actually reduces the probability of a financial crisis.
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Boonstra, W., Bruinshoofd, A. (2012). The Costs of State Intervention in the Financial Sector. In: Alemanno, A., den Butter, F., Nijsen, A., Torriti, J. (eds) Better Business Regulation in a Risk Society. Springer, New York, NY. https://doi.org/10.1007/978-1-4614-4406-0_6
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