NCPA - National Center for Policy Analysis

Banking Reform

November 27, 2002

Bank regulations result from political bargaining and therefore create as many distortions in financial markets as they purport to correct, according to economist Charles W. Calomiris.

Bank deregulation in the 1980s and 1990s w eliminated many inefficiencies in the state-regulated banking system set up in the 1890s. But important regulatory impediments still exist, such as the distinction between finance and commerce -- although there is no convincing economic argument for that separation. Another is the special status of the government-sponsored enterprises (GSEs). For example:

  • Banks may now engage in commercial activities within financial holding companies, but due to the desire to prevent unfettered mixing of "finance" and "commerce," the law does not clearly define what a "financial activity" is.
  • Vague definitions allow regulators discretion -- creating opportunities for a politicized regulatory process and unnecessary risks for banks.
  • This partly explain why so few non-bank financial institutions have sought to become financial holding companies under rules established by the Gramm-Leach-Bliley reform legislation.

Government sponsored enterprises (GSEs) that control housing finance in the United States (Fannie Mae, Freddie Mac and the 12 Federal Home Loan Banks) also create significant distortions and risk.

  • The government guarantee of their debts wastes taxpayers' money ($10 billion a year) and poses a risk of catastrophic loss to taxpayers.
  • Their role as privately owned firms with public benefits enables them to compete inappropriately with U.S. Treasury securities, thus raising government borrowing costs.
  • They attempt to monopolize mortgage origination and use that monopoly status to expand into retail operations, which could have adverse consequences for competition in the industry.

Calomiris recommends that Fannie Mae and Freddie Mac be reined in through a two-step process: immediate prudential regulation of their financial structure and risk management, followed by full privatization.

Source: Charles W. Calomiris, "Banking Approaches the Modern Era," Regulation, Vol. 25, No. 2, Summer 2002, Cato Institute.

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