"In theory there is no difference between theory and practice. In practice there is"

There are many views and opinions behind the rationale of bank regulation, there are many thoughts including the free banking view shared by economists such as Friedrich Hayek, Kevin Dowd and Lawrence H White.  Their belief is that the free market mechanism met with the competition associated will lead banks to behave in a prudent manner, hence removing the need for regulation.  They believe bank instability is due the governments monopoly note issue and the ever reliance on the lender of last resort facility.  A “lender of last resort” is a facility set up to provide funds for banks if they come into difficulty, which in turn will alter the actions of the bank as they will have a guarantee of being bailed out.. The above mentioned economists are known to be the forefathers of the “free banking school” and whilst their views have sparked much debate they are very much in the minority; Hickson and Turner (2004) found that free banking only appeared to work in times of “narrow legal restrictions” and they argued that bank regulation was an efficient solution in areas such as over issue and risky investments. 

There are many arguments for the reason for regulating banks, one of these includes the Systemic risk view.  The main reasoning here is that if one bank falls, the negative externality effect throughout could have an adverse effect on the system as whole through issues such inter-bank lending.  The asymmetry of information does not allow for depositors to distinguish between good and bad banks whereas some form of regulator will have access to private information and can set up practices of discipline and prevention tactics.   

There are indeed other views regarding the need for bank regulation; bank regulation is a relatively new concept, in 1878 the Bank of Glasgow collapsed under a system of no regulation, which in turn benefited its competitors.  This issue points us in the direction that one bank falling could have a positive impact on the economy however the heavy reliance on competitors in modern day finance can be seen as a symptom of structural weakness within the system.  However, in my opinion I feel that an unregulated system is not suitable in the modern day financial world.  With the media spotlight ever increasing appropriate actions met with stringent regulation will increase confidence within the system which in turn will allow any system to succeed under the correct market conditions. 

Next week I will talk about who should regulate the banks and give my own opinions on the current economic crisis.

Thanks for Reading

Take Care

PN

References

Title- Yogi Berra

C. R. Hickson & J. D. Turner, 2004. "Free banking and the stability of early joint-stock banking," Cambridge Journal of Economics, Oxford University Press, vol. 28(6), pages 903-919, November