Bank Regulation and Public Choice Theory
By Arnold Kling
There are several gems in the latest Milken Institute Review. On the topic of bank regulation, James Barth, Gerard Caprio and Ross Levine give an excellent generic description of how the public-choice view of government differs from the assumptions that government is a benevolent maximizer of the social welfare function.I want to quote at length.
the public-interest approach, stresses that market failures – the high costs of obtaining information and enforcing contracts – interfere with the incentives and abilities of private parties to monitor and discipline banks effectively. It follows from this perspective that a powerful supervisory agency that directly monitors and disciplines banks can improve bank operations. Designing banking policies on the basis of the public-interest approach assumes that there are market failures and that official regulators have the incentive and capability to correct them.
…The private-interest approach holds that politicians and appointed regulators – like everyone else – maximize their own interests, not those of the society as a whole. Thus, they may well abuse their authority, diverting credit to benefit those in power. Moreover, private bankers, maximizing their interests, will have the incentive to manipulate the regulatory process for their own benefit. Under these circumstances, policies that strengthen official oversight may reduce bank efficiency and intensify corruption
…countries that grant their regulators greater disciplinary powers have lower levels of bank development and greater corruption in lending. Governments that heavily restrict bank activities and impede entry have banks that are less effi cient and more costly to operate. And countries with greater government ownership of the banking industry have less banking-system development. We also found that restricting banks from diversifying into non-lending activities or prohibiting them from lending abroad increases banking system fragility.
The evidence is thus broadly consistent with the private-interest view.