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The limits of regulatory cooperation

One of the most striking structural weaknesses uncovered by the euro crisis is the lack of consistent banking regulation and supervision in Europe. Although the European Banking Authority has existed since 2011, its influence is often trumped by national authorities. And many national governments within the European Union do not seem anxious to submit their financial institutions to European-wide regulation and supervision. Given this impasse, is it possible that national authorities can manage regulation and supervision via informal cooperation rather than via something more concrete like an official banking union?

History suggests that the answer is no.

It is not difficult to understand why countries—particularly countries that are as closely linked economically and financially as the Europeans—would want to cooperate in the area of financial regulation. Because of the contagious nature of banking instability, no country is truly an island. A crisis in Greece will hurt French banks; a crisis in France will hurt German banks; a crisis in Germany will affect Dutch banks. And so on. Hence, it is in everyone’s interest to make sure that their neighbors’ banks remain stable.

And, to a certain, extent, the Europeans have cooperated, both with each other and other countries. The Basel accords, for example, prescribe capital standards which have been voluntarily adopted by many countries. The European Stability Mechanism, set up to manage the resolution of failed European banks organization, was established in 2012. Still, the adoption of unified regulation and supervision has eluded the Europeans.

Even though a more stable banking system is in everyone’s interest, many European governments are reluctant to put their financial institutions on the same regulatory and supervisory footing as those of their neighbors for fear of losing their competitive edge–a phenomenon economists refer to as “regulatory competition.” The fact that Europeans are engaged in regulatory competition should come as no surprise to Americans who have experienced such competition between the federal and state banking authorities for more than 100 years.

Image provided by Richard S. Grossman.
Figure 1. Image provided by Richard S. Grossman.

From 1789 until 1863, the US government stayed largely out of banking, leaving the business of chartering (i.e., creating) banks to the state governments. This was a good deal for the states, since they made money by imposing taxes and fees upon banks, as well as forcing them to buy—and hold–bonds issued by the state. It was a good deal for the state banks too, since they were allowed to print money–which they could lend out at interest—as long as they had enough gold or silver to buy back any of their outstanding notes when asked.

In order to raise funds to fight the Civil War, the federal government created a new type of bank, the “national bank.” These were to be created and supervised by the federal government, pay fees to the government, and be required to buy and hold US Treasury securities as a condition of doing business. Like state banks, they were also allowed to issue banknotes. This was the birth of the “dual banking system.”

Because the federal government wanted national banks to thrive, they provided them with an advantage over their state-chartered rivals by placing a tax upon state bank-note issues, effectively driving them out of existence. This was the first shot in the regulatory competition between state and federal regulators, and contributed to a surge in the number of national banks and a decline in their state-chartered counterparts (see Figure 1).

Image provided by Richard S. Grossman.
Figure 2. Image provided by Richard S. Grossman.

The states did not take this lying down, and made it easier for state banks to establish branches, something national banks did not do, thus giving a competitive advantage to state banks (Figure 2). Additionally, they began to reduce the minimum capital requirement—the amount of funds that banks need–to get a state charter. This led to a fall in the average state minimum capital requirement (Figure 3). The federal government’s counterpunch came in 1900, when they lowered the minimum capital requirement for national banks.

Lest you think that this legacy of federal-state regulatory competition is a thing of the past, consider the opening lines of a recent publication by the Texas state banking department aimed at potential bankers:

“Why Choose a Texas State Bank Charter? Just as market competition provides customers a choice among banks, the nature of the dual-banking system allows bankers a choice between regulators.”

Image provided by Richard S. Grossman.
Figure 3. Image provided by Richard S. Grossman.

Regulatory competition remains alive and well today in the United States, but it is significantly tempered by the fact that almost all state-chartered banks are subject to oversight by the Federal Deposit Insurance Corporation and the Federal Reserve.

In Europe, the supervisory and regulatory differences across countries are much greater and there is no equivalent to the US’s federal system of oversight. Unless the EU can establish a full banking union, regulatory competition will remain a threat to Europe’s banking system.

This post is based on a presentation made by Richard S. Grossman at the Law Institute of the University of Zurich on June 1, 2015.

Featured image credit: Euro bank notes, by martaposemuckel. Public domain via Pixabay.

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