12 - Banking Supervision

Summary

In the latter part of the twentieth century, a view developed that while the market economy was superior to alternative models and that competition generally was desirable for promoting optimal outcomes, it did not hold in banking, where ‘the social costs of failure outweigh any advantages that untrammelled competition might bring’, to cite just one authority. Some regulation therefore is required. The argument for regulation in banking derives in part from the problem of asymmetric information; markets then do not work as well as they might and could benefit from intervention. But there is also an important externality. When an ‘ordinary’ firm fails, its shareholders lose. When a banking firm fails, however, depositors also lose. If one such failure alarms depositors elsewhere and more generally, then there is a risk of a flight to cash or greater liquidity or quality. And this means that there is a potential threat to the payments system. One means of allaying the fears of depositors is the provision of insurance. However, even if this does not exist, or is seen as inadequate, or is not otherwise trusted, the authorities had a powerful tool at their disposal. The issuer of cash, usually the central bank, can reassure the banks by making it clear in advance that liquidity will always be available, albeit on terms – the role of the lender of last resort.