...The Illusive Quest for Deregulation" is so interesting.

Macey is well-known and highly respected scholar who has written extensively on the regulation of securities and banking. Generally, he is skeptical of regulation; if he defends regulation, one would expect a well-reasoned and persuasive case. In that sense, his article is both a disappointment and an encouragement--a disappointment because the case Macey advances for the continued (or increased) regulation of banks turns out to be so weak, and an encouragement because the very weakness of Macey's case suggests that bank regulation--while it retains support among the political class--is losing its intellectual foundation. As one who has questioned whether bank regulation is any longer necessary, that is good news.

INHERENTLY UNSTABLE?

Macey first sets an ambitious goal: "The point of this paper is to demonstrate that government regulation is necessary, sometimes in heavy doses, for private markets to function well." Despite this broad statement, he actually means that regulation in heavy doses is necessary to keep banking functioning well, and it is that much narrower proposition that I will address in this article. I will argue that Macey does not successfully defend the proposition that banks require government regulation, in "heavy doses" or otherwise. Part of the reason for this is that he makes the wholly erroneous assumption that banking is a business that cannot be carried on safely without regulation.

At the outset, Macey makes the following points:

* "Banks are systematically far more highly leveraged than other kinds of firms in the economy."

* "Banks' balance sheets are characterized by severe disparities in the liquidity and transparency of assets and liabilities."

* "Banks' balance sheets are unusual because of the mismatch in the term-structures of their assets and liabilities."

These statements are all true, of course. But Macey goes on to derive from them that "banks are inherently unstable because depositors have access to banks' liquidity on a first-come, first-served basis." Because of this, he says, banks are susceptible to runs as depositors seek to protect themselves.

Are banks, then, "inherently unstable"? It is true that banks are highly leveraged and have illiquid and non-transparent assets as well as liabilities that often are payable on demand or are for a considerably shorter term than their assets. But, without being flippant, that is because they are banks--they are in the business of intermediating between depositors and borrowers by pooling the funds of depositors and monitoring the condition of borrowers. This, in itself, does not make banks inherently unstable and is not in itself an argument for regulating them. Deposit banking has been around for over 500 years. It developed as a business because it served an economic purpose--and still does today. It is not therefore logical to believe that, for five centuries, banks and banking were inherently unstable. If the business of banking is inherently unstable, it would long ago have been supplanted by a stable structure that performs the same functions without instability.

[ILLUSTRATION OMITTED]

Only comparatively recently has banking become subject to government regulation and supported by deposit insurance. Indeed, before regulation and deposit insurance, banks--like any other commercial enterprise--held capital in order to maintain their stability and the confidence of their creditors. There is nothing about banking that forbids the holding of substantial capital or requires high leverage. High leverage is only a way to increase profitability; in an unregulated environment, depositors and other creditors might demand high levels of capital, which would simply reduce a bank's profitability while increasing its stability. In other words, banks are only unstable when they hold insufficient capital to reassure depositors and other creditors.

This raises the question of why banks, if they are susceptible to instability, would ever hold less capital than is needed to reassure depositors and other creditors. In the absence of regulation or deposit insurance, one would expect to see banks hold sufficient capital for this purpose, simply because instability would result without it and instability would make it difficult for banks to acquire deposits. So if we see banks with low capital ratios, it is because something other than market forces is allowing them to do it. That something is deposit insurance and government regulation. In other words, banks have high leverage (i.e., low capital) today, not inherently, but because regulation and deposit insurance have created moral hazard, lulling depositors into the belief that they do not have to be concerned about the financial condition of banks. When market discipline is impaired, high leverage should not be a surprise.

HISTORY'S LESSON Like any other business, banking has not only...

NOTE: All illustrations and photos have been removed from this article.



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