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State and Market in the Financial System

"A pragmatic vision of the public and the private does not consist in asking whether there should be more or less Market or more or less State, but in leaving to the Market and the State what they know how to do best."

The most important decision when reforming any economic sector is to determine the role that the State and the Market should play. It is essential to get it right in what should be left to the free decision of individuals and what should be the interventions of the State.

The history of economic regulation since the end of the Second World War can also be explained from this point of view. “As much of the Market as possible, as much of the State as necessary” has been the guide that has inspired most of the regulatory changes that have occurred over these decades.

The changes in the assignment of roles to the State and the Market during this period have had very positive effects. The first and most important of these changes was the liberalization of international trade guided by the GATT, now the WTO. But the list of regulatory changes is very long: the privatization of public companies, the liberalization of regulated or monopolized sectors such as telecommunications or the different forms of transport, labor markets, the reduction of barriers to the creation of the internal market in the European Union etc Without forgetting the great change produced at the end of the XNUMXth century in most of the communist countries with the introduction of market mechanisms in the production of goods and services.

These changes are explained because the legacy of the first half of the XNUMXth century was truly disastrous from the point of view of economic regulation. Both the left, with the temptation of the planned economy, and the right of the totalitarian countries, were implementing systems in which the State had a preponderant role in the functioning of the economy. An unjustified, unnecessary role that caused serious damage to the well-being of all.

And what can we say about the financial sector? To understand the evolution of the regulation of the financial sector, it is essential to distinguish the two parts of the financial system. On one side are the deposit institutions (banks, savings banks and the like) and on the other, the rest of the financial system (stock markets, investment funds, hedge funds, venture capital, derivatives, etc.). This distinction is important because the evolution of financial sector regulations has had two completely opposite developments.

 In the financial system there has been a regulatory change in the sense of allowing consumers, users and companies to decide freely and allowing the State to intervene only in those areas in which its role is absolutely necessary, such as the protection of consumers and investors, policies to defend competition, the demand for transparency and audits, etc.

 But this evolution, similar to that experienced in other economic sectors, has occurred in what is now the majority of the financial system but not in deposit institutions. Today the non-banking financial system functions fundamentally under the discipline of the market. and only with justified state interventions.

 And what has happened with the other part of the financial system, that is, with the banking system? How has banking regulation evolved? Well, curiously, it has gone in the opposite direction, in the sense of increasing the role of the State in various and numerous ways.

It is possible that this strong interventionism in banking activities explains thatA part of the financial system that works according to the market economy has been expanding more and more and the financial activity of the banks has been receding in recent decadesace. This has happened in almost all countries, although it is true that progress has been different in the United States and in Europe. In the United States, 85% of financial assets are already generated by the market and only 15% by banks. If the importance of bank liabilities in the balance sheets of non-financial companies is measured, it can be seen that in Europe they still represent 30% of total liabilities, while in the United States they are only 8%.

     It can be said that, at this time, once the communist countries have introduced competition in the production of goods and services, The banking sector is the most intervened and protected sector of all the economic sectors in any country in the world.

This is not perceived by the majority of the population who think that since the banks are private, they are supposed to operate according to the market economy. But it's not like that. It is true that Today, in most countries, the banks are privately owned, but the banking system is fundamentally penetrated by State interventionism and protectionism.

In the book "Goodbye to the Banks" I explain extensivelya list of protections, privileges and state aid that impede competition in payment and financial services  but the most interesting thing is that, right now, it seems that the regulation of the banking system is going to change throughout the world, in the sense of reassigning the roles of the State and the Market.

This change is already taking place in the field of ideas. The debate that has been opened thanks to The possibilities offered by the new technologies for providing payment services are radically calling into question the current monetary and banking system.

We are in the midst of a Big Bang of ideas, proposals and alternatives to the current monetary and banking system that come in various ways. On the one hand, from the world of cryptocurrencies and on the other, from the economic authorities themselves, with the proposal of digital public money or CBDC (Central Bank Digital Currency).

The current monetary and banking system

Those interested in the roles of the State and the Market in the functioning of an economic sector can have a feast if they spend some time analyzing how money and the payment system are currently working in our economies.

The justification for excessive state intervention is the fragility of bank money. Indeed, the growing accumulation of anti-market regulations is explained by the fact that most of the money we use now, bank deposits, are not really money but "promises" to repay money. They are financial assets with risk and to avoid their problems, the intervention of the State is necessary.

The bank uses the deposited money to lend or invest it, and the difference between the interest rates of those investments and those of the deposits is (or better, was) its main source of income. Cash withdrawals have a certain regularity and this allows banks to respond to the demands of depositors without major complications. But the problem arises, not only when the bank is insolvent, but much earlier, when it is not capable of quickly converting the investments it has made or the loans it has granted into money.

at the beginning andhe normal result of this financial fragility was a feature of the banking sector: recurrent bankruptcies and payment collapses.. But given the damage that this produced in the economies, lhe States sought formulas to avoid or reduce banking crises by increasing protections and privileges for banks and demanding certain requirements that would limit the assumption of risks.

In the nineteenth century, when the normal form of paper money was private bank notes, the frequency with which banks caused collapses in the flow of money by not honoring the promises of their notes increased, and then the first great debate about the need to change this system.

And there were two fundamental changes. On the one hand, one of the most important state protections was introduced, that of using central banks to lend to private banks when they had problems. It was done through a mechanism called “lender of last resort” advocated by Bagehot, the editor of The Economist.

The other change was in the opposite direction, that of strengthening public and safe money. The reform consisted of making it difficult and even prohibiting private banks to issue banknotes. And this was the last time progress was made in money reform, not by way of protecting fragile bank money, but by using public money, which therefore does not need protection.  Today, in practically every country in the world, banknotes are issued by the central bank and not by private banks, and of course central bank notes never collapse., especially when the monetary systems are already a totally “fiat” system.        

However, from that moment and to date, all the changes in the banking monetary system have been in the direction of increasing the protections and privileges of the State to the banks, as well as increasing the interventionism of the State in their economic decisions, fundamentally, in the assumption of risks.

An example of these regulatory changes was Roosevelt's creation of deposit insurance, which has been one of the interventions that has most prevented market discipline from working.

This reaction of increasing the privileges of the banks as well as the massive state interventionism to try to correct the problems of instability created by bank money has continued to this day. Even during the recent pandemic, to prevent banking crises from occurring, protections for deposit institutions were increased.

Also interested observe the reaction to the great banking crisis of Lehman Brothers. So there was unanimity in the diagnosis of the origin of the crisis, everyone repeated that “the market had failed”. And this diagnosis was defended not only by the usual suspects on the left but also by liberal-conservatives, such as Alan Greenspan, who preached that, in the case of banks, it was necessary to increase the protection of the State, as well as its interventionism in decisions risk-taking business.

This erroneous diagnosis gave rise not only to the increase in the volume of insured deposits (in the United States it went from $100.000 to $250.000) but also to the immense work of the Financial Stability Board (FSB) that approved the regulatory change that received the name of Basel III and that was incorporated into the different national legislations such as the Dodd-Frank law of the United States or the Capital Directive of the European Union.

No economic sector has a similar regulation. The regulatory development of Basel III in the United States and Europe occupies around two million words. If we compare it with the length of the Bible, it means that, if a banker wanted to know what he must comply with, he should read about three Biblias. But it is not a unique intervention only because of its volume but because of its content, since current prudential regulation is an example of the claim that regulators know better than businessmen (in this case bank managers) how they should manage their risks.

The Big Bang of Digital Money

This general attitude of complacency with the interventionist regulation of money and banking has been maintained until recently. It is true that as of 2013 the old ideas of economists opposed to the maintenance of fractional banking began to resurface, but these views critical of the current system remained in a very limited circle of economists.

And it was not the regulators or the central banks that started thinking about changing the monetary and banking system. As has happened in the liberalization of other activities, the possibilities offered by the new technologies of doing things differently and improving the services provided to citizens that have forced regulators and central banks to now consider changes in the current systeml.

In these years, many concrete initiatives for change have emerged. On the one hand, there are the proposals of the self-styled “cryptocurrencies” that preach a radical change and that consider that the State is absolutely unnecessary. On the other hand, most of the world's central banks are working on the introduction of public digital money that would be accessible to all citizens and businesses.

The current debate on digital money has led to a clear distinction between money and payment services. And this distinction is key to ensuring that these services can be provided by private companies other than banks. We are beginning to see the advantages of money being public (as is already the case with physical money, banknotes) and not being issued privately as is the case now. It is being discovered that using public money as means of payment – ​​such as CBDCs or stablecoins backed by public money – could serve to increase competition in private payment services.

It would be pretentious to predict how this great debate will end, since it is not just about deciding how the reform should be carried out following objectives that defend the public interest - the interest of all - but, as always happens, there are also important interests at stake private.

Specifically, and in parallel to the debate on the public objectives of the reform of money and banking activities, we are experiencing a battle between the interests of those who still have privileges and are trying to defend them and the interests of those who have seen the enormous possibilities of profit that exist if they are allowed to provide some services with a quality and cost that banks today, for different reasons, they are unable to offerr.

Where is the regulation of money and banking activities going?

It is not easy to predict the final outcome of the current debate on the possible liberalization of payment services and credit.or. And there are still many open questions.

The first question is whether we will continue to use a private and risky financial asset as money. as is the case now with bank deposits. And the same could happen if the new private digital currencies were inadequately regulated. Or if, on the contrary, money is clearly separated from payment services in such a way that the money can be public and secure, so that payment services could be provided by private initiative in full competition and without any relevant intervention of the Condition.

The second question is who is going to create the money? that is, will private companies continue to create it as is currently the case and as some new digital currency alternatives would like? Or will it be created by all citizens through the institutions of collective decision that democratic societies have?

 The third issue refers to how competition will look in payment services.or. Are we going to continue using closed and monopolistic systems like the current ones or will they be replaced by new systems open to competition between payment service providers?

These questions are open. The only thing that can be predicted is that the regulation of the monetary system and of the activities that banks provide today will surely be very different from the current one and, especially, in what refers to the role that the State and the Market will play.

If we move from the predictable to the desirable, it is to be hoped that the rethinking of what is being done now regarding the regulation of money and banking activities will be done with a pragmatic vision when deciding what should be public and what should be private. It is a hope based on what has happened with the liberalization experiences that have taken place up to now. All the liberalization processes of the last 70 years, including the transformation of the communist countries, have been guided precisely by pragmatism and not by ideological dogmatism.

A pragmatic vision of the public and the private does not consist in asking whether there should be more or less Market or more or less State, but in leaving to the Market and the State what they know how to do best. It is not about deregulating for no reason, but about introducing state regulations that favor competition and market discipline.

This pragmatic philosophy has been applied by many governments of the right and left over the last seventy years. And it is summed up well in a phrase by Ten Xiao Ping that said "I don't care if the cat is black or white, what matters to me is that it catches mice".

(This post is a variation of an article recently published in the magazine Time of peace)

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About the Author

Miguel A. Fernandez Ordonez

Miguel A. Fernandez Ordonez

State economist. Former Governor of the Bank of Spain and member of the Governing Council of the European Central Bank (ECB). He currently teaches Seminars on Monetary Policy and Financial Regulation at IEUniversity.

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