SliceOfNYC

Banking regulation has been extensively discussed by many politicians, economists, and regulatory agencies after the subprime meltdown in 2007. I decided to write about this topic after following an interesting lecture about Competition Policy in Financial Markets. The lecturer Prof. dr. Maarten Pieter Schinkel specializes in competition economics and regulation at the UvA.
Like any other economics course you might have taken in the past, I would like to start off by abstracting the world in a simple model using assumptions that may or may not occur in real life. However, as an economics student myself, it is nice to try modelling a complicated world in a relatively simple model. The goals are to try to see how exogenous (independent) shocks affect the chosen variables within the model.

Firstly, when analyzing competition in financial markets and its effect on total welfare, we should dive into more detail about ‘competition’ or a ‘competitive market’. Some people naturally dislike competition, others might see it as something positive. In contrast to lawyers which focus on maximizing the surplus of the consumer, economists rather see the whole society benefit. They want to maximize the total welfare instead of just consumers surplus. To make it easier to picture: they want to maximize the size of the ‘pie’ and afterwards argue what the exact redistribution should be. Using Economic lingo: under perfect competition, the welfare maximizing price and quantity sold can be found by setting demand equal to supply. When determining prices, firms will undercut each other in order to attract customers. Eventually no economic profit will be made by firms so all of the welfare is captured by consumers.

A perfectly competitive market sounds good, right?! Does a perfectly competitive market exist and is the Banking sector a good example? I have to disappoint you here, since there are hardly any perfectly competitive markets in the world. However, as I said earlier, it is important to be able to model the complex world in relatively simple models. This can be used as a proxy of how markets should be organized in order to design competition policy and laws. Achieving this ‘goal’ will maximize total welfare and at the same time benefit society.

The banking sector has been shielded from competition policy for long periods of time. Firstly, the second-to-previous paragraph explains the welfare consequences when there is no restriction in the competition. In the case of the banking sector however, there is no such thing as a competitive market. Banks artificially create scarcity in the banking sector by making it more difficult to borrow money for individuals and firms. This will lead to a higher price, lower consumer surplus, slightly higher producer surplus, and total welfare which is lower because of the artificial scarcity that is created in the banking sector. This loss in welfare, because we move from a competitive to a non-competitive market due to non-competitive pricing, is called deadweight loss.

Better: what are the possible reasons for government agencies and regulators to keep the banking sector from moving to a highly competitive market? Firstly, the banking sector is a strictly regulated market with high barriers to entry. The Dutch Central Bank and the Authority Financial Markets make it extremely difficult to start a financial institution in the Netherlands. A bank is not like a 7/11 you can open in just a couple of weeks. It takes time, regulation, large amounts of capital and high-end technology to do so.

Secondly, brand naming also leads to difficulties for the banking sector in emerging into a perfectly competitive market. Many consumers are skeptical if they, for example, are buying their first property and have to take a mortgage. They perceive smaller financial institutions who provide mortgages as ‘riskier’ as for example a well-known firm such ING. Fewer firms will try to enter the mortgage market because it is difficult to capture a piece of the pie from larger banks.

Thirdly, when there are too many competitive pressures this could lead to a decrease in effectiveness of adverse selection mechanisms. Normally, because banks lend out money to the consumer, they have an incentive to screen consumers properly to only choose the creditworthy people. However, if there is competitive pressure in the banking sector, profit margins will be lower, and banks will more easily lend out money in order to keep total profits the same. This means there is a higher probability for non-performing loans. In this case, there is an incentive for regulatory agencies and the Dutch Central Bank to not pressure commercial banks too much.

These 3 elements could have been the reasons why the banking sector was not heavily regulated until 2007. According to the financial institutions, it was really important to have no government intervention. Regulators should just leave them alone and let the market work for itself. Despite the fact that they indeed were left alone, the financial sector was still extremely unstable and managed to disrupt the world economy. The question that raises now is: why shouldn’t we heavily regulate the financial sector? According to economic theory, in a perfectly competitive market, all firms make zero economic profit given a market equilibrating price. So all the inefficient banks that cannot produce against this equilibrium price should leave the market. Why should we shield inefficient banks with certain competitive policy? Why is there so many critics from the banking industry about all the regulatory regimes? Are we not better off if we would just aim for a perfectly competitive market?