Free banking : the Scottish experience as a model for emerging economies

The notion of free banking is at least as difficult to define as the notion of central banking. The author focuses on a relatively unregulated banking system that operated in Scotland in the eighteenth and nineteenth centuries. He argues that a relatively unregulated system is a wise option for emerging markets today. In terms of private institutions and monitoring: 1) a private clearing system is feasible; and 2) so are private development and enforcement of capital and liquidity standards. Financial institutions have strong private incentives to create their own clearingsystem, to benefit both banks and the public, and will develop standards for capital, liquidity and prudential management by doing so. Competition is generally compatible with prudence and coordination. There are private alternatives to deposit insurance or to a central bank to maintain confidence in and foster the stability of the financial system: 1) sophisticated note and deposit contracts are feasible; 2) free entry is important to encourage innovation; and 3) branching and portfolio diversification can substitute for deposit insurance to stabilize the banking system. So can"extended"liability. Another alternative is the"option clause"or other contingent or equity-like contracts, which can solve or minimize the problem of bank runs. Therefore, an explicit central bank may not be needed, but rather mechanisms to provide added liquidity, perhaps through the clearing system, in times of trouble.Financial Intermediation,Payment Systems&Infrastructure,Banks&Banking Reform,Financial Crisis Management&Restructuring,Labor Policies,Education for the Knowledge Economy,Banks&Banking Reform,Financial Intermediation,Financial Crisis Management&Restructuring,Economic Theory&Research

The economics and politics of financial modernization

Financial services industry ; Bank supervision ; Industrial policy

Obstacles to Optimal Policy: The Interplay of Politics and Economics in Shaping Bank Supervision and Regulation Reforms

This paper provides a positive political economy analysis of the most important revision of the U.S. supervision and regulation system during the last two decades, the 1991 Federal Deposit Insurance Corporation Improvement Act (FDICIA). We analyze the impact of private interest groups as well as political-institutional factors on the voting patterns on amendments related to FDICIA and its final passage to assess the empirical importance of different types of obstacles to welfare-enhancing reforms. Rivalry of interests within the industry (large versus small banks) and between industries (banks versus insurance) as well as measures of legislator ideology and partisanship play important roles and, hence, should be taken into account in order to implement successful change. A divide and conquer' strategy with respect to the private interests appears to be effective in bringing about legislative reform. The concluding section draws tentative lessons from the political economy approaches about how to increase the likelihood of welfare-enhancing regulatory change.

Throwing Good Money after Bad? Board Connections and Conflicts in Bank Lending

This paper investigates the frequency of connections between banks and non-financial firms through board linkages and whether those connections affect lending and borrowing behavior. Although a board linkages may reduce the costs of information flows between the lender and borrower, a board linkage may generate pressure for special treatment of a borrower not normally justifiable on economic grounds. To address this issue, we first document that banks are heavily involved in the corporate governance network through frequent board linkages. Banks tend to have larger boards with a higher proportion of outside directors than non-financial firms, and bank officer-directors tend to have more external board directorships than executives of non-financial firms. We then show that low-information cost firms – large firms with a high proportion of tangible assets and relatively stable stock returns -- are most likely to have board connections to banks. These same low-information cost firms are also more likely to borrow from their connected bank, and when they do so the terms of the loan appear similar to loans to unconnected firms. In contrast to studies of Mexico, Russia and Asia where connections have been misused, our results suggest that avoidance of potential conflicts of interest explains both the allocation and behavior of bankers in the U.S. corporate governance system.