Alternative s to Government Regulations in the Financial Sector

Eco 2154 PPP #4 Alternatives to Government Regulations in the Financial Sector J.D. Han for Money (and Banking)

We all know that Information Asymmetry is an intrinsic problem to the financial industry. How can we help the Market Economy solve its own problems? What are the market-endogenous, as opposed to exogenous government intervention, solutions to Information Asymmetry?

1) Activate Information Market Information Revolution may resolve Information Free Rider Problem Then there occurs a Perfect Market of Information which will (almost) resolve Information Asymmetry

2) Mergers and Acquisitions will lead to More Information Disclosures • M & A targets Firms with severe problems of Principal and Agent (a Moral Hazard), and tries to correct them. • M & A process reveals Moral Hazard problems of the target firm. • M & A uses Leveraged Buy Out (LBO) with bonds, and replaces equities with bonds which carry more management monitoring through restrictive covenant.

3) New Forms of Financing rises for Close Management Monitoring: Private Equity • Private Equity is complex and elusive. • What it does? One major function is Mezzanine Financing (preferred stocks, and subordinated bonds) combines Equities and Bonds with best of both worlds – Lenders can constantly and closely monitor management. • related (confusingly) with Venture Capital (relatively new), Merchant Banking (as old as in 16th century) • Japanese Banking, European Banking, and U.S. Financial Trusts(J.P. Morgan) before Glass-Steagall Act of 1933 • Gramm-Leach-Bliley Act of 1999 allows Financial Holding Company to become lenders(no meddling with management) as well as share-holders( who can do management monitoring), and boosts Private Equity(Merchant Banking) • Performances in terms of Returns and Safety(Risk) are superior. • The only problem is “social equity issue” or “protection of small investors” who go alongside with giants – U.S. has unique legal system to protect them: “Lender’s Liability and Equitable Surbordination”

We should facilitate Information Revolution, and allows for active M & As and new forms of innovative financing formats. • In reality, the government often tries to suppress them. • Obama-Biden’s basic tone of objection to these pro-market evolutions may be wrong.

4) Eventually Free Banking • History may repeat itself. • There is no substitute for Caution on the part of financial investor • This is related to “Information Efficient Market”

Is Government Regulation Necessary for a Stable Financial Industry? : A Possibility of Self Regulated Financial Industry J.D. Han King’s College, UWO

1. Free Banking: Free Entry and Self Regulated Note Issues Historical Instances of Self-Regulated, or Free-Market Financial Industry • Scotland, 1720-1840 • U. S. A., 1836/7-1863 • Canada, prior to Bank of Canada 1935 • Sweden, 19C • Hong Kong, Contemporary

2. Were They Stable? • Conventional Wisdom -> Yes, Scotland, Canada, Sweden and HK -> “No”, U. S. A.  We would like to challenge the second part of Conventional Wisdom

3. Scottish Free Banking: • Period: 1720-1840 • How did it work?: -Banks could print out paper monies, or notes as long as they do not default on redemption request of the notes for species -No government charter needed; Self regulated, competitive (free market driven) supply of money and banking practices

* Evaluation of the Scottish Free Banking Era Compared with the Contemporary British Banking Experience • Stability: no major bankruptcy -exception: Ayr Bank • Availability: more banking services per capita • Competition: small banks along with large ones • Efficiency: • spontaneous evolution of a clearing house (payment association) • Rapid propagation of information

4. American Experiences 1) Conventional Wisdom:”Bad” -> Free Banks were called “Wildcat Banks” 2) Revisionist View: by A. Rolnick and W. Weber “Not So Bad in many states except for Minnesota, etc.”

(1) First Paper by Rolnick and Weber: “New Evidence on the Free Banking Era” In Three Categories (failure rate; years in business; loss for note holders): New York: Fairly Good (8%; 8 years; 26 cents per dollar) Wisconsin and Indiana: O. K.(26-31%; 4-3-2 years; 11-24 cents for dollar) Minnesota: Bad (58%; NA; 70 cents per dollar)

(2) Second Paper by Rolnick and Weber:“Explaining the Demand for Free Bank Notes” Did the note holder really suffer such a great loss (70-75% of the face value of the note or paper money) due to Bankruptcy of Free Banks in Minnesota? Their studies found that it was “Not Really” that bad at all. Why?

*Three Point Arguments i) “The note holders had been well informed of the true value of the assets/notes from Minnesotan Free Banks.” : Free Market is more efficient in propagating information than we expect (Evidence: Well conversed the New York/Chicago Market Value of Government/Railway Bonds as Major Assets and Reserves of the Banks)

ii) Mutual Funds Interpretation: “The notes were issued with railroad bonds, which were traded below par. The bank notes were priced to reflect the value of their backing assets” The value of the notes depends on the total value of the assets divided by the number of notes/shares” *Evidence: Payment for the grading of a mile of railway was a lot larger in Minnesota than elsewhere in the U.S.

iii) “Therefore, the note holders did not have much loss even in Minnesota” - Minnesotan Experiences with Free Banks were not too bad (given the time and the location)

5. Lessons to be Learned Self-Regulated, Regulation-Free, Banking/Financial Industry may be Viable and even be superior.

Just a second! • There are 3 segments to consider in the financial sector: - Banks - Securities Market - Money

-We have so far reviewed the strength of Self-regulated Banking Sector (Free Banking). -We have an emerging historical evidence of the Superiority of Self-regulated Securities Market. Read Neil Reynolds’s inspiring article on the Dutch Securities market of the 16th Century, entitled, “Self-regulation: The Dutch had it right,” The Globe and Mail, Aug.12, 2006. E. Stringham’s paper on Amsterdam E. Stringham’s paper on Czech and Poland Jeffrey Adams on Incentive versus Ignorance -We can also stretch this point to the Money (next).

6. Stretching the argument further: • Is government’s monopoly of a currency necessary for the stability of price level?

1) Conventional Wisdom: “ unregulated competitive production of money will lead to over-issue of money and thus an infinite price level”

2) Revisionist Model by Benjamin Klein“Do Private Monies Lead to Infinite Inflation?”: No for the following 2 reasons (1) Informed Consumers’ Screening No,as long as they are Distinguishable monies, and “Brand Name Identification” is possible. Financial Market is information efficient (2) Incentive Compatibility of Private Money and Honesty -Money demand is unique -Consumer Confidence is built over a very long time in a ‘smart’ way. -The present value of the bank’s non-deceiving “profit” stream will be larger than the benefits from deceiving scheme of printing bad monies and running away. * The cost of counterfeit was more serious than the cost of private over-issue fraud and bank failures.

3) Extension • In the age of Globalization, currencies will compete internationally freely in the domestic economy as well as in the financial market; • “High-confidence monies” will win over “low-confidence monies”; - Market confers Trust and Confidence, not Government • Euro, and an increasing (U.S.) Dollarization; “Is Euro going to succeed?” “Is Canada going to use U.S. dollars?” “What about conventional money alternatives?”

Alternative s to Government Regulations in the Financial Sector