Pros and Cones of a Decentralized Banking System

Decentralized systems are naturally occurring, usually self-regulating systems which function without an organized center or authority. In terms of banking system, the decentralization is assumed under the non-existence or limited interference of financial institutions or governmental authorities, which suppose limited regulations’ pressures on banks’ activity and decisions.

If historically reviewing the banking system, we would depict that even closer to the 19th century, when the new economic order was established and all economical structures started to liberalize, the banking system still remained under governmental and institutional control (Neuberger, 1959). In that period also was registered an accentuated tendency of banking services expansion as a result of increasing demand from companies, governments, and financial institutions. Thus, the banking system became attractive both as a profit-generator and as a method of economy control by authorities.

There were created at least two mainstreams arguing on the pros and cons of a decentralized baking system: the Keynesian School (supported by McCleskey, 2010; Down, 1993; Ojo, 2010 and obviously the world-well-known personalities involved in central banks activities or other financial-regulatory institutions, e.g. Bernanke) and the New Banking School or Free Banking (supported by Sergin, 1988; Gersbach, 1998; international organizations like the Centre for the Study of Financial Innovation, PriceWaterHouseCoopers). If the first one stands for a centralized system and government’ intervention into the economy, then the New Banking School advocates the abolition of central banks and the deregulation of the monetary system (Down, 1993). The most important divergence in opinions begins from the theory (supported by Keynesians and rejected by “free bankers”) that if the money supply is centrally controlled consequently authorities (central banks or FED, for U.S.) should also actively interfere and manipulate the banking system. Each of the schools provides arguments in favor of their own position, and the recent financial crisis impose researchers and practitioners to find the best fit and the most valuable argument out of these opposite theories.

The simplest argument in defense of it is being implied by Scott McCleskey (2010), a New York-based financial journalist: “Perfect markets regulate themselves perfectly; all others require some level of regulation. And perfect markets don’t really exist.” Thus, McCleskey’ argument follows from the incentive of the active participants on the market to act unfairly, determining the deterioration of markets principles – the main motif for regulating them.

Another contra-argument for decentralization is the theoretical issue on the information, showing that a free banking system is too controversial when supplying information to customers (Down, 1993). Well-known, the information on the internal risky strategies of banks is not actually available. The inexistence of a central authority which would regulate this situation increase the willingness of banks for “risk appétit”-strategies and consequently increases the liquidity and solvency risks. Furthermore, if a bank gets to hold a lot of information and becomes too interconnected, then appears the information asymmetry: the “too big to fail” theorem and “discriminates” the other players (Ojo, 2010).

Generally, banks have only one main objective: profit. Customers appear only as an instrument to increase profits. Bank regulators want to be sure about bank’s potential to measure accurately financial details, as well as about the customers’ safety. Furthermore, banks care the most about each daily individual indicator from its portfolio. However regulators care more about the overall and long-term riskiness of the bank (Pyle, 1997). Thus, in order to ensure the long-term stability of the banking system: regulators are needed to intervene. An example of how central banks decrease the riskiness of banking sector is the minimum reserves requirement which ensures that the bank will have the necessary liquidities to fulfill its responsibilities at any time, not disturbing the market equilibrium.

A very interesting idea of Scott McCleskey relies from the question: why the banking system collapsed in 2007 – 2009? The answer seems to be enough simple and ingenious: because of the insufficiently regulated complexity of the banking system: it doesn’t look any more linearly like a domino when fail, but expansionary: “like a flu epidemic in a crowded city” (McCleskey, 2010). To avoid any further failures, banks need a regulator who would become at least as complex as the whole system is and would be able to check all the uncertainties which appear within the system.

The last, but not the least important argument to imply in sustaining the centralization is: central bank is a depository bank for “regular” banks. Of course each commercial bank can deposit its funds into any other commercial-partner bank. Still, it is well-known that the safest insurance is offered by the central banks. The danger of one bank failure lending to others failing increases the danger of a collapse because of the complexity, interconnection, and non-regulation (Capie, Goodhart, Fisher, Schnadt, 2009).

However, the centralization is not promoted by all the financial economists’ theoreticians and practitioners. Furthermore, after the financial crisis of 2007 – 2009, more and more researchers become convinced on the strong need of banking system decentralization.

Recently (2010), the Centre for the Study of Financial Innovation in association with PriceWaterHouseCoopers published an analysis on banking risks. The primarily argument which appears to stress the risk guiding banks to fail is political interference. Obviously, centralization is directly linked to political interference through institutions which pretend to be independent, but still represent an informal (and sometimes formal) link to provide information, as well as exercising pressure when it “is decided” to be necessary. The political meddling in banking is being interpreted as invariably negative (CSFI, 2010). Furthermore, it guides banks to the moral hazard (at least because of the rescues).

Another contra argument on centralization is that usually there are infinitely too many policies, changing too often. When a certain policy is implemented, central authorities already start working on adjustments and additional complications, finally no perfect rule can be find (Sergin, 1988). In the Table 1 the “too much regulations” is also being interpreted as one of the most important risks faced in the banking system (CSFI, 2010).

Furthermore, in conditions of internationalized banking, there is always present more than one monetary authority or regulatory agency which makes even more complex the assignment of responsibilities inside of a bank for rule enforcement. For example, in the US, the banking system is regulated by a long list of regulators: Federal Reserve System, Office of the Comptroller of the Currency, National Credit Union Administration, Federal Deposit Insurance Corporation, and Office of Thrift Supervision.

Not the least important are the painful measures implied by central banks through several instruments of monetary control, mainly minimum reserves requirements. Even if this argument was implied also as being pro banking system centralization, it usually complicates the execution of the normal banks activities, making the liquidity management tough. Also, if the required reserve ratio is increased, the bank will have to adjust by acquiring reserves: borrowing, selling securities, or reducing loans, which are disruptive and costly measures.

Next pro decentralization argument: free competition required! Issuing authorizations for new registered banks is another centralized responsibility of financial authorities. Some of the requirements for potential banks are too demanding and hard to accomplish. However, new small banks could have a significant role in expanding the financial activities, promoting the development through increasing the volatility of money: deposits – credits – investments. And the most important: competition decreases prices on provided services. Thus, free banking requires free entry (Gersbach, 1998).

In my opinion, the banks have to be supervised, because the profits which are generated by this sector and the interference on the monetary market are enormous. Thus, it is not rational to let banks to act independently, even if regulations complicate the whole system and perhaps its efficiency.

Ludwig M. P. Van den Hauwe in his article regarding free banking stated that even if we find many arguments in highlighting that a bank can do great without a central authority, at the end banks themselves will tend to establish an authority who would give them a prospective view on the whole banking industry (Hauwe, 2008). However, certainly in that case this central authority would have less power to exercise than it has now.

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