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Ending the Myth of 'Too Much' Bank Competition

It seems that in financial regulation, bad ideas tend to die hard. The idea that too much competition leads to financial instability is one of them. Popularized during the Great Depression, it has maintained its appeal in recent years as policymakers doubled down on the same regulatory approach that failed to mitigate the 2007-08 financial crisis.

The idea, however, is more of a myth. It was not excessive competition that brought down the U.S. financial system in the 1930s, but disastrous monetary policy and a banking system that was purposefully fractured by government regulation. In the most recent crash, it was again the Federal Reserve and an array of government programs that encouraged homeownership that drove the housing bubble. It was not a lack of government intervention, but an excess of it.

The myth has not constrained itself to the United States, however. In my home country of Australia, the head banking regulator, the Australian Prudential Regulatory Authority, recently argued that, “too much competition can destabilise the financial sector.”

As I wrote earlier this month, the problem with the Australian financial system is not too much competition, but an utter lack of it. The largest four banks in Australia control more than 75 per cent of the industry and nearly 25 percent of the stock market. This is on the back of a swath of government protections and subsidies that have allowed them to capture the Australian market by regulatory default. As a result, Australian consumers suffer under higher prices, while scandals continue to plague the largest banks. Without competition, they remain unaccountable to their shareholders and customers. It seems that propping up the largest four banks is the problem, not the answer.

APRA doesn’t see it this way, however. The head regulator proclaimed that, “Periods of excessive and unsustainable competition can result in financial institutions… unintentionally accepting excessive risk.” But while government officials and their regulatory bodies are quick to blame the “excesses of the market,” they conveniently neglect their own role in financial instability.

Take the United States’ mortgage behemoths Fannie Mae and Freddie Mac, for example. These government sponsored enterprises were one of the main culprits in the subprime mortgage bubble. Yet in the ten years since the beginning of the financial crisis, nothing has been done to rein them in. This is the same story for the Community Reinvestment Act, which forced banks to make loans to subprime borrowers, or the easy money policies of the Federal Reserve that inflated the housing bubble to begin with.

In Australia, the issue of government guarantees is just as prevalent. The level of guaranteed deposits, for example, is some of the highest in the world. Initially, deposits up to $1 million AUD were insured by the government at no charge. This was recently lowered to $250,000 per person per institution, but is still much greater than the average Australian holds in his or her account. By guaranteeing customers deposits if an institution were to fail, customers lose the incentive to monitor a bank, and banks are encouraged to prioritise high returns over safety and soundness.

Government guarantees that allow banks to reap profits and socialize losses are the real cause of excessive risk taking. Perhaps the greatest example is the taxpayer bailouts of failing banks. By not letting banks that take too much risk fail, government policy distorts the incentives for banks to act judiciously. This, in effect, incentivizes more risky behaviour from banks as they focus on shareholder returns rather than stability. If regulators were serious about dealing with the fundamental risks of finance, they would quit bailing out bad banks and reform other government guarantees that promote risk taking.

It’s time to let the idea that too much competition is bad for financial stability finally die. In Australia, as in the U.S., more competition and less government interference in the financial sector can lead to a more efficient and stable system. It is government policy, not excessive competition, which is the cause of financial instability.