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Government Not Only Source of Regulation for Finance

One of the most misunderstood and underappreciated aspects of free market economics is the idea of private or “self” regulation. Up until recently, private enterprises largely self-regulated through forming partnerships or organizations that would privately enforce a set of standards or best practices. For banks, this included such things as lending standards and a firm’s capital structure. Over time, however, government agencies increasingly took over these roles and supplanted private regulation. But even today, examples still exist.  

Take the Australian financial technology (FinTech) sector’s recent decision to self-regulate the disclosure requirements for small business lending. The decision comes in response to a report commissioned by the trade association, FinTech Australia, which recommended that start-ups improve disclosures that will allow small business customers to compare total costs, understand obligations and penalties, and improve dispute resolution. Under no legal obligation (but an obligation to satisfy their customers) the industry is actively improving its standards through enforcing codes of best practice. 

The decision is a reminder that the government is not the only source of regulation in financial services, and that deregulation would not mean no regulation. Private companies look to implement best practices that address typical concerns of regulators, and they often do it in a more efficient and effective way. Because these agreed upon standards come from the bottom up, developed by the industry themselves to address concerns of its customers, they are often better suited than one-size-fits-all rules devised by bureaucrats in a nation’s capital.  

The decision is also a reminder that in a competitive market economy, firms want to do what is best for their customers, or risk losing them. A market economy ensures that those who satisfy their customers more effectively reap greater rewards. FinTech companies in Australia face stiff competition from more entrenched lenders with greater market power. Yet these “Big Four” banks are largely unresponsive actors entrenched by government protectionism. Competing via more responsive customer service differentiates the new FinTech firms from their rivals, ultimately to the benefit of the consumer.

Another example comes from the payday loan industry in the United States. The Community Financial Services Association, for instance, has a list of mandated industry best practices that “ensure responsible conduct among lenders, protect borrowers’ rights, and encourage self-governance of the payday advance industry.” The provisions include upfront, easy to understand disclosures of terms and conditions; the option of an extended payment plan, at no additional charge, if a customer cannot repay their loan when due; and limiting the number of “rollovers” to four. For CFSA members, this allows them to continue to serve their customers and stay profitable while addressing the kind of concerns that would inspire government regulation. And of course, if consumers do not prefer these standards, they are free to choose other stores that offer a different range of products. Contrast this flexible, tailored self-regulation to government regulation. The Consumer Financial Protection Bureau recently finalized a rule governing the payday loan industry, which applies unyielding underwriting standards that are completely inappropriate for these kinds of loans.

Perhaps the most surprising example is the United States banking system in the early 20th century. For the dominant banks of the era, there was no government safety net (such as federal deposit insurance) for either the bank or its partners. The financial system also (largely) did not rely upon enlightened regulators to decide what risks were and were not permissible. Yet institutions extensively regulated themselves to ensure a safe and sound financial system, because they fully bore the risks of their own actions. Kevin Dowd and Martin Hutchinson, for example, write in there book Alchemists of Loss:

By about 1900, both Britain and the US had evolved largely informal “regulatory” (or more accurately, supervisory) structures, in which lead institutions and key figures provided an oligarchic leadership that called the shots without formal regulatory powers. It was taken for granted that the big institutions had public duties even though they were private institutions.

In both countries, a banking crisis would be resolved by the leading player or players either allowing a weak institutional to fail…or calling on other members to assist in an orchestrated rescue…

The weakness of the system was that it created the potential for moral hazard…but the system worked well by modern standards, and the leaders of these banking “clubs” sought to control moral hazard (with some success, too) by limiting access to the club to “respectable” institutions who knew how to obey the club’s informal “rules.”

To many people today, it is unfathomable that the financial sector could largely operate on private, self-regulation. But the sector can, and has, operated on this basis in the past (see Dowd and Hutchinson for a lengthy discussion). Self-regulation has the benefit of flexibility, local knowledge, and maintaining consumer choice. To the contrary, government regulation typically picks winners and losers and imposes rigid rules written by those with little understanding of the industry or its customers. Where possible, regulators should refrain from pre-empting this form of private, self-regulation, and instead foster a competitive environment that encourages more of it.