Figure 3 The Principal-Agent Problems of Regulated Financial institutions

Principal	Monitors →	Agent
Taxpayers	→	President/Congress
President/Congress	→	Regulators/Deposit Insurers
Regulators/Deposit Insurers	→	Insured depositories
Insured depositories	→	Borrowers
Lenders (depositors) and equity holders (owners)	→	Financial intermediaries

Entry and Exit Rules

One of the requirements of a competitive market is freedom of entry and exit. The reregulation of U.S. banking, which began in 1980, permitted greater freedom of entry (e.g., by permitting existing banks to enter new product and geographic markets) but failed to allow economically insolvent banks and thrifts to exit (e.g., lack of prompt corrective action or an effective closure rule). The result was a financial disaster because both the bank and thrift deposit-insurance funds went bankrupt and had to be bailed out by the US. Treasury (i.e., U.S. taxpayers). The FDIC Improvement Act of 1991 attempts to provide for a more orderly exit of weak depositories by requiring "prompt corrective action" for such institutions.

Viewed in terms of a weakness-in-banking equation. The lesson for either a developed or a developing economy is unmistakably clear:

New Powers + Forbearance → Weakness in banking (1-2)

Forbearance (short for capital forbearance or, more generally, lax supervision) refers to the unwillingness on the part of the U.S. regulatory troika (Federal Reserve System/FDIC/Office of the Comptroller of the Currency, OCC) to close banks and thrifts before their economic net worths were exhausted. This practice means that economic insolvency (market value of assets < market value of liabilities) occurs before bank closure, which is a regulatory decision. The longer the lag between economic insolvency and closure, the greater is the risk of loss to the FDIC and taxpayers. The prompt-corrective-action provision of the FDIC Improvement Act of J 1991 attempts to provide firmer supervision for this regulatory shortcoming.

The regulatory dialectic (struggle model)

Kane [1977] describes the battle between bank regulators and bankers as a "regulatory dialectic," or struggle model. His idea builds on philosopher Hegel's concept of change as consisting of three stages: (l) thesis. (2) antithesis. and (3) synthesis. When thesis and antithesis clash, a synthesis results. The synthesis becomes a new thesis, only to be confronted by a new antithesis, resulting in a new synthesis. The struggle is an ongoing one because regulation acts as a tax that bankers try to avoid.

The nature of the struggle originates in the different objectives of regulators and bankers. Regulators typically focus on safety, stability. and structure ( competitiveness), whereas bankers focus on maximizing some variable, such as wealth, profits, or size or engaging in expense-preference behavior. When their actions are constrained, bankers look to circumvent restrictions by searching for loopholes in laws and regulations. Regulators react by trying to close loopholes, and the ongoing battle resembles a dialectic. To the extent that the struggle stimulates financial innovation (as a way of circumventing restrictions), the regulatory dialectic also explains the process of financial innovation.

The benefits and costs of regulation are difficult to measure because the benefits can be short term but the full costs are incurred over a much longer period. For example, the full costs of U.S. deposit insurance and regulatory restrictions, born in the 1930s, did not become apparent until 50 years later. Laws and regulations must be analyzed carefully for their good intentions and their unintended evils.