Richard W. Rahn currently serves as Director General of the Center for Global Economic Growth (a project of the FreedomWorks Foundation) and as a member of the Board of Directors of the Cayman Islands Monetary Authority (which regulates the world’s fifth largest financial center). He is also a visiting fellow with the Heritage Foundation, an adjunct fellow of the Discovery Institute, and an adjunct scholar at the Cato Institute. In addition, he writes a weekly economic column for „The Washington Times“ which appears in many other newspapers around the world.

Should government regulate financial institutions? I expect most people would answer "yes" to that question, but if you ask them “why,” I expect these same people will have a hard time giving an answer that makes sense.

Some may say, "in order to prevent financial institutions from engaging in fraud or misrepresentation." But we do not need regulation to do that; in virtually all countries there are already statutes against fraud and misrepresentation, and businesses that behave badly can be dealt with through normal civil and criminal legal means. Others, who are a bit more sophisticated, might argue that we need to regulate business in order to protect people from "market failures." However, the empirical evidence is that there are far fewer "market failures" than commonly imagined, and many of these so-called market failures are actually a result of misguided government policy or regulation.

For a minute, try to imagine a world without government regulation, but where all of the standard laws against theft, fraud, misrepresentation and bodily injury still exist. Under such a scenario, what do you think would happen if we had no food and drug administration to tell us what was safe to consume? No financial regulators to protect us from bank failures and financial scams? No health and safety regulators to protect us from unsafe products? Would we all die? Not likely, because the judicial system, coupled with private standard setting associations, would likely give us an equal, if not a higher, level of protection than we have now.

More than a century ago, when electrical appliances were first being developed and sold, there was a problem in that many of the new products shocked their customers and/or started fires. The electric appliance industry quickly understood that this situation was dangerous and not good for business and thus started an industry sponsored organization to test products to make sure they were safe and reliable. The organization was called Underwriters Laboratories. It still exists today to ensure that electrical products bearing the UL seal are safe, and its mark has become the standard. In the absence of regulation, virtually every industry would do the same thing, because legitimate enterprises know that being branded for selling faulty products would ruin their reputation and put them out of business. Unfortunately, as a result of ceaseless propaganda from pro-government interest groups, most people have been brainwashed into thinking they need regulatory agencies to protect them.

A most provocative paper was recently published by the American Enterprise Institute, written by former U.S. Treasury General Counsel Peter Wallison, entitled "Why Do We Regulate Banks?" Mr. Wallison argues that "it is difficult to identify a sound policy reason for regulating banks. Most of the conventional explanations -- inherent bank instability, deposit insurance, the Federal Reserve's role as lender of last resort, or the Federal Reserve's role in the large-dollar payment system -- turn out on examination to be either unfounded or based on risks that the government need not take in order to foster growth of the economy." Mr. Wallison goes on to detail "the huge costs to the taxpayers and the economy" caused by bank and Saving & Loan Association failures that have been due to regulation. Finally, Mr. Wallison, who has had major regulatory responsibility, concludes as to the question, "Why do we regulate banks?, that we do so because we want to, not because we must."

The arguments Mr. Wallison makes for the U.S. are in most cases equally applicable to other countries. Banking is no more unstable than most other businesses. Bankers can make errors in judgment, and, if so, their bank will suffer, and their competitors will gain an advantage. Bankers can be dishonest, but regulation cannot prevent most cases of willful dishonesty and laws against crime will not prevent the crime if an individual is set upon committing one. In most countries, the existing criminal statutes are sufficient to punish wrongdoers.

In the absence of government regulation, industry associations step in to provide codes of conduct and procedures for best practice. In virtually every legitimate industry, members have a vested interest in keeping out the corrupt and incompetent because it hurts everyone’s business. The financial industries are particularly sensitive to industry and product reputation. A bank or other financial institution that causes problems will most likely be expelled from the relevant industry associations, and consumers will be informed by the associations who is and who is not in good standing.

Because consumers believe that government regulators can protect them in many ways that they cannot, consumers tend to be less diligent in looking at the health and reputation of companies that are known to be regulated, which is very true with regulated financial industries.

In some countries, such as the U.S., the government provides “deposit insurance” in case the bank fails. There is no reason that providing “deposit insurance”, needs to be a government function. In some countries, such insurance is provided by private insurance companies, as it would be in the U.S. and other countries if they exited from government insurance programs. Private insurance would merely transfer the cost of the insurance from the taxpayer to the depositor, where it belongs.

It is often argued that financial institutions need to be regulated in order to handle a shock to the system – e.g., the failure of a large institution, a failure by a foreign government to fulfill its financial obligations or where the government fails to allow its own financial institutions fulfill their obligations, particularly, when it spills over to institutions in other countries. Government regulation of financial institutions can rarely prevent such financial shocks – and very frequently one or more governments or international financial institutions are the cause. Government bailouts add to systemic risk, whereby participants in the financial system from depositors to bank managers fail to exercise due caution because of the belief that the government will bail them out of their mistakes.

People around the globe are justifiably concerned about terrorism and ordinary criminality. A certain international political class has used this anxiety to argue that since criminals and terrorists use money, all monetary movements and holdings must be monitored. Yes, it is useful to be able to trace the money trail of al Qaeda operatives. But does that mean all citizens of every country should be subject to having all their financial privacy destroyed? Furthermore, is it cost-effective to monitor almost everyone, or would both public and private law enforcement dollars be more wisely spent monitoring the activities of those individuals or groups known or strongly suspected of engaging in terrorist or criminal activities?

Both U.S. and non-U.S. financial institutions are faced with a barrage of new rules and regulations from their own and foreign governments, plus the European Union, and from international institutions, such as the Organization for Economic Cooperation and Development (OECD), the Financial Action Task Force (FATF), the International Monetary Fund (IMF), and the United Nations (U.N.). The agencies within the U.S. government, issuing the new financial rules and regulations, include the Internal Revenue Service, the Federal Bureau of Investigations (FBI), the Justice Department, the Financial Crimes Enforcement Network (FinCen) and the Federal Reserve.

In addition, millions of other businesses which are not strictly financial institutions but are “money service providers” – such as real estate agencies, car dealers, and pawn shops -- are subject to, at least, some of these new rules and regulations, and it is almost impossible to inform them of their obligations. Even the largest international banks, with huge staffs of lawyers and anticrime enforcement personnel, are unable to fully work through this ever-expanding morass of regulation. Smaller banks and businesses are at a competitive disadvantage because of the disproportionate effect of these regulatory costs. Some of the regulators are aiming at terrorists, others at ordinary criminals, and some at tax avoiders or evaders. Most of the regulations are directed at "money launderers," even though the term has a very elastic definition.

Many of these new rules and regulations are overlapping, some are contradictory, some violate basic civil liberties, and many are costly to administer and do not meet reasonable cost-benefit tests. The reason we should care is that all of these extra, and in many cases totally unnecessary, costs are passed along to consumers of financial services as higher fees and more expensive and fewer choices in financial products. This directly translates into job losses, not only in financial industries, but in all businesses that rely on some outside financing.

In addition, these regulations make it more difficult for low-income people, the young and recent immigrants to open bank accounts. Costly regulations that force more people into the cash economy not only make life more dangerous for those who cannot open bank accounts, but also have the perverse effect of making it more difficult for law enforcement to trace funds of criminals. There is little evidence that all the new rules and paperwork are having any appreciable effect on crime or terrorism, because there is an almost infinite number of ways to "launder" money, and organized terrorists and criminals can nearly always find ways around the regulations. On the other hand, there is considerable evidence of damage to our pocketbooks and civil liberties from these regulations.

An international private sector organization should be created to demand and conduct strict cost-benefit and civil liberties' tests to all proposed regulations emanating from international bodies like the OECD, FATF, IMF, and the U.N., as well as those from governments that affect nonresident institutions.

In May, 2002, the Task Force on Information Exchange and Financial Privacy issued its Report of Financial Privacy, Law Enforcement, and Terrorism. Among the recommendations of the tax force are:

1. Better target anti-money laundering laws by creating watch lists to be provided to financial institutions rather than collecting millions of pieces of paper on law abiding citizens.

2. Prioritize national security, anti-terrorism and serious crime in information exchange efforts.

3. Take more aggressive steps to prevent sensitive information held by governments from reaching hostile hands.

4. Limit financial information sharing to responsible governments where dual criminality exists, where the requests for such information are limited to specific persons or institutions, and where such requests have been approved by the appropriate judicial authorities in each government.

In conclusion, if financial institutions and their customers are weakened or bled to death by regulatory malpractice, the war against real criminals and terrorists will only be made more difficult.