When Banks Act as Regulators within a Regime of Privilege

Brian Knight

Recently, some banks announced they were going to cease doing business with certain legal industries, like the maker of certain firearms and private prisons. The banks specifically said that these decisions were not based on standard business justifications like profitability, but rather on a desire to drive change in the underlying market. For example, the goal was to coerce firearms makers to refrain from making otherwise legal products. Regardless of how one feels about banks’ efforts to engage in de facto, private regulation, you would think that they are private actors and should be free to associate with who they see fit, right?

Well there is a potential wrinkle. Banks are not like most private sector actors. More than almost any other industry, banks are uniquely privileged by public policy. They enjoy significant barriers to competition, exclusive access to government provided services like FDIC deposit insurance and the Federal Reserve’s payments system, and even protection from outright failure, as we saw with the recent bailouts. These supports benefit all banks at the expense of their non-bank competitors, particularly in areas like lending and money transmission and in some cases uniquely benefit some banks more than others. Banks receive these benefits because they are believed to be essential for a functioning economy, but it is also likely that these benefits supplement the market power banks enjoy. Does that make banks trying to de facto regulate other industries by withholding services, in effect trying to impede lawful commerce, problematic?

This is the question Trace Mitchell and I examine in our recent research.  In it, we examine some of the ways public policy privileges banks, some of the reasons why we may want to be skeptical of banks withholding services in an effort to engage in de facto regulation. We also discuss the various options policymakers have if they believe banks acting as de facto regulators does present a problem.

Of course, the ideal solution would be to remove the privileges banks enjoy and make the market for banking services truly free. However, we acknowledge that in the current state, there may be political and practical barriers to this solution. Another option would be to deny banks that wish to engage in de facto regulation access to government-provided benefits while still allowing them to use nonpublic alternative such as private deposit insurance. While this solution is more flexible it also faces challenges. Finally, we could simply prohibit banks from using political goals and motivations as a criteria in bank decision making, akin to how discrimination law prohibits the consideration of race or sex. While simple and enforceable, this solution also is the harshest and places the most burden on banks’ freedom of association, an important — though not necessarily all-important — concern.

There is, of course, another option. We could do nothing. If you believe that banks’ actions are not problematic, or that the cure would be worse than the disease, doing nothing makes sense. However, even then it is likely appropriate for policymakers to be more explicit and specifically say that banks are permitted to attempt to regulate downstream markets. This transparency is important because, as mentioned above, banks’ privileges are justified to the American people as being valuable to a robust economy. It is not clear people would accept the same privileges if they saw banks as self-appointed regulators.

Ultimately, our research does not serve as a final answer but rather, we hope, as an initiation of a conversation on how government-granted privilege interacts with our assumptions about the rights of private actors.  As financial services (and everything else) gets more politicized, this question is likely to become increasingly important.

Brian Knight

Director of Innovation and Governance and Senior Research Fellow

Mercatus Center, George Mason University

Federalist Society’s Financial Services & E-Commerce Practice Group

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