01/11/2011 10:33 am ET Updated May 25, 2011

Bringing Back Those Old-Time Regulations

In the Financial Times on Monday, Amar Bhidé, a professor at Tuft's Fletcher School of Law and Diplomacy, offers up a deceptively simple solution to bank regulation: Return banking to an era, roughly from the '30s to the '70s, when tight caps regulated interest on deposits. The purpose of this interest rate regulation is to limit the threat to deposits, a key component of bank capital, posed by a run, mostly from so-called hot money. As Bhidé says, these caps were eliminated in the '70s when inflation soared, destroying the value of deposits offered at the so-called risk-free rate. And, as always, there was an accompanying competitive threat: the development of unregulated money market funds, which grew by paying up for deposits, thus undermining the banks.

Bhidé is not wrong. Capping deposits would provide a sort of prudential governor on lending. Such a cap on bank deposits and money markets would tend to even the playing field, at least in terms of traditional deposits. Banks could only boost their lending by increasing deposits the old-fashioned way -- expanding through M&A, adding branches or marketing -- rather than paying for hot money and praying that nothing goes wrong. Like any kind of fundamental regulatory change, that would produce a series of consequences, some obvious, many not. Larger banks with greater resources and extensive retail operations would have an advantage over smaller banks with limited branching (and in fact, branch expansion is expensive and often fruitless; the real issue here is bank marketing, which has rarely been terribly effective). Banks might have every incentive to take on more risk to make up for slower growth in deposits. And, of course, the effectiveness of the step would depend on imposing the cap across all forms of financial institutions and -- this is the real rub -- across the globe. In theory, this would have little to do with "banks" like Goldman, Sachs & Co. or hedge funds, which lack a traditional retail deposit base, and that finance themselves daily in short-term wholesale markets.

Bhidé understands some these complexities, but forges ahead nonetheless. His broader conclusions are inarguable: "The story of U.S. deposit regulation offers important lessons for bank regulators: pay attention to short-term liabilities -- just focusing on bank assets to control contagious imprudence is unwise. Moreover controls (and explicit guarantees) have to be comprehensive and uniform: they cannot exclude the deposits of sophisticated investors or exempt intermediaries such as money market funds. Allowing large depositors to earn higher rates (under the fiction that they face more risk) is particularly dangerous, when the mad music to which bankers dance heats up."

But to make this work in the real world, Bhidé is implicitly proposing something more than a cap on retail deposits: He's suggesting a broad return to a simpler set of institutions, at least as defined by regulators, and a simpler set of products. Banks and money market funds would be essentially identical (except for the bank edge in deposit insurance); the real divide would be between depository and nondepository institutions, which sounds a lot like Glass-Steagall. However, if we've learned anything in the financial crisis, it's that the Glass-Steagall divide between depository and nondepository institutions breaks down in a world of fiercely competitive publicly traded institutions. And Bhidé would need to impose this regulation around the globe to avoid regulatory arbitrage (consider how one tiny, obscure venue, Iceland, wreaked widespread disaster by offering very high -- unsustainably high -- rates on deposits). But that's just the start. Despite his ritual gesturing toward the '50s and '60s, such a broad regulation of deposit caps would limit the liquidity many institutions could generate, much as increasing capital would. For all the talk of re-regulation in the G-20, many politicians, particularly in the developed world, are leery of doing anything to restrain liquidity. It's true, emerging nations are more sensitive to the whipsawing of hot money, and deposit caps can be used to provide a brake on overheating economies. But there's a big difference between reining in an overheating emerging economy and not being able to kick-start a developed one that's mired in recession or malaise. The former isn't easy -- recall the metaphor of the punch bowl -- but the latter is well-nigh impossible, particularly politically.

Obviously, this experiment in turning back the clock would depend on tight and creative regulation, which is never guaranteed, particularly as time passes. But here's the big problem. Bhidé's notion might work for a time under very specific conditions, but would be vulnerable to exactly the same kind of dislocations that undermined it in the '70s: volatile macroeconomic conditions, the development of new financial products, competitive globalization. Commercial banks in the '70s cried for deregulation because they felt themselves losing out not only to money market funds but also to Wall Street, mutual funds and a variety of nonbank finance operations. What would insure that the level playing field imposed by rate caps could be held unless similar restraints were imposed on competitive, nondepository institutions? If deregulation, once launched, tends to lead inexorably to the demand for further deregulation, which is often true, the same applies to re-regulation. Both processes eventually take us to unsustainable locales -- failure or stall -- which help explains the pendulum swings so characteristic of financial history. It would be interesting for Bhidé to explain how rate caps can dampen those swings.

Robert Teitelman is editor in chief of The Deal.