There are four common types of market failures that support a call for regulatory intervention. Three of these were identifiable during the Banking Royal Commission, writes law school head and regulation expert Dr Benedict Sheehy.
Politicians, policy makers and commentators often refer to the market as if it were a regulator. Comments such as ‘leave it to the market’ or ‘improved competition will solve these problems’ are as common as they are unenlightening. They represent in many instances a fundamentally flawed understanding of both the task of regulators and markets.
While the institution of markets have an important regulatory role, that role and its limitations need to be well understood and considered prior to delegating a problem to the institution. In the current context where the Royal Commission into Misconduct in the Banking, Superannuation and Financial Services Industry complains about greed and lack of honesty, it is worth thinking about the role and potential limitations of ‘market as regulator’.
Royal commissions, inquiries and investigations into banking in Australia have repeatedly commented that increased competition is necessary to improve outcomes for consumers. This view makes a number of assumptions about markets and their regulatory potential. The basic assumption is that markets can operate as regulators. Stated in this way, many people may find it odd or confronting to rely on markets to regulate their relations. Yet, markets have a regulatory function and indeed, are superior to all known alternatives in their limited capacity as institutions of allocative efficiency. The basic regulatory functions of markets parallel their basic function of matching supply and demand using the pricing mechanism.
How does a market regulate?
Markets regulate the nature, quality and quantity of goods and services provided. For example, a market may be created for good or service X. The nature of X will be determined by the market and suppliers will organise themselves to provide good X. Further, the market will regulate the quantity of X supplied. Where the market is small or otherwise limited, the market will regulate suppliers to produce a limited amount of X. Where the market is practically unlimited, the market may be said to regulate an increased supply so that a vast quantity of X will be produced and a large number of suppliers are likely to spring up.
Additionally, the quality of good X will be regulated by the market. Where a higher or different quality of good X is in higher demand, producers and suppliers do not rely on government authority to increase production. Rather, the market regulates producers and suppliers to increase their production. The reverse is also true with falling prices leading to reduced production and supply and related producers and suppliers. In this sense it can be said that markets regulate goods and services as well as the number of producers or suppliers. Markets, however, also regulate demand. Buyers will make decisions and act according to market prices. By freezing or adjusting prices up or down, buyer behaviour can be regulated for any good or service and related qualities. In essence, therefore, markets can be described as a coordination mechanism that operates by way of pricing. Price signals indicate the value placed on goods and services by buyers and sellers and allows them to coordinate themselves.
Four common failures of markets
Markets, however, suffer from four types of market failures all of which support a call for regulatory intervention. These four commonly acknowledged failures are: information asymmetries, public goods, incomplete markets and externalities. The core failures the royal commission has found in the banking system are manifestations of at least three types of market failure.
The first of these failures, information asymmetry, occurs when customers cannot know what banks are doing because of the necessity for too much, timely and even undisclosed information. This state of affairs makes it impossible for consumers to make an informed, optimal decision. With thousands of services and products on offer, it is not reasonable to expect non-specialist consumers to invest the hundreds of hours required to pour through and evaluate the different services and products. Furthermore, given the constant change of terms and conditions set by the banks, the idea that timely information will be readily available and accessible is not a credible answer to the problem of information asymmetries. Finally, banks deliberately misinform customers about their products and services. Indeed, as the latest royal commission has made clear, banks are not supplying appropriate critical information about their products and services. In fact, they have refused to do so even at the request of the regulator, ASIC. It was only the credible threat of legal sanctions associated with compliance with the royal commission that true, timely and complete information about how banks are offering products and services that consumers and the public at large were informed. Hoping price will correct this failure is not a reasonable hope. After all, how much can a consumer be expected to pay for truthful, timely and complete disclosure in a useful, accessible format for the tens of thousands of products and services? More competition is unlikely to lead to this outcome in the foreseeable future.
‘Buyer beware’ is no basis for public trust
A second type of market failure, public goods, is also in play. These goods are of a type good that cannot prevent non-payers from their benefits or not consumed by their use (a common example is information which can be shared without loss to the first party). Banking is in part precisely such a good. Banks create liquid asset pools and create credit allowing people and businesses to buy and sell in ways that are unimaginable in a non-banking, barter economy. The acceptance of the institution of banking allows a society to allocate resources much more easily and efficiently. Such a society is able to provide for itself and distribute more easily the goods and services necessary for the lives of its citizens. Citizens expect to be able to “trust” their public institutions.
The issue for our society and our banks, however, is that they are not structured as public enterprises. Rather, they are structured as for-profit enterprises with the same commercial imperatives as any other business and run just as those businesses on the basis of contracts for products and services. There is no need for “trust” in this context. Rather, the old commercial maxim of “buyer beware” operates, subject to the various modifications of the law of contracts, consumer law and banking regulation. If banks are expected to be responsive to consumer trust, to be a publicly motivated institution, they require a different structural configuration or at the very least a different regulatory structure. Can the price mechanism be expected to sort out this knotty problem? Certainly no more than it can for the former market failure.
Social regulation when price is an ineffective solution
The third market failure, the problem of incomplete markets, too finds itself in the banking world. The lack of transparent, customer orientated, honest and trustworthy commercial banks is evidence of an incomplete market. Although models such as friendly societies have existed in the past, these models are far from major institutional structures. And, despite a likely preference for such institutions by informed consumers, the issues associated with marketing, access and the regulatory environment makes them far less popular, competitive and otherwise accessible than they otherwise may be. Again, prices seem unlikely to be an effective solution to this embedded institutional problem.
The severity and seriousness of each of these market failures has become clear through the work of the royal commission. Seeing the lost pensions, bankrupted businesses and destroyed lives widely spread across the population leads to the inevitable conclusion that banking regulation is inadequate in terms of market failure, not susceptible to correction by the price mechanism, and inadequate in terms of the tasks and expectations of the community. Public policy orientated legislation, banking as ‘social regulation’, needs to have a clear and robust place in the regulatory reform of the banks which is a likely recommendation of the royal commission.
Benedict Sheehy is Head of School at the School of Law & Justice, University of Canberra. He has published extensively on designing effective regulation.