The Peltzman effect and banking regulation

I like to tell people that I prefer taxis where the driver is not wearing a seatbelt. This mostly confuses people – at least non-economists – because the general perception is that people who do not wear seatbelts are more “irresponsible”.

However, if you know about the so-called Peltzman effect you would not be surprised by my preference of “irresponsible” taxi drivers. The Peltzman effect is named after Chicago economist Sam Peltzman.

In a very controversial article - “The Effects of Automobile Safety Regulation” – in the Journal of Political Economy from 1975 Peltzman showed that contrary to what should have expected the introduction of seat belt laws in the US did not reduce the total number death accidents in traffic.

Here Russ Robert (in a blog post from 2006) explains Peltzman’s results:

“Peltzman argued that mandatory safety devices such as seat belts reduced the probability of harm to the driver if the car crashed. That in turn would encourage people to drive more recklessly. The effect on the number of deaths was an empirical question. Which effect would be larger—the harm from the increase in the number of accidents or the reduction in harm when an accident occurred?

Holding other factors constant that might change the number of accidents (and this is never easy but he did the best he could with the data at hand), Sam found that mandatory seat belts did indeed cause more accidents. But this effect was roughly the same as the effect in the opposite direction, that accidents were less harmful. So the net number of fatalities of drivers was unaffected by the law. Sam found some evidence that the effect of the law might be to reduce driver fatalities. Unfortunately, because drivers were more reckless, there were more accidents involving pedestrians and cyclists. So their death rate due to cars increased. Total deaths were unchanged.”

It is obviously that such considerations are not only relevant for road safety. In fact we should be aware of Peltzman effects in all forms of regulation. And that particularly seems to be the case for financial regulation.

Hence, what does it for example mean when we introduce deposit insurance schemes to reduce to reduce “risks” in the financial sector. Well, following the logic of the Peltzman effect deposit insurance might reduce of bank runs (“drivers being killed”), but it will also make both bank owners and depositors take bigger risks. In fact depositors would tend to prefer more risky banks because the downside is limited by the deposit insurance if the bank collapses while banks, which take larger risks will be able to pay higher interest rates on deposits.

This would also mean that the introduction of deposit insurance schemes is likely to lower the amount of capital banks chose to hold. This is exactly what Sam Peltzman is arguing a great lecture from 2011, which I stumbled upon while searching YouTube for stuff on the Peltzman effect. Take a look here. Peltzman’s account of the development in banking regulation in the US since the Great Depression is fascinating stuff.

Peltzman spelled out similar argues in his 1970 article “Capital Investment in Commercial Banking and Its Relation to Portfolio Regulation” (also from the Journal of Political Economy), in which he also demonstrates that capital ratio did indeed drop significantly in the US after the introduction of deposit insurance.

Anybody who doubt that such a Peltzman effect exists in financial regulation should study how the Icelandic banks prior to the Icelandic collapse in 2008 set-up internet based bank in countries with generous deposit insurance schemes.

PS Gordon Tulluck came up with what I believe is the best safety device for cars – a spike attached to the steering wheel (I got this example from David Friedman’s fantastic book “Hidden Order”.)

PPS I should stress that just because deposit insurance likely leads to more risk taking and lower capital ratio it still could be desirable regulation and proponents of deposit insurance will undoubtedly point to the fact that deposit insurance led to sharp drop in bank run episodes in the US after it was introduced in 1930s. Hence, it is a trade-off, which policy makers have to be aware of.

HT Blake Johnson

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2 Comments

  1. it is a trade-off, which policy makers have to be aware of

    More importantly, the trade off is usually in different “currencies”, that need to be weighted appropiately. Thus, putting a fence around a well increases the likelihood of kids playing near the well, but it still accomplishes the objective of reducing the number of people that fall into it.

    Deposit insurance might well have decreased capital ratios, but it has had a number of positive properties as well (reduced bank runs, reduced search costs for smaller depositors). Does DI make the banking system overall safer? That is the question that needs to be answered.

    Somehow these discussions (at least the ones I’ve seen on the blogosphere) never end up answering that question.

    Reply
  2. Blake Johnson

     /  September 13, 2013

    fsateler, you are skipping a step in your well example and jumping straight to the conclusion that it reduces the number of people that fall into it. Also, the analogy works better if taking risks is something people get some kind of benefit from, i.e. driving faster gets you there faster and increases your risk of an accident. Lowering your capital ratio, or maintaining the same capital ratio but investing in more risky assets increases your risk of default and shifts risk from those who have a low cost method for avoiding it, depositors and shareholders, to those who have a much higher cost of managing that risk, regulators and taxpayers.

    Even if in the end you manage to keep bank failures stable or reduce them, it may come at the cost of a gigantic increase in regulatory burden which has its own costs for society, not just in reduced competition, but in a new kind of risk, which is whether or not regulators will do their jobs effectively and consistently.

    One of the original arguments in favor of deposit insurance was made under the assumption that bank runs happen for random, spontaneous reasons. If bank runs in fact occurred when a bank was truly insolvent, then a run on the bank is actually efficient, because it stops the incompetent management from allocating more capital from savers to bad borrowers.

    Reply

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