Government Regulation, Competition, and Corruption

A widely accepted definition of corruption by businessmen is that their behavior violates laws or widely accepted ethical norms. Using this definition I would claim that the banking industry is more corrupt than the typical industry not because it is reasonably competitive, but partly because it is a highly regulated industry, and partly because it is an industry trusted with large amounts of money of customers. I will consider in turn the effects of competition, regulation, and trust.

Many believe that competition leads to a race to the bottom, where cheating of customers and other forms of corrupt behavior prevail because of competitive pressures. However, if repeat business is important for a company's profitability, and if customers are aware of when they are cheated or are the victims of other unethical behavior by companies, competition tends to eliminate corrupt companies and promotes companies that behave honestly toward consumers. The reason is that corrupt companies will have little repeat business, and by assumption that would crush their profit prospects.

When repeat business is of little importance, as in many tourist centers, corrupt businessmen have much better chances of surviving and even thriving. It is in these cases that honest businessmen have trouble doing well because they are outcompeted by corrupt businessmen. Tourists do not have sufficient incentives to invest in knowledge of the reputations of local businessmen since they usually do not return to the same locality. In that case, their unhappy experience with cheaters would not affect their future behavior very much.

Unfortunately, the empirical evidence is limited on the relation between the degree of competition in an industry and its degree of corruption. Part of the reason for the scarcity of reliable information is that empirical studies of competitiveness do not tend to account for how important repeat business is, and the interaction between regulation and competitiveness.

One widely cited study on international corruption is Transparency International's annual ranking of countries by the degree of corruption among government officials (its Corruption Perception Index). New Zealand, Denmark, Finland, Sweden, and Singapore head the list, while Sudan, Turkestan, North Korea, and Somalia are at the bottom. Some countries at the top have large governments, such as Norway and Sweden, but all the top countries have rather competitive economies, certainly much more competitive than countries at the bottom. These international comparisons do not indicate that competition leads to greater corruption, when corruption is measured by corruption of government officials.

While these indexes show that government officials are more corrupted in some countries than in others countries, greater regulation and government control in an industry often induces more corrupt practices in that industry. Companies that are successful at bribing or otherwise influencing officials to gain extra business or other advantages clearly are more likely to survive such competition. Of course, the advantage to corrupt business behavior would be eliminated if all officials and lawmakers were completely honest, but that is far from always the case.

Numerous examples are available of the advantages to businesses from corrupting regulators and other government officials. Fannie Mae and Freddie Mac, quesi-private companies, engaged in various corrupt practices during the housing boom in order to gain added business (see the expose of these companies in "Reckless Endangerment" by Morgenson and Rossner). Chinese government officials are accused of widespread corrupt practices as they allocate valuableland and capital to different companies.

From this perspective, the banking industry may well be more corrupt than the average industry not because it is reasonably competitive, but partly because it is highly regulated. Banks gain financially if they can induce regulators and others officials to give them advantages in the enforcement of the many complicated regulations that govern modern banking.

Corruption in the banking industry is also induced by the large quantities of money that that they receive in trust from depositors and others. Some regulations have undoubtedly protected lenders to banks from corrupt practices by bankers, although not sufficiently to prevent various highly suspect banking practices during the run up to the financial crisis. Still, an expansion of certain rules-based regulations of the banking industry has been warranted, such as greater capital requirements relative to bank assets.

In any case, my discussion indicates that the corruption of businessmen depends mainly on the importance of repeat business in a competitive environment, the ability of companies to influence the decisions of lawmakers and regulators, and the magnitude of the liquid assets of customers that are entrusted to companies.