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FRBSF Economic Letter

1999-38 | December 31, 1999

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Financial Modernization and Regulation

Fred Furlong and Simon Kwan

The push to liberalize and modernize financial systems worldwide has marked the last two decades and is sure to continue into the next century. One of the key policy issues it raises is how financial supervisors and regulators should adapt to the new and emerging order.

The causes of the push to modernize financial systems and the implications for policymakers are featured in an upcoming special issue of the Journal of Financial Services Research; it will publish several papers on these topics that were presented at the “Financial Modernization and Regulation Conference” cosponsored by the Federal Reserve Banks of Atlanta and San Francisco.

This Economic Letter highlights six major themes from these conference contributions: financial modernization, market discipline and financial regulation, systemic risk, corporate structure, pricing deposit insurance, and conflicts of public policy goals.

Financial modernization

Financial modernization generally is used to describe the combination of consolidation, convergence, globalization, and product innovation among financial institutions. For many countries, however, the more fundamental change, or modernization, comprises reforms allowing for more open financial markets and a greater role for market incentives in providing financial services.

Flannery discusses some of the key forces for change. In countries such as the U.S., forces that include advances in computer and telecommunications technologies as well as in financial theory are reshaping financial services in ways that directly challenge traditional structures of financial supervision and regulation. In other economies, financial instability appears to be the lightning rod for regulatory reform.

On one level, the forces affecting the financial sector can be viewed as coming from outside of banking and financial systems. Kane’s paper, however, proposes a theory in which financial modernization, instability, and change in financial supervision and regulation are parts of an ongoing dialectic. In this framework, financial services are supplied jointly by financial institutions and their regulators, where customer choice for financial services focuses not only on the supplier of financial products but also on the cost and quality of supervisory and safety net services provided by the regulator. For example, regulators may subordinate the interests of consumers and the public to the interests of domestic financial institutions; they may provide subsidies to domestic financial institutions, erect entry barriers, and guide credit allocation. This leaves financial systems susceptible to financial crises for two reasons. First, credit is misallocated (funds are not channeled to projects with the highest economic return); second, the favorable arrangements invite competition from foreign firms that are more efficient providers of financial services. The financial crisis, when it does occur, provides the catalyst for change in the regulatory system. In this context, financial modernization can be both a cause and an effect: it can speed the demise of a system through competition from systems that have modernized, and it can be part of the restructuring of a system.

Yoshi sees a connection among modernization, stability, and changes in financial regulation in Japan. He notes that financial deregulation in Japan gave large nonfinancial firms access to the capital market, but it failed to loosen the product restrictions on banks, leading them to chase after risky lending to small and medium firms in real estate and construction industries after losing their large industrial customers. As the asset price bubble burst in the late 1980s, banks were left with a huge “bad loan” problem. The revelation of severe problems in turn has led to further regulatory restructuring.

In Europe, a dimension of modernization is the move towards a single banking market. Through mutual recognition agreements, a host member country may no longer require foreign banks to seek authorization to operate in its banking market, and foreign banks are supervised by their home country supervisors. Benink argues that the European arrangement requires a high degree of harmonization of supervisory standards and practices across member states. While this may be so, according to Kane, harmonizing standards worldwide could be seen as damping the dialectic that drives changes in financial supervision and regulation.

Market discipline and financial regulation

Flannery argues that financial modernization poses serious challenges to financial regulators. In particular, the traditional approach of supervision and regulation may be very costly and ineffective, especially for large, internationally active institutions that have complex financial instruments and substantial cross-border transactions. He advocates shifting prudential oversight towards private investors with stakes in financial institutions, thus harnessing market discipline in bank supervision. Support for a larger role for market oversight is echoed in the remarks by Ferguson.

In light of the increasingly competitive and complex banking environment that blunts the effectiveness of the current set of regulatory tools, the paper by Boot, et al., also argues for a bigger role for market discipline. To make room for market incentives to work, the authors advocate a shift from intrusive, control-oriented regulation towards certification-based regulation. Llewellyn also argues for a more parsimonious approach to rule-making and few or no limits on permissible activities for financial firms, while maintaining the so-called risk-focused approach to supervision.

Systemic risk

Market discipline alone, however, cannot be expected to eliminate concerns about systemic risk. To address the issue of systemic risk, Flannery calls for securing the payments system by shifting towards a collateral-based settlement system, suggesting that there is less need to withdraw from financial transactions if the counter-party risk is negligible. While Flannery’s push for securing the payments system should improve financial stability, it is unclear whether a foolproof payments system would be enough to contain systemic risk. Indeed, a recurring theme in the discussion at the conference was that threats to payments systems do not appear to be the main concern of policymakers during a financial crisis. Rather, their top priority is the impact of a financial crisis on the flow of credit.

The paper by Diamond and Rajan provides a theoretical basis for the view that concerns can extend beyond the payments system. Their theory suggests that the combination of credit and liquidity activities distinguishes banks from nonbank financial institutions. In gathering deposits and making loans, banks provide liquidity services to borrowers and lenders. Firms can count on bank loans for uninterrupted financing without worrying about the banks’ liquidity needs, which can be met by demand (liquid) deposits. At the same time, banks subject themselves to deposit runs by choosing a fragile capital structure, which has the effect of keeping the banks honest by forcing them to share with depositors some of the gains from making loans.

Specific theories aside, these features of banking are exactly what raise concerns among policymakers over systemic risk. In response, governments have given banking agencies roles both in corporate governance, through direct supervision and regulation, and in providing guarantees on liabilities through the government safety net. A basic question in adapting policy to financial modernization is how to structure supervision and regulation so as not to extend the government safety net and the attendant rigors of bank-like supervision and regulation to more entities than necessary.

Corporate structure

In the U.S., the corporate structure debate has been whether certain nonbank financial activities should be carried out in bank subsidiaries or in bank holding company affiliates. Kwast and Passmore argue that the government safety net may give banks certain financial advantages, for example, in the areas of funding and risk-taking, over nonbank financial institutions. Therefore they think that newly approved nonbank activities generally should be operated outside the bank’s reach. They point to the fact that banks tend to operate with lower equity capital than nonbank financial institutions as evidence of the safety net effect and, thus, of the “subsidy” incidental to the bank safety net. It should be noted, however, that the Diamond and Rajan paper suggests that, while this fact may be consistent with a safety net subsidy, it is not conclusive evidence of it.

Rather than directly studying the presence (or absence) of a safety net subsidy, Whalen examines how U.S. banking organizations structure their foreign securities operations, which can be a holding company subsidiary, a direct bank subsidiary, or an indirect bank subsidiary, to study the linkage between organizational structure and the bank safety net. Regarding the relationship between structure and performance, Whalen reports that, measured by variability in the return on assets, bank securities subsidiaries are less risky than those organized as holding company affiliates. It turns out, however, that bank securities subsidiaries tend to have lower capital than holding company subsidiaries, so that the overall risk of the former could be higher. In fact, Whalen finds that bank securities subsidiaries tend to have higher funding costs. This would be consistent with their being riskier than their holding company affiliated counterparts but inconclusive regarding the main question of the safety net subsidy.

Pricing deposit insurance

Pennacchi studies an important component of the federal safety net–deposit insurance. He critically examines the current policy of linking deposit insurance premiums to whether the accumulated insurance fund is equal to a predetermined percent of industry deposits. Pennacchi compares the currently employed targeting policy against the benchmark “fair insurance” policy, which charges premiums that reflect banks’ risk-taking. He finds that since the growth rate of bank deposits is below the default-free interest rate, the “targeting” premium is less than the “fair” premium, suggesting that the current deposit insurance program systematically underprices deposit insurance.

Conflicts in public policy goals

While Kane focuses on conflicts between public and private interests, Wall and Eisenbeis study the financial regulatory structure in the presence of potentially conflicting public policy goals, such as maintaining bank safety and soundness versus promulgating bank lending to low-income communities. They describe three models. In one model, a single agency is given conflicting goals that must be resolved internally. In a second model, an agency is given a goal that conflicts with another agency’s goal, so the conflict must be resolved externally (that is, publicly). The third model resembles the situation in U.S. banking regulation and is a combination of the first two models: the same set of conflicting goals is given to multiple agencies; thus, the goals must be resolved both internally and externally.

Wall and Eisenbeis do not specify an optimal framework for dealing with conflict resolution. Hence, they do not assess whether using separate supervisory agencies, as in the U.S., makes more sense than using a single financial supervisor, as in the U.K. and other countries. However, their framework opens the possibility that the differences between the U.S. and the U.K. approaches to supervisory structure, for example, in part may be a matter of choosing how to deal with conflicts in public policy goals and not simply a matter of differences in outcomes in battles over regulatory turf.

Conclusion

Financial modernization poses challenges to policymakers when striking a balance among an array of public policy goals, from encouraging sound micro foundations in banking to managing systemic risk in the global financial market. At the more basic level, modernizing the regulatory structure requires carefully considering the scope of the existing safety nets and the associated banking supervision. However, the growing complexity of modern financial organizations and constant market innovations will likely limit regulatory responses to the rapidly changing environment, prompting policymakers to close the gap by harnessing market forces to complement financial supervision and regulation.

Fred Furlong
Vice President

Simon Kwan
Senior Economist

Conference papers

Benink, H. “Europe’s Single Banking Market.”

Boot, A.W.A., S. Dezelan, and T.T. Milbourn. “The Future of Regulation of the Financial Services Industry: From Control Instruments to Certification Requirements.”

Diamond, D.W., and R.G. Rajan. “Liquidity Risk, Liquidity Creation and Financial Fragility: A Theory of Banking.”

Ferguson, R.W. Jr. “Alternative Approaches to Financial Supervision and Regulation.”

Flannery, M. “Modernizing Financial Regulation (Again).”

Hoshi, T. “Financial Modernization and Regulation: Experience from Japan.”

Kane, E. “Offshore Financial Regulatory Competition: A Force for Modernization and for Crisis.”

Kwast, M.L., and W. Passmore. “The Subsidy Provided by the Federal Safety Net: Theory and Measurement.”

Llewellyn, D. “Financial Regulation: A Perspective from the United Kingdom.”

Pennacchi, G.G. “Deposit Insurance Premiums and the Value of the Bank Insurance Fund: Should They be Linked?”

Wall, L., and R. Eisenbeis. “Financial Regulatory Structure and the Resolution of Conflicting Goals.”

Whalen, G. “The Relationship between Organizational Form and Performance: The Case of Foreign Securities Subsidiaries of U.S. Banking Organizations.”

Opinions expressed in FRBSF Economic Letter do not necessarily reflect the views of the management of the Federal Reserve Bank of San Francisco or of the Board of Governors of the Federal Reserve System. This publication is edited by Sam Zuckerman and Anita Todd. Permission to reprint must be obtained in writing.

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