FRBSF Economic Letter
99-38; December 31, 1999
 Economic
Letter Index
Financial Modernization and Regulation
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 this newsletter 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. Editorial
comments may be addressed to the editor or to the author. Mail comments
to:
Research Department
Federal Reserve Bank of San Francisco
P.O. Box 7702
San Francisco, CA 94120
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