sou · GOB311d5 · 2001-01-01 00:00:00 — The efficient operation of the financial markets depends critically on confidence that financial markets and institutions operate according to rules and procedures that are fair, transparent and place the interests of first. This confidence is a public good. It increases flows through financial markets and the effectiveness with which financial markets allocate resources across time and space. But this public good may be underproduced, because the private returns to firms that adhere to strict codes of conduct are likely to be less than the social returns. Unethical firms may be able to free ride on the reputation established by ethical firms and take advantage of the relative ignorance of clients in order to boost profits. The primary efficiency rationale for conduct of business rules and conflict of interest rules is to correct this perverse incentive. Finally, financial markets provide critical information that helps to coordinate decentralized decisions throughout the economy.5 Prices in financial markets are used by households in allocating income between savings and consumption and in allocating their stock of wealth. These prices also help firms decide which investment projects to select and how they should be financed. Financial markets will provide better price signals and allocate resources more efficiently the better the access of participants to high quality information on a timely basis. This applies not only to information regarding issuers of financial instruments, but also to financial institutions themselves and the products they sell. Disclosure standards thus also serve an efficiency rationale as well as a consumer protection rationale. Efficiency would also be enhanced if regulators were required to justify each new regulation with a careful assessment of its costs and benefits. This requirement is an obligation of new financial services authority. It should be a fundamental part of the regulatory process everywhere. 5 See Santomero and Babbel (1997) Chapters 1 and 2. Volym D:174 Supplement 26 2.4Achieving other social objectives Governments are often tempted to exploit the central role played by the financial sector in modern economies in order to achieve other social purposes. Budget constrained governments frequently use the banking system as a source of off-budget finance to fund initiatives for which they chose not to raise taxes or borrow. time this politically connected lending can have a devastating impact on the efficiency and safety and soundness of the financial system as we have learned from the experience of many central and eastern European countries and the recent Asian banking crises.6 The housing sector is often favored by government intervention in the financial system. For example, the has chartered financial institutions with special regulatory privileges that specialize in housing finance. It has also promoted home ownership by extending implicit government guarantees to securities backed by housing mortgages and by allowing homeowners to deduct mortgage interest on their income taxes. In addition, until its interest rate ceilings were eliminated, the favored housing lenders by allowing them to pay their depositors a slightly higher interest rate than banks could pay their depositors, a policy that had the effect of enhancing the funds made available to finance housing. Governments also channel credit to favored uses in other ways. Most countries subsidize financing for exports, sometimes through special guarantees or insurance or through special discount facilities at the central bank. Many countries also require their financial institutions to lend to certain regions or sectors. Since the enactment of the Community Reinvestment Act in 1977, the has required its commercial banks and thrift institutions to serve the credit needs of low-income areas. The has also used regulation to achieve the social objective, first articulated by , of preventing large concentrations of political and economic power within the financial sector, especially among banks. Until recently, the had restricted the ability of banking organizations to expand across state lines. Restrictions continue against bank participation in nonbanking activities. Finally, many members of the Organization for Economic Cooperation and Development have imposed reporting requirements on banks and some other financial institutions in an effort to combat money 6 See Santomero (1997b, 1998) for a fuller discussion of this issue. What Is Optimal Financial Regulation? laundering associated with the drug trade and organized crime. In the banks are required to report all currency transactions of ,000 or more. Currently, Congress is considering even more stringent reporting requirements that have raised serious concerns about violations of privacy rights. Similarly the new Authority in the (1998, p. 2) has adopted the objective of preventing financial businesses being used for the purposes of financial crime. Volym D:176 Supplement 26 3Why banks have been especially important The preceding survey of the objectives of financial regulation has identified three categories of rationales that apply not only to the financial sector but also to some non-financial products and services as well. Although the means of regulatory intervention may vary from sector to sector, the objective of protecting consumers from opportunistic behavior by or agents applies equally to services, food and many other consumer purchases. Similarly, the objective of enhancing the efficiency of markets motivates regulation in a broad range of industries in addition to the financial services industry. And, budget-constrained governments are always eager to exploit opportunities to advance broad social objectives through off-balance sheet means. Because of its status as a heavily regulated industry, the financial services industry is highly vulnerable to such attempts, but it is not unique in this regard. However, one motive for financial regulation is distinctive to the financial services industry. Systemic risk motivates a considerable amount of financial regulation but does not apply to regulation in other industries. Moreover, within the financial sector concerns about systemic risk tend to focus on banks. Why are banks especially associated with systemic risk? Whats special about banks? Many of the products and services provided by contemporary banks are indistinguishable from products and services provided by other kinds of financial institutions. To that extent banks are less special than they once were, a topic we will investigate in section 5. However, the argument that banks are special is based on: the distinctive functions they have performed, the importance of those functions to the economy, and the consequences these functions have had for the vulnerability of their balance sheets to liquidity shocks. First and foremost, banks have been the principal source of non- market finance to the economy. Banks and assess information about prospective borrowers and their investment opportunities. Using specialized human capital and financial technologies7 they screen 7 For a fully developed model of this function, the reader is referred to (1984), Santomero (1984) and Bhattacharya and Thakor (1993). What Is Optimal Financial Regulation? borrowers to identify wealth-enhancing projects that they will then finance. This may, in fact, be their most important contribution to economic performance.8 The assets that banks acquire in this process are frequently illiquid and difficult for external parties to value without substantial effort.9 After originating loans, banks have traditionally funded and serviced the loans, monitored the borrowers performance and provided workout services when necessary. These efforts enhance returns from the investment project, as borrowers respond to on-going monitoring by increasing effort and by making operating decisions that adhere to the proposed purpose of the loan.10 The bank role as monitor improves the financial performance of the project and the returns accruing to the intermediary itself. On the liability side of their balance sheets banks mobilize savings to fund the loans they originate. The second distinctive function performed by banks is to serve as the principal repository for liquidity in the economy. Banks attract demand deposits by offering safe and reliable payments services and a relatively capital-certain return on investment. Banks have developed the capacity to mobilize idle transactions balances to fund investments while at the same time clearing and settling payments on behalf of their depositors. By pooling the transactions balances of many different transactors they can acquire large, diversified portfolios of direct claims on borrowers which enable them to meet liquidity demands while still holding substantial amounts of illiquid assets. For the economy as a whole, the smooth and reliable functioning of the resulting payments system is critical to the health of the economy.11 In addition to providing sight deposits, banks offer longer-term deposits that must compete directly with other instruments available in the financial markets.12 The return on deposits must be sufficient to compensate for the risk and delayed consumption associated with accepting deposit claims on the bank. These functions – making loans, clearing and settling payment transactions, and issuing deposits – are performed more or less simultaneously. Banks transform the longer-term, risky, illiquid claims that borrowers prefer to issue into safer, shorter-term, more liquid 8For a fuller discussion of this role and its effect on the economy, see Herring and Santomero (1991). 9For a discussion of this issue, see and Pennacchi (1990) and Santomero and Trester (1997). 10See and Gale (1988) for a discussion of the importance of monitoring to project outcomes. 11Goodfriend (1989) and Flannery (1998) make this case quite effectively. 12This point is made theoretically and empirically in Fama (1985). Volym D:178 Supplement 26 demand and savings deposits that savers prefer to hold. This asset transformation often involves maturity transformation as well. The consequence of the simultaneous performance of these three functions is that banks have balance sheets that are vulnerable to liquidity shocks. While these functions are usually mutually compatible – indeed, some researchers have argued that banks have an advantage in monitoring loans because they can observe the cash flows of their borrowers through transactions accounts (1975, Fama 1985, and 1991) – a sudden, unanticipated withdrawal of the deposits that fund longer-term, illiquid loans can give rise to instability.13,14 Instability in the banking system can undermine confidence in the financial system and disrupt its role in facilitating the efficient allocation of resources that enhances economic growth. Moreover, it can impose massive costs on society. From 1980 to 1995 more than three-quarters of the members of the experienced serious and costly banking problems. In 69 of these countries losses exhausted the net worth of the entire banking system, in several cases driving it to negative levels. Ten countries spent more than 10 percent of their GDP in bailing out their banking systems (1998). These direct costs of recapitalizing the banking system do not include the heavy costs imposed on the real economy due to the disruption of the payment system, the interruption of credit flows to bank-dependent borrowers, and the withdrawal of savings from the financial system. The systemic risk rationale for the regulation and supervision of banks starts from the presumption that the three basic functions that make banking special – loan origination, provision of payment services and deposit issuance – are central to the functioning of the financial system and the real economy, but give rise to bank financial structures that are vulnerable to crises. The opportunity for depositors to run from a bank arises from the fact that deposits must be redeemed at face value on short notice or demand. The motive for a bank run can arise because banks are highly leveraged – with an equity-to-asset ratio that is lower than other financial and non-financial firms – and hold portfolios of illiquid assets that are difficult to value. A rumor that a bank has sustained losses that are large relative to its equity may be sufficient to precipitate a run. Moreover, because forced liquidation of 13The classic references here are and Dybvig (1983), and (1988). 14See Kareken and (1978), Jacklin (1987), and Santomero (1991) for a fuller discussion of these issues. What Is Optimal Financial Regulation? illiquid bank assets can cause additional losses, once a run has begun it tends to be self-reinforcing. Even depositors who were not alarmed about the original rumor of losses may join the run once it has begun because they know that the run itself can cause substantial losses that may jeopardize the banks solvency. The failure of a nonbank firm is usually not a source of public policy concern in most countries.15 Indeed, the failure of one nonbank firm often improves business for the remaining firms in the industry. In contrast, a shock that damages one bank seriously can spread to other banks. Contagious transmission of shocks may occur because of actual direct exposures to the original shock and/or the failed bank or, more insidiously, because of suspected exposures. In the absence of clear and convincing evidence to the contrary, depositors are likely to suspect that the banks least able to withstand a shock have been damaged. They will attempt to protect themselves by liquidating their deposits at the suspected, weaker banks and reallocating their portfolios in favor of deposit claims on banks perceived to be stronger or claims on the government.16 The result is a flight to quality and a banking panic that destroys not only the specific capital of the banks under pressure, but also diminishes the capacity of the financial sector to fund economically viable projects and monitor them to a satisfactory conclusion.17 When banks fail and markets seize up, they cannot perform their essential function of channeling funds to those offering the most productive investment opportunities. Some firms may lose access to credit. Investment spending may suffer in both quality and quantity. Indeed, if the damage affects the payments system, the shock may also dampen consumption directly. The fear of such an outcome is what motivates policymakers to act. regulation and supervision to safeguard against systemic risk arises in the first instance from this externality. While bank managers and shareholders of a bank have appropriate incentives to take account of losses to themselves if their bank should fail – destroyed shareholder value, lost jobs and damaged reputations – they do not have adequate incentives to take account of the potential external costs to other banks and the real economy. Thus they may take riskier positions 15Nevertheless, the failure of very large firm tends to attract governmental attention in most countries because of its impact on employment. 16If depositors withdraw their balances and hold them as cash, bank reserves will contract unless the monetary authority neutralizes the shift. This may be an additional source of contagion. 17See the work of Bernanke and Gertler (1989, 1990) for two similar models of this phenomenon. Volym D:180 Supplement 26 than if they were charged a fair market price for such risks. regulation and supervision is designed to counteract the incentive for excessive risk-taking. What Is Optimal Financial Regulation? 4Prudential regulation and supervision: the financial safety net The financial safety net is an elaborate set of institutional mechanisms rigged to safeguard the economy from systemic risk that might result from contagious bank runs. This safety net can be viewed as a series of circuit breakers designed to prevent a shock to one bank from spreading through the system to damage the rest of the financial grid. For our purposes the safety net can be seen as consisting of six circuit breakers that are triggered at various states in the evolution of a banking crisis.18 First, the chartering function seeks to screen out imprudent, incompetent or dishonest bank owners and managers who would take on excessive insolvency exposure. This usually involves fit and proper tests that bank owners and managers must pass to qualify for a banking license. In the aftermath of the collapse of , which was engaged in fraud on an international scale, a number of countries established additional tests for continuance of a banking license for foreign banks. Second, in the event that some financial institution managers do attempt to expose their institutions to excessive insolvency exposure, the supervisory function seeks to prevent it. supervision is concerned both with leverage and asset quality. Capital adequacy standards, which have been partially harmonized internationally, attempt to constrain leverage risk and ensure that the bank has an adequate buffer against unanticipated losses. Supervisors attempt to control asset risk by risk-weighting capital requirements, diversification rules, restrictions on connected lending or outright prohibitions on certain kinds of assets. Bank examinations focus not only on the banks own processes and procedures to control asset risk, but on individual bank assets to make sure that they are stated at fair value and that reserves for loan losses are appropriate. Third, in the event that supervision does not prevent excessive insolvency exposure and a damaging shock occurs, the termination authority attempts to make a regulatory disposition of the bank before it exhausts its net worth and causes losses to depositors. 18 This safety net is discussed in greater detail in Guttentag and Herring (1989) and Herring and Santomero (1991). Volym D:182 Supplement 26 depositors could rely on prompt termination19 before a banks equity is exhausted, there would be no incentive to run. But the supervisory authorities face technical and political difficulties in implementing the termination function with such precision. The result is that insolvent banks are often permitted to operate long past the point at which they have exhausted their net worth. Fourth, if the termination authority acts too late to prevent the bank from exhausting its net worth, deposit insurance may protect depositors from loss and remove the incentive for depositors to run from other banks thought to be in jeopardy. In response to the banking crisis of the Great Depression, the established the in 1933 to provide insurance against loss for owners of small deposits. Although most other countries have long had systems of implicit deposit insurance, it is only within the last thirty years that other countries have established similar systems of explicit deposit insurance. Although deposit insurance is motivated by concerns for consumer protection as discussed earlier in section 2.2., it may also play an important role in stabilizing the banking system against shocks. The protection is imperfect, however. Even in the US, where the link to financial stability has been most explicit, deposit insurance has been limited, leaving some depositors vulnerable to loss. Thus, the possibility of a run continues. Fifth, even if runs occur at other institutions, the lender of last resort may enable solvent institutions to meet the claims of liability holders by borrowing against assets rather than selling illiquid assets at firesale prices. and articulated the rationale for the lender of last resort function during the 19th century. Usually the central bank functions as the lender of last resort because it has the resources to intervene credibly to meet any extraordinary demand for domestic liquidity. Although the members of Monetary Union have agreed on the powers of for the conduct of monetary policy, they have not yet agreed on how – or whether – to provide lender-of-last-resort assistance to banks in the euro zone. Sixth, even if the lender of last resort does not lend to solvent but illiquid banks, the monetary authority may protect the system from cumulative collapse by neutralizing any shift in the public's demand for 19 The termination of a bank means that the authorities have ended control of the bank by the existing management. Termination may involve merging the bank with another, liquidating it, operating it under new management acceptable to the authorities or some combination of these actions. What Is Optimal Financial Regulation? cash thus protecting the volume of bank reserves. In this way the monetary authority can prevent any flight to cash from tightening liquidity in the rest of the system. This is precisely what the US monetary authorities failed to do during the Great Depression. But the lesson was not wasted. Most modern monetary authorities are committed to maintaining policy control over the reserve base. In the major industrialized countries, the various circuit breakers that comprise the financial safety net have been generally successful in preventing a problem at one institution from damaging the system as a whole. In the , for example, the safety net which was constructed in the 1930s has virtually eliminated the contagious transmission of shocks from one depository institution to the rest of the system. Similarly in the recent Swedish banking crisis, the Riksbank succeeded in preventing a contagious transmission of shocks to the rest of the financial system and minimized the damage to the real economy. In effect, banking systems in most market economies operate with the implicit support of their regulatory authorities. With the possible exception of , where the authorities have explicitly taken down their safety net for banks,20 the intervention of the regulatory authorities in time of crisis is rationally expected in every market economy. Financial safety nets have reduced the frequency of bank runs, banking panics, and financial disruption. However, these safety nets may have worked too well. Depositors and other creditors have come to rely on their banks access to the safety net as a protection against loss with the consequence that they exercise only limited surveillance over riskiness. The pricing of bank liabilities depends heavily on the banks presumed access to the safety net. The result is that banks are not penalized for taking greater risks as heavily as they would be if they did not have access to the safety net.21 Consequently, banks take on greater risks.22 This moral hazard feature of the safety net has contributed to the frequency and severity of banking problems, which appear to be rising. In both Eastern Europe and the we have ample evidence of institutions that have assumed excessive risk and suffered severe consequences. As noted above, from 1980 to 1995 three-quarters of the members of the IMF experienced serious and costly problems. 20New Zealands policy is especially credible because all major banks are owned by foreign residents. 21There are a large number of empirical studies on this point. See and Santomero (1990), and Flannery (1992) and Flannery and Sorescu (1996). 22For empirical evidence see Keeley and Furlong (1987, 1991). Volym D:184 Supplement 26 example, the real cost of the Savings and crisis in the US has been estimated at less than five percent of GDP, and current estimates for the Japanese economy center are five to ten times this proportion. In less developed economies, where the magnitude of the crisis is even greater and fewer resources are available for resolution, the costs associated with the financial safety net have exceeded the countrys financial capacity.