sou · GOB311d5 · 2001-01-01 00:00:00 — The failure of a counterparty could set off a chain reaction that might bring the whole system to a halt. This kind of credit exposure is especially insidious. Although it is relatively easy to measure and monitor direct bi-lateral exposures to a particular bank, it is virtually impossible to evaluate indirect exposures. (1986) illustrated this point when he simulated the consequence of the failure of a single settling participant in the () system in the era before bi- lateral credit limits, net debit caps and collateralization arrangements were established. He found that the failure had devastating knock-on effects to many other banks in the system as the original default caused other banks to default which caused still more banks to default. When tried the simulation on another day during the same month, the scope of the devastation to the payments system was comparable, but a different set of banks was effected. These indirect exposures are opaque not only to outsiders monitoring the banks, but also to the banks themselves. Under pressure from the regulatory authorities, led by systems, private sector clearing houses and central banks have been taking measures to reduce and eventually eliminate overdrafts. Real-time gross settlement, in which settlement is made payment for payment without overdrafts, is the objective. Indeed, there are plans for implementation of a to eliminate default risk from the clearing and settlement of foreign exchange transactions. Collateralization techniques have long been used to eliminate default risk from the settlement of futures contracts and they have also been used to eliminate the risks that illustrated in the CHIPS system. The private sector, following proposals by the Group of Thirty (Global , 1993), has pressed for strengthening the legal infrastructure to support netting of gross exposures so that smaller, net amounts, need to be settled. In support of these efforts to reduce credit risk in the payments systems central banks in the three largest economic regions have committed to expanding their hours of operation so that payment against payment transactions can take place in bank reserves. Since , has extended the operating hours of Fedwire from 12:30 a.m. to 6:30 p.m. Eastern Standard Time so that it overlaps with the entire European business day and two-and-one-half hours with . The TARGET system for settling euros began operations in January 1999 from 7:00 a.m. to 6:00 p.m. Central European Time. And, by 2001 will open its Net from 9:00 a.m. Volym D:200 Supplement 26 Time so that it will overlap Fedwire for four-and-one- half hours and TARGET for four hours. Flannery (1998, p. 30) sees this movement away from a credit-based payments system as eliminating the need for government supervision of large financial firms. Once the issue of bank solvency has been divorced from the integrity of the payments system, the last remaining aspect in which banks are special will have ended. When banks are no longer a source of systemic risk, the safety net can be taken down and banks can be regulated like other financial firms. What Is Optimal Financial Regulation? 7Optimal regulation in the transition: some simple prescriptions Banks everywhere have been subject to intense regulatory oversight and limits, to one degree or another, on allowable activities. Banks in the have been subject to relatively tight activity restrictions that have, until quite recently, prevented them from entering many lines of the investment banking business or providing most kinds of insurance to their . Nonetheless, they and their counterparts throughout the world have managed to restructure their businesses so that they are much less dependent on traditional intermediation income than they were even a decade ago. As we have seen, most of the large American banks now earn a greater portion of their income in the form of fees and trading revenue with less from spread income. Relative sources of revenue of major banks The same trend is apparent for their counterparts throughout Europe and the major nations. Figure 12 illustrates this. Using data, it contrasts the ratio of interest income to fee income over two discreet periods, 1986-1988 and 1993-1995. Notice that in each case, with the exception of , the relative importance of on-balance sheet net interest income has declined over the period. (The Danish case can be explained by the volatility of Danish financial reports due to their mark- to-market accounting practices.) Volym D:202 Supplement 26 European banks by tradition have long been permitted to offer a much broader range of services than their American counterparts. They have been for some time in underwriting, the direct purchase of equity in the industrial sector, investment management, and a wide array of securities activities. In a recent study of comparative financial systems, , and (BNR) (1997) illustrate the wide range of bank activity across Europe and around the world. Their comparison across the G10 and other EU nations (replicated here as Figures 13, 14, and 15) illustrates that European banks have broad charters and are fully competitive across the entire range of banking products. Swedish institutions tend to look quite similar to many of their European counterparts. traumatic experience with real estate finance at the beginning of the decade has led Swedish regulators to be somewhat more restrictive with regard to real estate activities than other regulators in Europe and this is presumably the reason for BNRs designation of the Swedish regulatory regime as somewhat restrictive. But, in general, banks may offer a wide array of permissible services and have a broad range of affiliations. In view of the more liberal regulatory regime in Europe, it is surprising that European banks continue to be relatively heavily reliant on traditional intermediation services. Spread income is still more important to European banks than non-interest income. In this regard, European banks remain more special than their counterparts in the . Nonetheless, they are subject to the same forces of technological advance, innovations in financial instruments and institutions and heightened competition as banks in the . This difference is likely to disappear over time, as is evident in Figure 12 reported above. In light of this unmistakable trend, what should be the role of financial regulation? Here the message should be clear. If, as we have argued, it is not possible to fully correct the distorted incentives for risk taking that are implicit in the safety net, it is important to facilitate and nurture the trends that will ultimately make the safety net unnecessary. If the safety net cannot be patched adequately, the best course of action may be to advance the conditions under which it may be taken down. How can this be accomplished, or at least supported by regulating authorities? Here, we offer several simple prescriptions. First, the authorities should encourage the introduction of technological improvements that are lowering the costs of information and the costs of storing, retrieving and organizing these data. They should be supporters of competition in the technology and communication sectors. These technical advances will intensify international financial What Is Optimal Financial Regulation? Already, major investors routinely compare returns across a wide array of international financial arenas, and major borrowers choose from a menu that includes not only traditional domestic sources, but also numerous international alternatives. Technical advances will accelerate the pace of innovations in financial products and institutions. The ability to call up information cheaply at any time from any location will enable institutions to design new products that will better serve the needs of their . This may often be a cheaper substitute for a service provided by a heavily regulated institution and thus will add to pressures to liberalize regulation where it is counterproductive. Institutions will introduce new processes and streamline existing ones. Cheap and easy access to customer data and the application of expert systems will enable financial firms to target particular market segments more efficiently and to distribute multiple financial products at very low marginal cost. Technical innovations will also enable financial firms to assess the profitability and riskiness of each line of business with greater accuracy and timeliness and thus to manage capital more efficiently. As firms employ sophisticated management information systems to determine which lines of business to expand and which to exit, new kinds of financial institutions will inevitably arise. The second prescription is for regulators to resist the temptation to re-regulate or promulgate regulations that will forestall the inevitable financial restructuring that is part of this change process. The fundamental thrust of the forces of change – intensified international financial integration, increased innovations in financial instruments and institutions, and the liberalization of financial regulation – is to heighten competition in the financial services industry. will be painful to many firms. It is likely to reduce the prices of financial services, diminish profit , reduce market shares both globally and locally and reduce the franchise value for some institutions. There will be strong political pressures to restrain these forces of creative destruction by providing implicit and explicit subsidies to local firms in general or selectively to firms in distress. There will also be attempts to restrict entry so as to slow the pace of change. Thus, the important challenge for regulation will be to maintain pro-competitive policies, which in the long run are in the national interest. This is not an easy task. In addition, the regulatory authorities will be pressured to exercise forbearance to enable weak firms to adjust to new forces of competition or to support local firms facing aggressive external competition. It is important for the authorities to resist. Not only do such actions create a barrier to entry and maintain excess capacity in the market, but also they Volym D:204 Supplement 26 put the deposit insurer and taxpayers at significant risk. Entrenched managers may resist competitive pressures to downsize, streamline or merge, and instead take on riskier projects to try to maintain the size and profitability of their institutions. Since a regulatory response is likely to lag a banks actual risk exposures, it could have serious consequences on both the financial sector and the real economy that depends upon it for capital. Inaddition, the standard competition policies will need to be reassessed. Anti-trust policy, for example, has an important role to play because incumbent firms may try to bar new entrants. However, anti- trust enforcement will need to be reconsidered because the relevant product markets may often be global and extend across a range of competitors that includes other financial institutions as well as banks. The conflict of interest rules, and fit and proper entry tests should also be reexamined. Care should be taken to make sure that they are calibrated to accomplish consumer protection objectives and efficiency objectives only. It is important that they not deter new entrants unduly. Third, since market discipline will increasingly substitute for regulation, it is important to assure that both regulation and the regulatory staff are of a quality that is consistent with global standards. In terms of the former, increasing emphasis must be placed on market values throughout the regulatory process, and it is important to improve disclosure standards as well. Banks should be encouraged, if not required, to report their exposures to risk in terms of the market value of their assets, liabilities and off-balance-sheet positions. This will enable , creditors and shareholders to evaluate their and react accordingly. They should also be required to report on the risk management and risk control systems in place. The development and use of rating agencies should be encouraged. In terms of the latter, the quality and expertise of the regulation and examination staff must keep pace with the escalating standards of the global marketplace. In many respects the infrastructure of any regulatory regime is the people that enforce and oversee regulations that have been put in place by the political process. In this changing financial sector investments must be made in this infrastructure to insure that the regulatory staff are cognizant of global market trends and are capable of assuring the health of institutions under their regulatory mantle. The safety net will undoubtedly be subjected to substantial new strains before it can be taken down. The transition will be painful for regulators and for entrenched firms. But, the gain will be a much stronger, more flexible financial system that serves its at much lower cost. What Is Optimal Financial Regulation? Permissible banking activities and bank ownership in selected EU and G-10 countries: 1995 Country and (s) Unrestricted; conducted either directly in Permitted; sale of insurance products/ services may be Permitted; either conducted directly bank or through subsidiaries. conducted directly in bank, but underwriting must be done in bank or through subsidiaries, but limited to of the banks net Regulatory Commission, and Unrestricted; conducted directly in bank. Restricted; conducted as principal only through insurance Permitted; Investments in equity and subsidiaries, which are supervised by the Insurance real estate, calculated at book value, Insurance regulation does not allow may not exceed a banks liable any business other than insurance business being carried capital, but unlimited through out by an insurance firm. However, a bank may conduct insurance activities as agent without restrictions Unrestricted; conducted either directly in bank Permitted; sale of insurance products/services may be Restricted, generally limited to bank or through subsidiaries. However, for brokering conducted directly in bank, but underwriting must be done and dealing in securities listed on an Italian exchange other than Italian government and government-guaranteed securities, only through a special subsidiary. Firewalls are mandated. Restricted; only bonds (not equities) and only Restricted; generally limited to bank through securities subsidiaries. A bank can only (primary responsibility) own more than of a securities firm with permission from the and Fair Trade Commission. Unrestricted; conducted directly in bank or Permitted; bank may only directly sell insurance Restricted; generally limited to bank No firewalls mandated. products/services. However, both banks and insurance firms are allowed to form concern constellation (financial groups) as long as the two activities are conducted in different firms. Unrestricted; conducted either directly in bank Permitted; sales of insurance products/services may be Unrestricted; conducted either or through subsidiaries. conducted directly in bank, but underwriting only through directly in bank or through market making must be conducted through a However, the bank's investment in the No firewalls mandated. subsidiary must be deducted from the banks capital when calculating its capital adequacy if the bank ownership share in the subsidiary exceeds . Volym D:206 Bilaga 26 Permissible banking activities and bank ownership in selected EU and G-10 countries: 1995 Country and (s) Restricted, banks generally may engage in credit life and Restricted; banks generally are disability insurance underwriting and agency activities. restricted to investment in premises , Comptroller of the dealing in corporate debt and equity instruments National banks, in addition, bay engage in general or that which is necessary for the insurance agency activities in towns with less than 5,000 in transaction of their business. discount and full service brokerage as well as serve as agent for issues in privately placing State non-member banks are subject to the same restriction as national banks, unless the FDIC determines the activity would not pose a significant risk to the deposit insurance Bank holding companies may, on a case by case basis, be permitted to underwrite and deal in corporate debt and equity securities through a Section 20 subsidiary so long as the subsidiarys revenues for these activities do not exceed 10 percent of total gross revenues. Not applicable; permissibility is subject to Not applicable; permissibility is subject to home country Not applicable; permissibility is home country authorization and limited host subject to home country and host (A single EU passport exists.) What Is Optimal Financial Regulation? Permissible banking activities and bank ownership in selected EU and G-10 countries: 1995 Geographical Branching Restrictions on Supervisor(s) Commercial Banks within Country Unrestricted; Complies with EC Second Unrestricted, complies with the EC Second limitation a bank may own or the Regulatory Commission, and equity in any non-financial firm. Unrestricted; Complies with EC Second Unrestricted, complies with the EC Second Subject to this limitation a bank may own or the equity in any non- Restricted; more restrictive than the EC Second Restricted; more restrictive than the EC Second Most banks are subject to an Persons who engage in overall investment limit of of own funds significant business activity in sectors other than (in the case of unlisted firms) and to a banking and finance are forbidden from concentration limit of of own funds in each acquiring an equity stake which, when added to holding in non-financial firms or groups. those already held, would result in a holding banks, due to their size and proven stability, are exceeding of the voting capital of a bank or subject to less stringent limits (overall and in control of the bank. concentration limits of respectively and or leading banks, and and for specialized banks). principle of separation between banking and commerce is ensured by a further investment limit of of invested firms capital for all Restricted; a single banks ownership is limited Restricted; total investment is limited to firms to of a single firms shares, including other capital or net assets. banks (Article 9, Anti-Monopoly ). prohibits of a holding company whose main business is to control the business activities of other domestic companies through the holding of ownership. Volym D:208 Bilaga 26 Permissible banking activities and bank ownership in selected EU and G-10 countries: 1995 Geographical Branching Restrictions on Supervisor(s) Commercial Banks within Country Restricted; Investments on an aggregated basis Restricted; ownership is limited to except are limited to of a banks own funds. under certain circumstances when a bank is near Ownership in a firm is limited to of this insolvency and there is a need for external base (i.e. in a firm or group of firms In the latter case, greater related to each other). ownership may be permitted, based upon in a firm must not exceed of the total voting suitability of new owners. power in the firm concerned. not apply when a bank has to protect itself against credit losses. In this case the bank must sell when market conditions are appropriate.5 Unrestricted; complies with the EC Second Unrestricted; complies with the EC Second Yes (see adjacent Subject to this limitation, a However, a firm would have bank may own of the equity in any non- to make application to to However, an ownership share of become a shareholder controller and receive the more than requires that the investment be deducted from the banks capital when into the UK under calculating its capital adequacy on a risk basis. Otherwise, the investment is treated as a commercial loan for the risk-based calculation. Restricted; national and state member banks Restricted; a non-financial firm may make generally are prohibited from making direct equity investments in banks and bank holding equity investments in voting or nonvoting stock. However, the investment must not Comptroller of the Currency, Federal State non-member banks generally are limited exceed of the banks capital to avoid to investments that are permissible for national becoming a bank holding company. Bank holding companies are limited to words, banks may only be acquired by an investment not to exceed of a non- companies that limit their activities to those financial firms capital. deemed to be closely related to banking by the What Is Optimal Financial Regulation? Permissible banking activities and bank ownership in selected EU and G-10 countries: 1995 Unrestricted; the directive (Article 12) None (A single limits qualifying investments to no more than of a are fully regulated by banks own funds for investment in a single firm, and to no the authorities of the more than for all investment in non-financial firms. only on the suitability of EU member state in exceptional circumstances, these limits may be exceeded, but which they are situated the amount by which the limits are exceeded must be covered and do not have access by a banks own funds and these own funds may not be included to the single EU in the solvency ratio calculation. A qualifying investment is defined as a direct or indirect holding in an undertaking equal to at least of its capital or voting rights or permitting the exercise of significant influence throughout the EU. over its management. Source: Supervisory authorities in the listed countries provided information used to prepare this table. However, they are not responsible for any errors or misinterpretations. For exact information, one must consult the pertinent laws and regulations in the individual countries. For and , a source was (1995). Definitions: Unrestricted – A full range of activities in the given category can be conducted directly in the bank. Permitted – A full range of activities can be conducted, but all or some must be conducted in subsidiaries. Restricted – Less than a full range of activities can be conducted in the bank or subsidiaries Prohibited – The activity cannot be conducted in either the bank or subsidiaries. 1Securities activities include underwriting, dealing and brokering all kinds of securities and all aspects of the mutual fund business. 2Insurance activities include underwriting and selling insurance products/services as principal and as agent. 3Real Estate activities include investment, development and management. 4The EU members are (January 1, 1995), (original member), (January 1, 1973), (January 1, 1995), (original member), (original member), (January 1, 1981), (January 1, 1973), (original member), (original member), (January 1, 1986), (January 1, 1986), (January 1, 1995), and the (January 1, 1973). 5The Directive (Article 12) limits qualifying investments to no more than of a banks own funds for investments in a single non-f inancial firm and to no more than for aggregate investments in non-financial firms. In exceptional circumstances these limits may be exceeded, but the amount by which the limits are exceeded must be covered by a banks own funds and these own funds may not be included in the solvency ratio calculation. A qualifying investment is defined as a direct or indirect holding in an undertaking equal to at least of its capital or voting rights or permitting the exercise of significant influence over its management. 6The directive (Article 11) subjects qualifying investments to regulatory consent based only on the suitability of shareholders. Permissible banking activities and bank ownership in the EU and G-10 Somewhat Restricted Powers: Securities activities include underwriting, dealing and brokering all kinds of securities and all aspects of the mutual fund business.