sou · GOB311d5 · 2001-01-01 00:00:00 — This has led many to argue that financial regulation and the safety net itself needs some adjustments. Indeed, perhaps the entire approach to regulation needs to be reexamined to find a better way to obtain the benefits associated with a well functioning financial sector, but at a lower cost. What Is Optimal Financial Regulation? 5Optimal regulation in the static case: pricing risk to counter moral hazard Since the safety net distorts incentives for risk-taking by insulating institutions and their creditors from the full consequences of their risky choices, and the consequences are seen as quite costly, the challenge for optimal regulation is to increase market discipline. In principle, this may be accomplished in a number of ways–risk-rated deposit insurance premiums, least-cost resolution combined with prompt corrective action, a subordinated debt requirement or a narrow bank structure. In practice, none of these remedies is entirely satisfactory. 5.1Risk-rated deposit insurance premiums Ideally, the deposit insurer could set risk premiums for deposit insurance that would be identical to the premiums that depositors would demand if the safety net did not exist. In the US, the Improvement Act of 1991 (FDICIA) required that the () implement a system of risk-rated deposit insurance premiums. However, to date the result has been very crude. The maximum price difference between the safest and the most risky bank when the system was implemented was 8 basis points. This differential was far below the differential that would be charged in debt markets for such large differences in risk.23 It is also far less than the differences in actuarially fair insurance premiums estimated from option pricing models.24 Although the FDICs approach was especially crude, it is difficult to see how the ideal system could be implemented effectively. The deposit insurer faces two problems. First, the deposit insurer must be able to measure the banks current net worth, evaluate its risk exposure, and 23For example, the differential between B-rated and AAA-rated bonds is typically well over 100 basis points. 24Kuester and OBrien (1990), for example, estimated that fair premiums for most firms would be very low, less than 1 basis point, while a few very risky banks had fair premiums in the 1000s of basis points. Volym D:186 Supplement 26 assess how the banks net worth will vary under alternative scenarios. Such information is not currently available to the regulators and in view of the opacity of most banks, it would be very costly to obtain and verify. Second, the deposit insurer must be able to constrain the ability of the insured bank from increasing its exposure to risk after the deposit premium is set. This would require an ex post adjustment procedure to constrain moral hazard that has yet to be satisfactorily specified.25 5.2Prompt corrective action and least cost resolution FDICIA implemented yet another market-mimicking approach to countering the moral hazard incentive implicit in the safety net. The aim was to make sure that banks would not be able to operate without substantial amounts of shareholders funds at risk. 26 It attempted to reduce the scope for forbearance by replacing supervisory discretion with rules that would mimic the conditions that banks impose on their own borrowers when their financial condition deteriorates.27 The FDICIA rules are designed to stimulate prompt corrective action as soon as a banks capital position deteriorates. The regulatory sanctions become increasingly severe as a banks capital position declines from the well-capitalized zone down through three other zones to the critically undercapitalized zone in which the supervisor must appoint a receiver or conservator within 90 days. The objective is to provide the banks owners with incentives to take prompt corrective action by recapitalizing the bank or reducing its risk exposures before its capital is depleted. This is a strategy of deploying the termination authority in a way that substitutes for market discipline. 25Some researchers have argued that private insurance companies should provide some deposit insurance coverage. But private insurers would face the same challenges that the government insurer faces. Moreover, if the government continues to be concerned about systemic risk, its problem may shift from one of guaranteeing banks to guaranteeing private insurers of banks. 26One of the clear lessons from the S&L debacle in the is that losses surge as institutions become decapitalized and shareholders and managers are tempted to gamble for redemption. 27The fundamental analysis underlying this approach to bank regulation may be found in Benston and (1988) and Benston et al (1989). What Is Optimal Financial Regulation? FDICIA also attempted to end two other sources of distortion implicit in the safety net. The , like many other countries, has provided implicit deposit insurance for all depositors at large banks. This subsidy has been provided in two different ways. First is the practice of using purchase and assumption transactions in which the institution purchasing the assets of a failing institution assumes all of its liabilities. FDICIA reduced the scope for these transactions by requiring that the FDIC use the least costly method of resolution under the assumption that its only liability is for explicitly insured deposits. Second is the practice of extending lender-of-last resort assistance to insolvent banks. This provides uninsured depositors the time and opportunity to flee before the bank is closed. FDICIA attempted to deter such practices by depriving the central bank of the protection of collateral for advances extended to banks near insolvency. There is a major exception if the Fed and the Secretary of the Treasury agree that such advances are necessary to prevent a severe adverse effect on the national economy. Whether this will be a significant constraint on Fed behavior when a large bank is in jeopardy remains to be seen. But there is at least some reason to doubt that protection will be automatic and this should enhance market discipline. FDICIAs prompt corrective action measures are subject to the same problems as risk-rated deposit insurance. Both depend on accurate measurement of the economic value of a banks capital position and its potential risk exposure. At a minimum this would require adoption of a mark-to-market accounting system.28 Moreover, capital adequacy will need to be monitored in shorter intervals than in the past since a bank in derivatives markets can change its risk exposures drastically within a very short period. A rule that banks fulfill a specified part of their capital requirements with subordinated debt provides an alternative way to increase market discipline on banks. Subordinated debt is junior to all claims other than equity and so serves as a buffer against losses by the deposit insurer. Subordinated debt has some of the characteristics of patient money because it typically has a maturity greater than one year and cannot be redeemed quickly during a crisis. Subordinated creditors have strong 28 FDICIA called for accounting reforms that would move regulatory measures of capital closer to actual market values, but no real progress has been made. Volym D:188 Supplement 26 incentives to monitor bank risk-taking and impose discipline – provided that they believe that they will not be protected by the safety net in the event of failure. Indeed, their loss exposure is similar to that of the deposit insurer. They are exposed to all downside risk that exceeds shareholders equity, but their potential upside gains are contractually limited. In contrast to shareholders that may choose higher points on the risk-return frontier, subordinated creditors (like the deposit insurer) generally prefer safer portfolios and are likely to penalize banks that take significant risks. The price discipline of traded subordinated debt – which is actively traded in secondary markets – is a much quicker and perhaps more precise way of controlling bank risk taking than regulatory measures which are often blunt and cumbersome to deploy. A falling price of subordinated debt can alert other creditors about the condition of the bank or actions of the managers, creating a broader market reaction. Moreover, market prices are more forward looking than regulatory examinations and may provide regulators with valuable information on the markets perception of the risk taken by banks (Horvitz 1983). When bank risk increases unexpectedly, banks may not have to pay higher rates or face possible quantity discipline until their subordinated debt matures. For this reason, subordinated debt proposals generally require that banks stagger the maturities of their subordinated debt so that a modest proportion matures each quarter. In this way market discipline – through price and quantity sanctions – may be effective and informative, but sufficiently limited in magnitude to provide time for crisis resolution or orderly termination. Critics of subordinated debt requirements emphasize that subordinated debt holders would face the same informational asymmetry problems that the deposit insurer faces, but without the authority to conduct detailed examinations.29 They also question whether secondary markets in subordinated debt would be broad and deep enough to provide reliable price signals. 29 While disclosure practices are endogenously determined, one might expect subordinated debt holders to demand fuller disclosure. As (1995, p. 455) observes an outside risk sharer must be able to persuade institutional managers to open their books in ever-changing and nonstandard ways. What Is Optimal Financial Regulation? Another approach to correcting the distortion of incentives that arises from the safety net is to narrow the range of assets that the insured unit of a bank can hold so that the risk to the deposit insurer is essentially zero and so that whatever remaining subsidy inherent in the safety net does not spill out to distort other lines of business. Narrow bank proposals (Litan 1987, 1991, and 1995) require that insured deposits be invested only in short-term Treasury bills or close substitutes. Banks would also issue non-guaranteed financial instruments such as commercial paper to fund conventional bank loans, just as finance companies and leasing companies now do. Alternatively, most of the benefits of the transparency and simplicity of this approach could be maintained, while allowing greater flexibility in portfolio choice, if banks were permitted to hold not only short-term Treasury bills but also other assets that are regularly traded on well- organized markets and can be marked to market daily. This could be implemented in two ways: (1) the secure depository approach in which institutions would be required to form separately incorporated entities taking insured deposits and holding only permissible, marketable assets; or (2) the secured deposits approach in which insured deposits secured by a lien on a pool of permissible assets would be in a corporate entity holding other assets and liabilities (Benston et al, 1989). Capital requirements for the secure depository (or the analogous excess collateral requirements for secured deposits) would be set to ensure that the chance of insolvency between daily mark-to-market points is reduced to some minimal probability. This would, in effect, permit the termination function to be performed with the precision necessary to protect depositors and the deposit-insuring agency from loss. Critics argue that the narrow bank approach does not address all of the features that make banks special and especially vulnerable to systemic risk. Government might still feel compelled to exercise oversight over the other parts of financial institutions that provide credit to difficult-to-monitor borrowers and issue liabilities that substitute for lower-yielding deposits in the narrow bank. The commitment to constrain the safety net to the narrow bank might not be credible and thus the distorted incentives for risk-taking may continue. Volym D:190 Supplement 26 6Looking beyond the static view: Banks have become less special The case for regulation of banks to safeguard against systemic risk rests on the argument that banks are special. This stems from their central role as providers of credit, as repositories of liquidity and as custodians of the payment system which gives them a balance sheet structure that is uniquely vulnerable to systemic risk. Indeed, in most countries, banks retain a central role as the most important providers of credit. (See Figure 2.) Banks share in financial intermediation, 1994 Source: , Annual Reports and Financial Statistics. The one exception is the , where banks have experienced a marked decline in their share of the assets held by the financial sector.30 Although this declining share is often assumed to be a recent phenomenon, in fact the trend was apparent in the 1920s. Indeed, the 1920s were an era much like the last two decades in which the share of assets held by banks declined and that of pension funds trusts and investment companies grew. In the broader historical context the anomaly may have been the relative stability of the bank share of total assets from the 1940s through the mid-1970s. Figure 3 offers some evidence of this for the US case. 30 and Santomero (1997) present evidence of a trend away from bank finance in other leading countries. What Is Optimal Financial Regulation? Relative shares of total financial intermediary assets, 1900-1995 Q4 Pension, Trust, and Source: Federal Reserve Bulletin, 1995. The reasons for this long-term trend and its recent acceleration are, no doubt, numerous. However, technology is clearly an important force. Advances in technology have led to innovations in financial instruments and institutions that have blurred traditional product-line boundaries that formerly distinguished banks from other financial institutions. The ability to call up information cheaply at any time from virtually any location has enabled other financial institutions to design new products that compete effectively in terms of price and quality with traditional bank products. Regulators have generally responded to these developments by liberalizing some of the regulatory restrictions that constrained competition among banks and between banks and other financial institutions including foreign financial institutions. The impact has been most dramatic on the asset side of banks balance sheets. The increased institutionalization of consumer savings, especially in pension plans, life insurance and mutual funds, has given other institutions the scale to assess and diversify credit risk in competition with banks. Improved disclosure standards have made information regarding the creditworthiness of borrowers, which was once the proprietary domain of bankers, publicly available. Credit-rating agencies have grown in importance and perform the kind of analysis that was once the comparative advantage of banks. Moreover, when credit rating agencies have turned their attention to banks, they have often concluded that banks are less creditworthy than many of their prime borrowers. Volym D:192 Supplement 26 Commercial and industrial loans as a share of short-term business C & I Loans Source: of System, Flow of Funds accounts, 1998. The decline in the role of banks as intermediators of credit risk has been most pronounced in a US context with regard to business finance as Figure 4 indicates. Banks have lost ground to other, less regulated intermediaries such as finance companies and to securities markets, especially the commercial paper market and the high yield securities market. Indeed, some cynical have asserted that the typical bank loan is simply a less liquid, under-priced junk bond. The decline in business lending is also mirrored in consumer lending. (See Figure 5.) Banks have lost market share to nonbanks such as AT&T, GMAC, GE & . Twenty years ago, banks completely dominated the card-transactions processing business. Now, banks hold less than of receivables and close to of credit card transactions are processed by nonbanks such as First Data Resources.31 Increasingly, nonbank, single-purpose providers have successfully competed for some of the most profitable traditional bank products. The development of securitization techniques has transformed the way in which many kinds of credit transactions – which would previously have been conventional bank loans – are structured. 31 See , 12, 1995, p. What Is Optimal Financial Regulation? Bank market share of credit card receivables, 1986-1998 The growing importance of securitization is especially obvious in the transformation of the traditional mortgage. (See Figure 6.) Formerly, a bank originated, funded and serviced the mortgage until it was repaid. Now one firm may originate the mortgage. Another firm may fund the mortgage or pool the mortgage with others and partition the anticipated flow of income from the pool into marketable securities that will appeal to particular groups of investors around the world. Another firm may insure the pool of mortgages to facilitate this process. The servicing of the mortgage may be allocated to yet another specialist firm that has data processing expertise. The consequence is that mortgages will be funded at lower cost than if firms were obliged to hold mortgages to maturity and what was once an illiquid bank asset is transformed into a highly marketable security. This unbundling can be executed so smoothly that the mortgagee may be entirely unaware that it has taken place. These techniques have been successfully applied to many other kinds of credit transactions including credit card receivables, auto loans, and small business loans. Volym D:194 Supplement 26 Securitized mortgages as a percent of total mortgages, 1980-1998 Source: of System, Flow of funds accounts, various years. Banks are also losing ground on the liability side of their balance sheets. As the baby boom generation matures and inherits wealth, consumer demand will shift from credit products to savings products. This trend is apparent in most industrial countries. In the over the next twenty years the population under age 50 will remain the same as it is today, but the population older than 50 will double. The traditional bank entry in the competition for consumer savings – the time and savings account – is deservedly losing ground to mutual funds that have much leaner cost structures and can offer higher returns.32 Bank time and savings deposits have declined steadily relative to fixed-income mutual funds since 1980. (See Figure 7.) 32 See Santomero and (1998) for even more evidence of this trend away from banking institutions. What Is Optimal Financial Regulation? Bank time and savings deposits decline relative to fixed-income mutual Source: Fact Book, 1998; and , Historical Statistics on Banking, 1997. New technology – often introduced by nonbanks – is jeopardizing even the fundamental role of banks in facilitating payments. (See Figure 8.) Checkable deposits decline relative to money market mutual fund Source: Fact Book, 1998; and , Historical Statistics on Banking, 1997. Many mutual fund families and most brokerage houses offer cash management accounts that permit individuals to arrange for their salaries to be automatically deposited in their cash management accounts from which routine payments can be made automatically and irregular payments may be made by phone twenty-four hours a day. Volym D:196 Supplement 26 checks may be drawn on the money market account. In addition, money market accounts can be linked to a credit card that also functions as a debit card at automated for cash needs. Although payments through the account are cleared through a bank, the role of the bank is a regulatory artifact, not an essential, unique part of the transaction. Looking ahead, it is not clear how retail will want to deal with their banks in the future – or, indeed, whether they will want to Net interest income less charge-offs as a percent of financial sector Source: Survey of Current Business; and , Historical Statistics on Banking, 1997. deal with banks at all. It is clear that retail customer want ubiquitous access, speed and reliability. Channels for delivery of banking services are proliferating and some by-pass banks altogether. Cyber cash or e-money is the most revolutionary concept. In principle, money can be downloaded to a personal computer or a palm-sized electronic wallet or smart card and used to make purchases over the internet or even from on the street. Banks retain the advantage – due in part to deposit insurance – of consumer trust, but other firms – e.g. software, telephone or cable companies – may have advantages that will prove to be more in the world of cyber cash. In view of the declining role of the traditional intermediation business, it is not surprising to see the importance of net interest income to both the banking sector and the economy as a whole has fallen in the What Is Optimal Financial Regulation? (See Figure 9.) Because this decline in the intermediation business is economically motivated and technologically driven, it is likely to be both irreversible, and global in impact. Although the intermediation business has declined, banks have managed to nonetheless by shifting from traditional intermediation functions to fee producing activities such as the trusts, annuities, mutual funds, mortgage banking, insurance brokerage and Noninterest income as a percent of financial sector GDP 1977-1997 Source: Survey of Current Business; and , Historical Statistics on Banking, 1997. (See Figure 10.) Notwithstanding the constraints on allowable bank activities in the US, imposed by the Glass-Steagall Act and the , banks have managed to develop new lines of business to compensate for the decline in the traditional intermediation business. Overall, banks are holding their own, (see Figure 11), but with a very different configuration of earnings.33 Spread income accounted for about of bank earnings only a decade ago. Now most large regional and money center banks earn more than half their income from fees and trading income. 33 and Gertler (1994) emphasized this point. Volym D:198 Supplement 26 Bank value added as a percent of financial sector GDP, 1977-1997 Source: Survey of Current Business ; and , Historical Statistics on Banking, 1997. The result is that banks are markedly less special in the than they were even a decade ago. They are no longer the primary source of business and consumer finance. Neither are they the main repository of liquid savings for the financial system. They do remain custodians of the payment system and for that reason concerns about systemic risk persist. The principal source of concern is what Flannery (1998) has described as credit-based mechanisms for the exchange of large-value payments. The problem is that many (but not all)34 national payment systems permit banks to run substantial overdrafts in the process of clearing and settling payments. In effect, the systems rely on the equity of participating banks to control default risks and, failing that, the willingness of governments to intervene and support the system in the event of crisis. has attempted to measure and quantify exposures that result from settling foreign exchange transactions. The Allsopp Report (BIS, 1996) concluded that exposures could exceed three days worth of trades with 34 , , and the new TARGET system for clearing and settling euro payments operate without permitting participating banks to run overdrafts. SOU 2000:11 What Is Optimal Financial Regulation? exposures to a single counterparty in excess of a banks capital.